Charlotte Conlan, head of leveraged finance at BNP Paribas

The secretive nature and narrow investor base of the European leveraged loan market meant it was hit harder and is taking longer to recover from the downturn than its counterpart in the US. There is a general consensus that Europe needs to open up its markets, improve transparency and introduce public ratings. Writer Charlie Corbett

The leveraged loan market was at the centre of the credit-driven boom. Banks and investors tapped into a rich seam of demand that led to a bonanza in fees and quick profits. It seemed at the time that private equity funds were taking over the world, and banks were more than happy to provide the cheap debt to finance their ambition. Investors flocked to the deals in the guise of hedge funds and special investment vehicles and provided abundant liquidity.

Fast forward to today and the sector is a shadow of its former self. Volumes for leveraged loans have collapsed, deal flow is non-existent and banks have spent the past 12 months restructuring debt, issuing waivers and soaking up defaults rather than focusing on finding new business.

False alarm

Hopes of a revival in the industry were raised after Anheuser-Busch InBev agreed a deal to sell its beer brands in eastern Europe to private equity firm CVC, but they were soon dashed. As The Banker went to press, a deal that could have signalled the partial resurrection of the leveraged buyout (LBO) market was snuffed out. The £765m ($1.25bn)transaction to buy the UK bus and rail operator National Express fell apart after the consortium that was due to buy it got spooked over the terms of the refinancing of the company's debt. This is indicative of a wider malaise in the sector.

According to research firm Dealogic, global leveraged finance volume collapsed by 49% in the first nine months of 2009 to $392.4bn, compared with the same period last year. With bank lending tight, the figures also reflect the growing attraction to companies of the high-yield bond market over the leveraged loan market. High-yield bonds made up 29% of total leveraged finance in the first nine months of 2009, up from just 6% in the same period last year. In fact, the collapse in leveraged finance volumes has been driven by a collapse in leveraged loan volumes, which fell 61% in the first nine months of this year. High-yield bond volumes, on the other hand, soared 137% during the same period.

Private equity sponsors that had initially driven the boom in LBOs have spent the past year licking their wounds and struggling to keep their companies afloat. Their portfolios are crumbling, and war-weary, limited partners are pulling back their investments with charred fingers.

European gloom

Europe's leveraged loan bankers have been hit particularly hard. Ratings agency Standard and Poor's (S&P) has estimated that the default rate among a selected portfolio of European speculative-grade companies could hit 15% in the second half of 2009. A survey of the same portfolio of companies showed that there were 48 defaults in the six months to June 2009, up from just six in the same period last year.

The story is not much better for those companies that have survived the economic downturn intact. S&P found that the earnings growth, which sponsors hoped could be used to pay down debt, was grossly overestimated when many of the LBO deals were signed before the crisis. The ratings agency's latest survey of leveraged loan performance found that 45% of European speculative-grade companies that had been through a leveraged buyout were more than 10% behind original forecast earnings before interest, taxes, depreciation and amortisation.

Recipe for disaster

According to Taron Wade, senior research analyst in leveraged finance at S&P in London, the market in Europe fell apart far more than it did in the US. "Before the 2003/07 European leveraged finance boom, the market in Europe was small, private and dominated by bank lending. It was not operating as a true capital market, but starting in the early 2000s a rush of new money arrived in the form of CLOs [collateralised loan obligations] and hedge funds."

It was this money, alongside giant investment bank-backed mezzanine funds, that pumped liquidity into Europe's leveraged loan industry and created a false sense of security. When the crisis took hold, the investors dissipated and liquidity rapidly left the system. In the US, however, the investor base for leveraged deals was far broader, encompassing large institutional investors such as mutual funds and pensions funds, both of which were absent in Europe's more closed market. "We need a wider range of investors and more transparency," says Ms Wade. "The US market is recovering more quickly than the European market simply because it is more transparent and there is more public disclosure."

Michael Sheren, head of leveraged finance at Calyon in London, agrees. "Most leveraged loans in the US have public ratings and most make the inter-creditor and other documents public, this makes for transparency within the market," he says. "This is not true of Europe, which remains almost exclusively a private loan market. The private equity investors have preferred smaller, more manageable syndicates and many of the investors have liked access to private information." Many see Europe's culture of secrecy as a key reason why its markets fell further and are taking longer to recover than the more mature and open leveraged loan market in the US.

Market closure

While public attention focused firmly on the evils of collateralised debt obligations (CDOs) as the financial crisis gripped the world's financial markets, not much attention was placed on their, in many cases, equally toxic cousins, the CLOs. Based on a similar concept to the CDO, CLOs came to dominate Europe's leveraged loan market.

According to one leveraged finance banker, CLOs went from being almost non-entities in 2002 to being 50% of the asset holders in the market in 2007. This was a sea change from the past, when most debt had been traditionally held by banks. "CLOs were like rats breeding, they were everywhere," he says. "Then you had the hedge funds in between, plus giant mezzanine funds. It was something we had never had before in Europe." For Mr Sheren, however, the warning signs were all too apparent. "You could see clearly that if anything went wrong, there was going to be a problem because the wall of liquidity was going to dissipate considerably. We had no escape valve - in the form of a [true] secondary market."

Once the music stopped, the market could only go one way. Although a secondary market for leveraged loans did exist in Europe, it was never particularly liquid. In the good times, buyers could be found, but when the market went to the wall, most European investors in leveraged loans chose to sit and hold, rather than trade out of their positions. If Europe had had a true secondary market then investors could have sold out at the first hint of danger. Or in the words of one loans specialist: "You're not stuck in a house with the doors locked from the outside."

There was no impetus for CLO funds and banks to sell because they were not prepared to take an immediate hit on their bottom lines, when they could just as easily keep hold of the bad loans and hope for the best. As a result, prices for leveraged loans on Europe's secondary market fell as low as 60 cents in the dollar at one point, down from an average of 101 at the peak of the boom.

According to Charlotte Conlan, head of leveraged finance at BNP Paribas, this reflects a fundamental difference between the US and Europe. "In Europe, post the collapse of the market in summer 2007, much of the debt was simply retained by the underwriter, whereas in the US, with a clear mark-to-market dynamic, the investment banks were forced to be a lot more pragmatic about their exposure from an early stage," she says. Banks in the US bit the bullet in the summer of 2007 and sold at 90 cents or 80 cents in the dollar, while in Europe they hung onto the loans.

Loan fever

Like all bubbles, the leveraged loan market boom was driven by the desire to make fast profits. According to one leveraged finance specialist, the traditional way of doing business was thrown to the wind. "Traditionally the goal was to buy undervalued companies at the best price with lots of leverage, turn the company around and sell it on in three years. In the last boom, nobody held onto the assets for long enough," he says. "A lot of younger guys entered the market that were good at financial engineering, but did not know how to create value in the companies they bought. After all, what would they know about how to run a widget factory in northern England?"

Banks and CLO funds saw huge opportunities in funding leveraged deal upon leveraged deal. Fees were lucrative and demand was high. "Everybody had an easy ride. Every time there was a refinancing, the banks made another set of fees," says the source. He quotes an investment banker at the height of the boom: "There is only one question asked of us, can you shift it? I don't care how badly it is structured, just push it out the door." For the CLO funds, it was a case of populating as many vehicles as possible, getting the fees and creating another one.

The market eventually collapsed because investors ended up using short-term financing, such as 365-day commercial paper, to buy long-term assets with maturities of up to seven years. "I don't care who you are, if you're buying long-term assets and you're putting short-term financing in place, that is just an absolute recipe for an unmitigated car crash," says one financier.

Bumbling along the bottom

Looking ahead, the leveraged loan market is showing some signs of life. "It has been a year of waivers and restructurings in an attempt to minimise losses, rather than a year of new business," says Ms Conlan. "But the rate of restructurings occurring has started to slow and investors and arrangers are starting to come out of the bunker and position themselves for 2010."

Mr Sheren is equally cautious in his optimism: "Twelve months ago the leveraged loan market was about as bad as it has ever been, following the collapse of Lehman Brothers. However, since then it has improved significantly with liquidity slowly coming back," he says. "It will most likely be a low-trajectory comeback unless we are unlucky and the economy heads down into a W [-shaped recession]. Otherwise, I suspect we are now bumping along the bottom and have begun the long task of building back to the volume levels of the past."

Mr Sheren talks of more liquidity emerging in the market as a result of a resurgence in the bond market and an increase in appetite for initial public offerings. For the first time since the nadir of the crisis, bankers are beginning to be able to pick out the wood from the trees. "Almost all of the fast and hot money has left the EU market, hence, there is more stability among those who do have liquidity," he says.

For BNP Paribas' Ms Conlan, the future of the market rests on two critical questions: is the money out there and is there a willingness to invest it? "In terms of the leveraged debt market, investors are starting to call us now, looking for new opportunities, and that hasn't happened for 12 months," she says. Some interest is returning to the leveraged loan market, but having had their fingers burnt once, will some banks just not come back at all?

One of the secrets of the success of the leveraged loan market at its peak was the international nature of the bank groups. Since the onset of the recession, however, banks have reined in their international aspirations and focused on domestic markets that they know better and feel more comfortable with. According to Ms Conlan, banks will be far more circumspect in the future. "The nationalistic lending tendency is slowly starting to ease on the investment grade side, but much less so the leveraged loan side."

This caution was highlighted in the two major deals that emerged this year in Europe. Both the Anheuser-Busch InBev deal and the failed National Express deal were arranged on a club basis with no underwriter. According to Ms Conlan, the club deal - where banks all invest at the same level with no underwriter or arranger - was the only structure that would keep the handful of banks that were prepared to lend happy. "Justifying use of capital is critical, banks will only lend to support their own deals and then only on an equal basis," she says.

Call the underwriter

Before the leveraged loan market in Europe can open up again in any meaningful way, banks have to be prepared to underwrite deals again. Ms Conlan says, however, that this is an unlikely event in the near future because banks want the option to change, or flex, the pricing before a deal closes, while sponsors want a price locked in at the outset. "Because the deals that have closed this year have been club deals, no market clearing price has been established because there has been no broader distribution," she says. "In the absence of a market price, arranging banks will err on the side of caution [before agreeing to underwrite a deal] and need the protection of a likely large flex."

It is clear to most in the market that underwriting will only come back when flex levels become more acceptable to sponsors or the level of confidentiality required means the club approach won't work anymore. Ultimately, however, Europe's leverage loan market needs to rebuild itself along different parameters to those that sustained it in the past.

"The market in Europe needs to go through some structural changes," says Ms Wade. "For a mainstream capital market to develop, the culture of privacy must change and investors need to demand commensurate returns for the risks they take."

Syndicated Leveraged Loan Volume, 2000-09

Syndicated Leveraged Loan Volume, 2000-09

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