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Surging European leveraged loan demand clears way for add-on deal rush

Capital Markets View – February 2021

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Surging European leveraged loan demand clears way for add-on deal rush

A combination of strong investor demand in the European leveraged loan market and an absence of new debt being originated means the final weeks of 2020 are providing an ideal opportunity for private equity sponsors to tap into that demand with add-on requests backing existing names across their portfolios. Add-on loans allow borrowers to increase their loans either through an existing or new tranche.

This activity stepped up in October when 11 add-on deals launched for a total of €1.36 billion, or roughly 30% of the overall loan volume. Levels stepped down a little through November, but add-ons still accounted for roughly 26% of total loan activity in that month, according to LCD. Indeed, add-ons could now well be the major source of new loan supply for the remainder of 2020, as the year's launch window closes for brand new borrowers to launch a full two-week syndication process.

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So far this week, CeramTec GmbH has hosted a bank meeting for a new deal, which followed on the heels of add-ons from SYNLAB International GmbH, DomusVi SAS, AVS Group GmbH and TERREAL SAS last week. “These are win-win trades,” said one senior banker at a transatlantic firm. “Investors get some much-needed paper and borrowers get quick opportunistic financing.”

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Clear opportunity
For sponsors, the opportunity is plain to see. On the supply side, there was a clear-out of primary deals and secondary inventories ahead of the U.S. Presidential election on Nov. 3, as banks prepared against volatility coming from an uncertain result. Investors too have seen a meaningful flow of repayments in recent months, as sponsors have taken advantage of strong markets to exit some holdings either through a public listing or trade sale. KKR, for example, listed defense electronics group Hensoldt AG in September, in a deal that brought a full repayment of the firm's €920 million leveraged term loan.

On the demand side is issuance from the CLO market, which is the predominant investor segment in leveraged loans. CLO supply has easily surpassed volume expectations at the start of the COVID-19 crisis, to reach €20.5 billion for the year to Nov. 27. This tally falls well short of €29 billion of CLO issuance at the same point last year, but is through predictions made as markets tanked in the spring, when analysts from banks such as Barclays slashed their outlooks for 2020 to €13 billion to €15 billion. Overall then, this combination of higher-than-expected CLO issuance and lower than hoped for loan issuance has left LCD's measure of technical market pressure (on a rolling three-month basis), which essentially tracks supply and demand, flashing red since June.

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November also brought a late-month flurry of CLO pricings, which has put further pressure on the technical picture. This is because CLOs tend to be ramped by 40% upward at pricing, and then look to take this figure up before final closing. “A typical CLO warehouse may look to primary in its first stages, but once the vehicle is priced, then it will probably need to go to secondary to finish the ramp,” said one manager, adding there is little incentive to hold on to cash at the moment, given few expect pricing to weaken in the coming weeks. Another manager agreed, though cautioned that any delays to a vaccine rollout could bring further volatility in the new year.

Either way, secondary levels have risen sharply since Pfizer Inc. announced the result of its COVID-19 vaccine trials in November. This boost was maintained all through the month, with the average bid on the S&P European Leveraged Loan Index, or ELLI, rising in every session save three days in the month. Returns for the year also turned positive during November to reach 1.84% (excluding currency) by the end of the month, with the average bid on the ELLI now less than 1.5 points away from its yearly highs reached in January. “The strength is totally unexpected,” said a manager at a major global house. “It's been a truly bizarre end to a bizarre year,” they added, noting that difficulty in sourcing loan supply was perhaps the last problem they expected to face back in the spring.

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Discount sellers
In this context, add-ons provide lenders with the opportunity to add paper from existing names at a discount to actual secondary trading levels. Bankers explain that these deals now tend to price in a similar fashion to bonds in that launch yields take their cue from secondary prices, with guidance tending to come at a slight discount to these levels. “It is not simply a matter of looking at a 2x2 quote from a dealer, but secondary provides a good starting point,” said one manager, who added that issues such as time-to-funding are also taken into consideration — especially if a sponsor is looking to finance a tuck-in acquisition. Not all add-ons are fungible, and a sponsor can opt to offer a separate tranche with a higher margin if they feel the discount needed to meet investor yield requirements is too deep. “Sponsors will always prefer to offer yield through margin rather than OID,” a banker explained. “They can never get the OID back, but they can always reprice the margin when conditions improve."

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But the strength of today's market means the discount required is inevitably getting squeezed as the focus from syndication of the new tranche helps in turn to push up secondary pricing on the existing loan. Zentiva NV is a case in point. The Advent-backed generics firm went out with a €100 million add-on to its E+400 September 2025 term loan — which now stands at more than €1 billion — at an initial offer price of 98.50-99. This was at a discount to the secondary quote at the time of 99/99.875, but as the book for the new deal built, so the price on the existing facility moved up, which in turn pushed the add-on tighter too. In the end the deal closed with a book that was multiple-times covered, allowing an increase to €125 million and a final offer price of 99.50. This compared with a secondary quote around pricing of 99.5/100, meaning the deal effectively priced at the bid. The offer subsequently moved up further.

This trend has been in play across several deals over the last few weeks, with Terreal, AVS and Synlab among those to have priced inside of initial guidance. This also reflects a general tightening of OIDs, that initially started to move inwards for “must-have deals” through the autumn, before benefiting all deals as markets tightened through November. In October eight deals allocated below 99, including Babilou at 95.5, while just three of an albeit smaller number of syndications allocated below this figure in November, to a low figure of 98.5.

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Back to the future
For the moment, few think there is any reason why these trends cannot continue into 2021. So far indications suggest the year will start with a relatively full calendar of new-money underwrites, though it remains an open question whether this will bring the number of decent-sized liquid deals needed to sate demand in Europe's CLO community. Indeed, a step up in activity will almost certainly bring back managers that have slowed or even paused their ramp in the hope of improved supply.

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Either way, the technical is likely to encourage sponsors to consider a wider range of purposes when adding debt. So far, the focus has been using add-ons to support strategic acquisitions or for refinancing of revolver or subordinated debt rather than dividends or recapitalizations, and this dynamic has taken both the volume of add-on recaps and its share of total markets to nine-year lows. Among recent transactions, only INEOS Group Ltd. and AVS Group have gone out with a dividend deal either as a single tranche or as part of a wider financing request.

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But as markets continue their recovery, bankers and investors agree it is only a matter of time before dividend deals return. As ever, the prospect of such deals elicits mixed responses. For some the market risks getting ahead of itself here, meaning it is still too early to be relevering assets given the risks that remain from a pandemic that is not over, while others are more relaxed. “If a credit has performed well and delevered then I don't have a problem if a sponsor wants to return and take some cash off the table,” said one manager. Another agrees, but cautions this is all down to whether the business involved is "the right credit," adding that borrowers also need to demonstrate that their performance is not down to one-off factors related to the pandemic. “Some credits have benefited from the disruption through the summer, but that may be just a one-off as conditions normalize again next year,” concludes the source.