Vice-like technicals keep pressure on European leveraged loan terms

Technical factors rather than fundamentals are driving terms in Europe's early year leveraged loan market, partly on the back of a spurt of CLO issuance last year that helped push loan demand well ahead of supply. A reasonable pipeline of new loan deals should help meet some of this need over the coming month or so, but sources say this supply is unlikely to be enough to shift the balance away from borrowers' favor.

Under some measures, the market at the start of 2021 looks remarkably similar to that seen at the beginning of 2020, when COVID-19 was a problem impacting Asian countries and had yet to bother Europe beyond some concerns over supply chains. Then this January, the emergence of vaccines has made all the difference: "The vaccine roll-out created the light at the end of the tunnel and the market is now firmly positioned for a full recovery," said a fund manager. The S&P European Leveraged Loan Index, or ELLI, provides a case in point here, with this measure now quoted less than half a point away from its 2020 high reached in January last year, meaning the Index has retraced almost all its lockdown losses, which saw it fall by roughly 20 points from peak to trough.

Central banks have backstopped this recovery, which in turn has given managers and banks the confidence to invest and put capital to work. “Central banks have made it clear that they will do whatever it takes to underwrite this recovery and, at this stage, no one is talking about tapering or withdrawal of support,” said one banker.

The scale of this intervention ensured the market has not lacked for cash over the past year. "Any company that needs liquidity at the moment can get it, whether that is from the syndicated market, revolver lenders, distressed players or governments," said a manager at a global firm. "Whether sponsors like the terms of this liquidity is another matter — but it is there." Another manager agreed, adding that this access to cash means investors are increasingly looking through the EBITDA hit from the remaining months of lockdown for COVID-19-exposed borrowers, and ahead to reopening in the spring and summer.

Default rates

Either way, the access to funding has helped keep the default rate at a much lower level than many had feared as the first lockdowns spread across Europe in the early spring of last year. Of course, these predictions may yet be borne out (S&P Global Ratings expects the European trailing 12-month speculative default rate to rise to 8% by September, from 4.3% in September 2020), but for the moment at least, few appear concerned about any disruption. "The technical is a fact and as a manager you have to accept it and work with it," said one account of the strong demand in the market for European leveraged loans. "But there are still plenty of credit considerations and a lot of companies remain under significant pressure," he added.

This market confidence has not yet brought a corresponding rise in new leveraged loan issuance, however. Despite pockets of activity through the second half of 2020, year-end deal volumes were lackluster, leaving the total European loan volume down for the third year in a row. The loan tally also compared poorly with other asset classes, and especially European high yield — where activity rose to a three-year high in 2020. In response, sources note that fixed income is the primary beneficiary of central bank action, as the crushing of investment-grade yields has sent investors into higher-rated sub-investment-grade deals in the search of returns.

The disappointing loan issuance was not due to any lack of demand, however. Indeed, the end of the year brought a rush of pricings from CLOs (the predominant investor segment in leveraged loans) that in turn delivered a considerable slug of fresh liquidity, much of which ended up flowing through to the secondary market. "The number of CLOs that priced at the end of last year sent the technical in secondary to painful levels," said a manager. For CLOs in Europe, the last quarter of the year was easily the busiest of 2020.

The pace of CLO issuance is likely to slow in the first quarter of 2021, but sources say there are more than 40 open warehouses now active in the European market. Other inflows from sources such as managed accounts are said to be more modest but remain an important factor, bankers note. Managers have also had to deal with a steady stream of repayments over the past few months that shows little sign of slowing just yet. The first quarter, for example, is expected to bring some multibillion, though well-trailed, repayments from borrowers including Refinitiv US Holdings Inc., Nets Holding A/S and Paysafe Group PLC.

Opportunity knocks

The financing opportunity is therefore clear. "Issuance conditions are near-perfect for borrowers at present," said one arranger. Indeed, H&F-backed alarm monitoring group Verisure Holding AB (publ) highlighted the scale of this opening last week, when it blasted through the market with a roughly €4.4 billion recapitalization that came with a €2 billion seven-year loan (in a financing that priced Jan. 15).

The loan cleared the market with ease, closing ahead of schedule at a final margin of E+350 with a 0% floor, which compared with initial talk of E+375-400. Demand carried on into the secondary market, where the deal freed to trade some 50 basis points through a 99.75 reoffer into a 100.25/100.75 market, where it has so far managed to hold amid brisk trading, sources add.

Indications already suggest that Verisure's performance could be just the prelude to a round of borrower-friendly deals, according to bankers. "Loan pricing is tied in with the CLO arbitrage [the spread differential between a CLO's assets and liabilities] but I think we have further to go in terms of pricing," said one arranger. Indeed, Verisure's loan priced outside a concurrent bond offering that came at 3.25%, and the final margin was probably at least 25 bps away from what the B/B2 rated borrower could have achieved pre-lockdown.

In its inaugural Global Credit House View published this week, Investcorp Credit Management noted that it expected further pressure on margins in the first quarter, adding "as is usual with the European market, there will be a floor driven by the CLO market especially given the current need to optimize CLO equity returns." Sources add that normalized markets mean CLOs are now able to better manage these margins through barbell strategies, cautioning that further pressure on yields could nevertheless be uncomfortable for vehicles that reopened the pandemic market at higher liability costs. "All vehicles that priced around 220-240 bps [on the WACC] will have to reset or refinance," comments one manager. That said, other managers note there is evidence of strong demand for CLO liability paper, meaning yields will also be under pressure in that market too. "Triple-A CLO tranches offer good value against other similar assets," said one banker.

The secondary market could also have further to tighten, managers say. This is because while the ELLI is close to pre-pandemic levels, there are still far fewer credits trading at par-plus levels than a year ago. The market has already seen upward pressure on B-/B3 names this year, while there has been further positioning in COVID-19-exposed credits. "No one wants to be underweight and miss out on another rally," said one investor. The strength in lower-rated single-B names, meanwhile, reflects the work funds have done to address ratings-based WARF tests that have in turn been helped by higher-than-expected secondary prices. "A lot of outlook downgrades to negative have either been reversed or even put on to positive, and this has put a floor under the WARF," said a manager.

Given this technical backdrop, other borrowers are already lining up to follow Verisure, and this week saw French labs group Biogroup LCD launch a €2.5 billion refinancing of its capital structure that will bring a €1.40 billion to €1.65 billion loan component. This will, however, likely represent a net repayment for loans as Biogroup also plans to expand its capital structure into secured and unsecured bonds. Others on their way for a near-term launch include Klöckner Pentaplast GmbH, which is pre-marketing a refinancing deal ahead of 2022 maturities, according to market sources.

Fresh blood

But beyond like-for-like refinancings or recaps, what investors want to see are new deals, agree arrangers. "The buyside wants to see new buyout names brought to market," said one banker. And for sure, there are some large deals on their way to market — not least from the roughly £3.5 billion drawn financing supporting the carve-out of British supermarket group ASDA from Walmart. Others waiting in the wings include a euro portion of the debt backing Advent's carve out of Nielsen's Global Connect business, and the debt from Warburg Pincus-backed Allied Universal Corp's acquisition of London-listed security group G4S PLC.

While such activity points to a considerably quicker pace of issuance than was seen in the final months of 2020, it is still not as fast as many would like. "Given conditions are so borrower-friendly I would like to have a better pipeline than I do," said one arranger. Similarly, one investor source was relaxed about the ability to meet the coming deal flow: "The calendar has been pretty well flagged for Q1'21 and I suspect the market will take primary in its stride," he said, adding that liquidity is such that large deals would bring no more than patchy or temporary weakness in secondary, given the vast demand for new issuance.