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When The Cycle Turns: How S&P Global Ratings Reflects Increased Risk In The European Leverage Finance Markets


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When The Cycle Turns: How S&P Global Ratings Reflects Increased Risk In The European Leverage Finance Markets

The leverage finance market continues to be of particular interest in 2020. Because we are deep into the economic cycle, there are three key areas where S&P Global Ratings believes investors should remain vigilant:

  • The weakness of documentation is unprecedented, and could weaken debtholder protection.
  • Many view the magnitude of pro forma EBITDA add-backs as adding credit risk.
  • Leverage levels remain high.

For those looking to analyze the risk in buying debt in the sector, European leverage finance ratings are a useful tool because they reflect our expectations of increasing default risk, both for existing and new debt. They also reflect our expectations that recovery, following default, will be materially lower than empirical evidence might otherwise suggest.

Weaker Loan Documentation Has Led To Lower Recovery Expectations

The steady erosion of senior lender protection in loan documentation is well recognized. The lack of any effective maintenance financial covenants, erosion of the guarantor group, creation and upsizing of "freebie buckets" (clauses that allow new pari-passu debt without senior lender approval), less frequent financial reporting, and restrictions on transferability are key changes. (For more information, see "When The Cycle Turns: Assessing How Weak Loan Terms Threaten Recoveries," published Feb. 19, 2019, on RatingsDirect.)

Without effective financial maintenance covenants, an underperforming company has no covenants to trigger, and lenders have much less ability to demand changes to protect senior debtholders. Therefore, a company might underperform for longer, delaying default and potentially reducing recovery to lenders.

Historically, the group companies that guaranteed senior debt would typically represent all or almost all of the asset holding or revenue generating operating companies. This has evolved into language that typically states that at least 80% (sometimes less) of "eligible" group companies provide guarantees. In practice, this can leave valuable businesses outside this guarantee net, unavailable to senior lenders. This could further reduce any recovery.

Recently, freebie buckets have become more prominent. These give a company the right to raise senior debt, ranking equally and sometimes ahead of existing senior debt, without needing to seek permission of existing senior debtholders. While there is limited evidence of these buckets being used thus far, they do create a risk that, as the point of default, the level of senior debt might be much higher than a transaction's start. S&P Global Ratings typically does not assume any use of freebie buckets when rating transactions, unless there is a clear near-term plan for them.

Less frequent financial reporting (typically moving to quarterly from monthly) affect's a lender's ability to closely monitor an exposure, but typically has limited impact on ratings or recovery prospects. Restrictions on transferability, while potentially frustrating for lenders, similarly have little impact on ratings.

In short, the impact of weaker documentation is likely to be seen in lower recovery prospects, once a company has defaulted, rather than in the corporate rating.

Chart 1


The recovery rate for first-lien debt, typically senior secured loans, has averaged just under 75% in from 2003-2018 (see chart 1). (For more information, see "2018 Annual Study of Corporate Recoveries in Europe: Little Change, For Now," published May 20, 2019.) Recovery ratings on the €450 billion of first-lien speculative-grade debt that we rate averaged just under 60% at September 2019. This is a material difference. Effectively, we expect the current cohort of first-lien debt to receive, on average 15% lower recoveries, in default, than the historical average.

EBITDA Add-Backs Can Lead To Material Differences In Ratio Calculations

When S&P Global Ratings analyzes leveraged finance transactions, it typically meets with management, reviews historical financial data and forecasts, including the issuers' proposed EBITDA adjustments, and excludes the adjustments it views as less plausible predictors of recurring cash flow from our adjusted forecasts. These issuer forecasts, incorporating their proposed EBITDA adjustments, are what we term marketing EBITDA.

In September 2019, S&P Global Ratings released a study, based on U.S. data, that concluded EBITDA addbacks continue to be substantial and overstated, and in fact have expanded as the current prolonged cycle extends (for more information, see "When the Cycle Turns: The Continued Attack Of the EBITDA Add-Back," published Sept. 19, 2019.) This study reviewed a large sample of merger and acquisition (M&A) and leveraged buyout (LBO) transactions that originated from 2015-2018.

A key observation from this study is that reported EBITDA in 2017 and 2018 averaged 35% below marketing EBITDA for both 2017 and 2018. The study concluded that "this marketing EBITDA is typically not a good indicator for future EBITDA."

In Europe, we also see substantial differences between marketing EBITDA and our analyst-adjusted EBITDA calculations. (Marketing EBITDA is the same as the "S&P LCD Issuer Reported Pro Forma EBITDA." Both refer to the EBITDA a company presents for a new transaction, which often includes a number of pro forma adjustments to the reported EBITDA.)

On Dec. 3, we published a study comparing the marketing debt-to-EBITDA as compiled regularly by S&P LCD from bank presentations, with the S&P Global Ratings-adjusted debt to EBITDA. (For more information, see "How Leveraged Are European Leveraged Finance Transactions?" published Dec. 3, 2019.) While S&P Global Ratings' adjustments (see chart 2) include capitalization of leases and rents, they also contain substantial pro forma EBITDA adjustments.

Chart 2


Our Corporate Ratings Reflect The Higher Risk

Chart 3


European corporate speculative-grade ratings has increased, to nearly 700 today from 200 in 2009 (see chart 3). It also shows that much of this growth has come from 'B' and 'B-' ratings, the latter in particular.

Chart 3 also highlights the increase in 'B' and 'B-' ratings as a proportion of European speculative-grade debt outstanding. As both the volume and mix of 'B' and 'B-' ratings have grown considerably, an increase in absolute numbers of defaults is highly likely.

Chart 4


While ratings are a comparative ranking, it is interesting to view the historical long term default rates per rating category (see chart 4). For example, for 'B' rated assets, about 12% defaulted after five years. 15% after seven, and 17% after 10.

Chart 5


While one cannot directly extrapolate from these historical default rates (see chart 5) to expected default rates based on current ratings, because ratings are not designed to predict specifically when an issuer will default, one can see default rates are materially higher than the current and recent default rates.

Chart 6


Looking Ahead

We will continue to monitor developments in the sector. Further weakening of loan documentation, or more pervasive use of EBITDA add-backs, might make forecasting ratios more difficult, which could have negative rating implications for issuers that decide to use these methods frequently.

European leverage finance ratings reflect our expectations of increasing default risk, both for existing and new debt. They also reflect our expectations that recovery, after default, will be materially lower than empirical evidence.

This report does not constitute a rating action.

Primary Credit Analyst:David W Gillmor, London (44) 20-7176-3673;

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