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European Leveraged Finance And Recovery Second-Quarter 2020 Update: Finding Equilibrium

Encouraging Primary Volume Activity At Quarter-End

Decisive monetary action, reversal of high yield flows, abatement of coronavirus cases in key economies, and hopes of vaccine trials have restored the technical background seen in speculative-grade primary demand. S&P Global Ratings rated €39 billion of total new debt tranches, including unsecured and subordinated debt, during this quarter.

The market first reopened with senior unsecured offerings by frequent corporate issuers, such as Renault S.A., Virgin Media Secured Finance PLC, Altice France Holding S.A., Fiat Chrysler Automobiles N.V., and fallen-angels Rolls Royce and a handful of airlines. Of the €39 billion total primary volume, less than €17 billion were first-lien, senior secured offerings, the lowest activity we have seen since 2018 (see chart 1). Existing issuers led the charge by coming to market first, either to refinance existing debt (such as Synlab Bidco) or boost liquidity. Sponsor-backed leveraged transactions that were structured and signed in the early part of the year, such as Vertical Topco III GmbH (Thyssenkrupp elevators) and Lorca Telecom Bidco S.A.U. (Masmovil), bolstered the first lien, contributing half of the total volume.

Chart 1


Average Recovery Expectations Are Higher, Based On Limited New Issuance

A recovery rating of '3' (indicating a meaningful recovery of 50%-70% in an event of payment default) was the most common assessment for first-lien new issues. The average expected recovery for rated first-lien debt during second-quarter 2020 was 62%, boosted by the sizable first-lien debt issued by Vertical Topco (Thyssenkrupp Elevators), to which we assigned a preliminary recovery rating of '2' (70% recovery expectations). This is above the previous quarter, though largely due to volumes in this quarter being driven by sponsor-backed first-time issuers compared with refinancings and debt add-ons stretching leverage for existing issuers in the previous quarter.

'BB' First-Lien Issuance Was Mostly To Refinance Existing Debt

Table 1

Rated First-Lien New Issuance, By Rating Category And Type Of Debt

Second-Quarter 2020, By Value And Average Estimated Recovery

--'B' category rated tranches-- --'BB' category rated tranches--
Amount issued (bil. €) Average recovery (%) Amount issued (bil. €) Average recovery (%)
Loans (incl. RCF) 7.7 58.9 0.6 60.0
Bonds 5.4 57.1 2.5 68.8
Total 13.1 58.1 3.1 67.0
RCF--Revolving credit facility. Source: S&P Global Ratings.

For European issuers in the second quarter, new first-lien issuance in the 'BB' category came from existing obligors, mainly to refinance existing debt. Bonds were the preferred instruments, with volume driven by four issuers, including Virgin Media, Ardagh Packaging Finance PLC, and MA FinanceCo. LLC (Micro Focus).

'B' Category Issuance Focused On Liquidity Improvement And Debut Issuers

First-lien issuance in the 'B' category was sporadic in April and May, focusing on 'B' and 'B+' rated issuers. This was initially from issuers seeking to inject liquidity, in most cases in conjunction with a full drawing on their committed RCF lines and covenant waivers--such as Motion Bidco (Merlin Entertainment) and Piolin Bidco S.A.U. (Parques Reunidos). The notable exception was Synlab's bond and loan offering, largely aimed at leveraging demand from its existing investor base to extend maturity by two years.

Sponsor-backed issuers were responsible for over 80% of the primary supply for first-lien debt, with two issuers--Vertical Topco III (Thysenkrupp elevators) and Lorca Holdco (Masmovil) raising nearly €8.5 billion.

Masmovil's upsized €2 billion loan, backing the take-private offer from Cinven, KKR, and Providence, was the first widely syndicated loan with interest payments stepping up or down based on environmental, social, and governance (ESG) factors. ESG-linked financing has so far been mostly the domain of banks. Masmovil had raised a revolving credit facility (RCF) and capital expenditure facility line in 2019 linked to its ESG score.

Table 2

Single-B Rated First-Lien New Issuance, By Value And Average Estimated Recovery

since 2018

--'B-' rated tranches-- --'B' rated tranches-- --'B+' rated tranches-- --Total 'B' category rated tranches--
Amount issued (bil. €) Average recovery (%) Amount issued (bil. €) Average recovery (%) Amount issued (bil. €) Average recovery (%) Amount issued (bil. €) Average recovery (%)
2018 10.3 49.7 57.7 52.5 38.5 53.8 106.5 52.3
2019 11.9 59.9 53.0 56.5 40.1 61.8 105.0 58.6
1Q20 (Updated) 5.6 56.3 19.6 53.9 8.1 61.7 33.3 55.9
2Q20 0.5 52.5 9.0 62.7 3.5 48.8 13.1 58.1
YTD 2020 6.2 55.8 28.6 55.8 11.6 58.4 46.4 56.3
YTD--Year-to-date. Source: S&P Global Ratings.

Average recovery for 'B' category rated debt was higher than the previous quarter, at 58% in second-quarter 2020. However, this is heavily influenced by Vertical Topco's first lien, which we assigned a recovery rating of '2' (70%), and the relatively low number of new offerings. Excluding this transaction, the average expected recovery remained at 55%.

Credit Quality Deteriorated, With Average Recoveries Of 58% Vulnerable To Creative Liquidity Boosting Maneuvers

As of June 30, 2020, we rated €731 billion equivalent of speculative-grade corporate debt from 687 European obligors. Rated first-lien debt amounted to €487 billion equivalent (see chart 2), including committed RCFs and excluding defaulted debt.

Chart 2


A '3' recovery rating remains the most common assessment for first-lien new issues in Europe, covering nearly three-quarters of rated debt.

Chart 3


Average expected recovery for first lien debt has been adversely affected by rising weighted debt-to-EBITDA ratios (see Appendix for definition and chart 3), which on average have increased 1.1x to 9.0x for senior secured debt issuers with speculative-grade rating. This has been due to debt add-ons (including government support in many cases, pari passu with existing debt) and S&P Global Ratings' revised assumptions for 2020, with gradual recovery in 2021 in most sectors. For more information on particular sector recovery assumptions, see "COVID-19 Heat Map: Post-Crisis Credit Recovery Could Take To 2022 And Beyond For Some Sectors," published June 24, 2020, on RatingsDirect.

On top of fully drawn RCFs and additional pari passu debt, we have seen an emergence of fully leveraged issuers exploring and using J Crewe-like "asset appropriation" maneuvers by using transfer baskets (or overly complex covenants) to move collateral away from the reach of existing lenders. In cases such as Travelport, this strategy was used to shore up liquidity and potentially initiate a debt restructuring. Existing lenders have retaliated by accelerating the debt, with a final resolution depending on a court ruling. In cases where leverage has been stretched to the fullest, in conjunction with covenant waivers, issuers have sought to find pockets of noncore assets to leverage outside of the restricted group. One example is Cineworld, which decided to ring-fence real estate assets in noncore geographies as collateral on a priority basis for new debt, boosting liquidity but leading to reduced expected recovery on its existing first-lien debt.

For highly leveraged companies, whether as part of a path to debt restructuring or an attempt to improve liquidity, these maneuvers would negatively affect first-lien recovery expectations. Most issuers have also obtained financial covenant waivers until 2021, so first-lien debtholders could find themselves exposed further, because their only recourse to getting management and sponsors around the table could be a conventional non-payment default, at which point the salvage value and negotiation position might weaken significantly.

Chart 4


Year to date, the credit quality distribution (see chart 4) for speculative-grade issuers in Europe deteriorated significantly. 'B-' rated issuers have increased by 48 (or 64%) compared with the beginning of the year. Moreover, 'CCC+' and 'CCC' and below rated issuers increased by 26 each, up about 35% compared with year-end 2019. So far in 2020, we have downgraded nearly one-third of speculative-grade issuers within each rating category, some by multiple notches.

Chart 5


Furthermore, the negative bias (CreditWatch with negative implications or negative outlook; see chart 5) has more than doubled to 251 issuers at June 30, constituting nearly half of European speculative-grade issuers. The downward pressure is particularly acute at the lower end of the rating spectrum, where approximately 41%, 48% and 67% of 'B', 'B-', and 'CCC+' issuer credit ratings, respectively carry a negative bias.

Chart 6


Debt in the 'BB' rating category shrank by €4 billion (see chart 6), driven by downgrades and offset by a handful of fallen angels (issuers with ratings declining to speculative-grade from investment-grade categories). 'B+' rated first-lien debt decreased €9 billion, whereas 'B' rated first-lien debt fell €26 billion net. Conversely, 'B-' and 'CCC+' or below rated debt increased by €29 billion and €27 billion, respectively, with the two categories now constituting 28% of senior secured debt issued, compared with 18% in first-quarter 2020.

The most vulnerable sectors, with issuer credit ratings of 'B', 'B-', and 'CCC+' with negative bias (issuers on negative outlook or CreditWatch with negative implications), are illustrated in chart 7.

Chart 7


Media, entertainment and leisure, auto, retail, and aerospace have the highest proportion of issuer credit ratings (70-80% of total issuers) are most vulnerable to further negative rating actions. These are followed by chemicals, consumer products, packaging and building materials, with roughly half of rated issuers carrying a negative outlook.

Sectors least affected by the pandemic include health care, technology, telecommunications, and services, where only a quarter of rated issuers currently carries a negative bias. Furthermore, these sectors also had the lowest proportion of downgrades in the second quarter.

Downgrades Dominate, Increasing The Risk Of Defaults And "Delayed Restructurings"

Chart 8


S&P Global Ratings published 137 ratings actions in the European speculative-grade rating categories in second-quarter 2020, of which 134 were downgrades (excluding defaults) (see chart 8). This brings the number of downgrades for the year to 203 for obligors based in Western Europe. Unsurprisingly, retail, media, entertainment and leisure, and transportation (including auto) sectors constituted nearly half of all downgrades this quarter.

There were 10 fallen angels during second-quarter 2020, increasing the total in 2020 to 15. Six were airlines and auto-related issuers including Deutsche Lufthansa AG, International Consolidated Airlines Group S.A. and British Airways PLC, Rolls Royce Plc, Renault SA, and ZF Friedrichshafen AG.

We downgraded 11 obligors to 'D' (default) or 'SD' (selective default) so far in 2020, bringing the number of defaulted issuers year to date to 15, equal to the total defaults in all of 2019. Nearly half of the defaults were in U.K. Also included in the number of defaults was Noble Corp. PLC, which we downgraded after it undertook a distressed exchange on its debt. We upgraded the issuer to 'CCC-' afterward because the risk of further debt restructuring persists.

The number of issuers and debt rated 'CCC' or below also sharply increased in the second quarter, to 28 issuers with €15 billion of first-lien debt outstanding. The rating level implies that we believe that the debt servicing capacity of these issuers is severely impaired, such that the current capital structure is unsustainable and some form of debt restructuring within the next 12 months is likely. The number of defaults to date and the number of 'CCC' or below rated issuers is broadly supportive of our published base-case expectation of 62 defaults (or 8.5%) by end of March 2021 (see "The European Speculative-Grade Corporate Default Rate Could Reach 8.5% By March 2021," published June 8, 2020).

Highest Recoveries In Technology, Media, And Telecommunications

Table 3

Speculative-Grade European First-Lien Debt And Average Recovery, By Industry

Rated First-Lien Debt (by Industry) Amount outstanding (bil. € equiv.) Average recovery (%) Standard deviation
Telecommunications 83 62 7
Media, entertainment, and leisure 59 62 11
Health care 54 54 12
Consumer products 47 55 11
High tech 39 59 6
Business and consumer services 36 56 9
Chemicals 36 59 8
Restaurants and retailing 32 62 15
Cap goods/machine and equipment 30 53 14
Packaging and building materials 27 55 15
Auto and trucks 12 59 14
Transportation 7 55 14
Financial services (nonbank) 7 58 15
Aerospace and defense 5 51 10
Oil 3 63 20
Infrastructure 2 65 0
Real estate 2 85 6
Mining and minerals 1 65 17
Total 483 58 12
Source: S&P Global Ratings.

By sector, technology, media, and telecom is the largest contributor to European senior secured debt that we rate, followed by health care, consumer products, and business and consumer services.

Overall, average expected first-lien recovery remained broadly in line with the previous quarter at 58% (see table 3). From the top 5 sectors by debt outstanding, those with the highest average recovery are telecommunications (62%) and media, entertainment, and leisure (62%), while health care and consumer services have the lowest at approximately 55%.

Chart 9


According to our estimate of post-default recovery of all first-lien senior secured debt that we rated as of June 30, 2020, the average expected recovery for all senior secured rated debt is 57.9% (see chart 9). Altice Financing S.A. and Altice France contribute over €26 billion equivalent (in U.S. dollars and euros) within the 60% expected recovery bucket. Various tranches issued by Virgin Media, Ziggo, and other telecommunication entities contribute the equivalent of €34 billion of all debt with 65% expected recovery.


Weighted debt-to-EBITDA ratio

Leverage is based on the assumptions we make around debt and EBITDA, as used in our rating analysis:

  • Debt: For the purpose of debt, we include items such as leases (both capital and operating), preferred shares (if deemed as debt-like), and accrued dividends; and
  • EBITDA: Earnings before interest, taxes, depreciation, and amortization. That is, revenue minus operating expenses plus depreciation and amortization, including noncurrent asset impairment and asset reversal.

Beyond that definition, our decision to include or exclude an activity from EBITDA depends on whether we consider that activity operating (for example, acquisition-related or restructuring costs) or non-operating (for example, asset impairment or nonrecurring items).

We generally calculate a company's credit ratios based on a three-year weighted average: the previous year's results, our current-year forecast (incorporating any reported year-to-date results, and our estimates for the remainder of the fiscal year), and our forecast for the next fiscal year. We apply weights to the core and supplemental ratios for the respective years to get to one final ratio for each metric. The length of the time series applied depends on the company's relative credit risk and other qualitative factors, and the weighting of the time series varies according to transformational events.

Weighted interest coverage ratio

For entities with weaker leverage assessments, interest coverage ratios can also shed light into the issuer's ability to service its debt. We use the EBITDA value, as described above, divided by the carrying cost, or interest burden of the issuer's debt.

This report does not constitute a rating action.

Primary Credit Analyst:Marta Stojanova, London + 44 20 7176 0476;
Secondary Contact:David W Gillmor, London (44) 20-7176-3673;
Research Contributor:Maulik Shah, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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