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Leveraged Finance: European Leveraged Finance And Recovery Q4 2021 Update: Finishing On A High

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Leveraged Finance: European Leveraged Finance And Recovery Q4 2021 Update: Finishing On A High

Primary markets concluded a record year across a multitude of categories. Total speculative-grade issuance in Europe topped €225 billion according to S&P Global Market Intelligence Leveraged Commentary And Data (LCD), comprising the highest ever loan and bond issuance to date. Unlike previous high-volume years, such as 2017, where issuance was primarily driven by debt refinancing activities, debt issuance in 2021 was spurred by mergers and acquisitions (M&A), which contributed over 60% of the volume for the year. Over 70 new issuers replenished the dwindling 'B' rated category, which was severely affected by negative rating actions during 2020. This permitted the issuer-friendly supply/demand dynamics in the European loan market to prevail and translated into maintained tight margins, despite slightly higher leverage at closing of transactions.

The fourth quarter brought attention to inflation and central banks' activity, when the U.S. Federal Reserve and the Bank of England both brought forward their interest rate calendars to curb inflation. This introduced some pricing volatility, which we see spilling over into 2022. Credit selection is likely to play a bigger role in 2022 and struggling or more vulnerable issuers will likely see wider pricing than the typical 350-375 basis points. Given the European Central Bank's (ECB's) possible change in stance regarding rate rises to curb inflation, we will probably see a preference for floating-rate instruments, rather than fixed rate, especially for the 'B' rated category or longer duration debt. Debt repricing , traditionally a driver of activity in previous years, may take a pause, as market participants gauge headwinds from the macroeconomic picture. M&A will be a significant contributor to volume, driven by corporate divestitures and, to a lesser extent, public to private transactions.

Supply-chain and inflationary pressures transpired to produce a dramatic slowdown in upgrades in the final quarter of 2021. Whereas upgrades outnumbered downgrades during the first three quarters of the year, the last quarter was characterized by net neutral impact on credit quality from rating actions. Stabilization of outlooks continued however, and the number of weakest links was halved to 69 by year end. Negative outlooks across speculative-grade corporate issuers have reverted back to pre-pandemic levels. There were no defaults in the fourth quarter.

Based on our forecasts, we anticipate nonfinancial 'B' category rated issuers will deleverage at a faster pace than historically. The strong forecast deleveraging prospects are driven by higher-than-historical revenue growth expectations over the next four years. Long-term median EBITDA margins peaked before the pandemic at 22%, and we expect them to be relatively stable at about 21% going forward. This is in line with inflationary headwinds, due to supply chain disruption and elevated energy prices in the foreseeable future.

New First-Lien Speculative-Grade Issuance

Senior secured debt expected recovery rate was in line with the first half of the year

The average expected recovery rate for newly rated first-lien debt remained flat at 55% (see chart 1), driven by subordinated debt cushions, fewer bond-only transactions, and multiple tranches of senior secured debt issued by telecom operator Iliad Holding SAS (BB/Stable/--), to which we assigned 'B+' ratings, reflecting the structural and contractual subordination of this debt.

New leveraged buyouts (LBOs) and add-on M&A continued the trend of coming to market with higher first-lien leverage levels than historically. According to LCD, total first-lien leverage reached nearly 6x, compared with 5.8x in 2020 (based on marketed pro forma EBITDA).

Chart 1


Leveraged buyout and M&A sponsor-backed issuance dominated

According to LCD, loan and high-yield bond issuance totaled €255 billion in Europe in 2021, of which approximately €54 billion priced in the final quarter. Fourth-quarter activity was concentrated in October and November, while December proved a very slow month filled with macroeconomic headwinds and concerns over the omicron variant.

Table 1

Rated First-Lien New Issuance, By Rating Category And Type Of Debt
Q4 2021 average estimated recovery
Average recovery (%)
Loans (excl. RCF) Senior secured notes All issuance
'B' category rated tranches 59 59 59
BB' category rated tranches 59 59 59
Q--Quarter. RCF--Revolving credit facility. Source: S&P Global Ratings.

Sponsor-backed issuers raised €109 billion in new speculative-grade senior secured loans in 2021, and €21 billion in October and November, while December saw only a handful of transactions. Additionally, approximately €47 billion was raised in senior secured high-yield bonds. Fourth-quarter new issuance was all contributed by sponsor-related transactions.

'B' category rated issuance was supported by buoyant sponsor M&A and LBO activity, as well as dividend recaps. Approximately 60% of the overall transaction volume was in order to support LBOs or add-on M&A activity--significantly higher than the 30%-40% historically. A record €22 billion was distributed to sponsors via dividend recapitalization by year end, of which approximately 80% was funded via new term loan tranches.

European First-Lien Speculative-Grade Debt Analysis

The average recovery rate on outstanding rated debt remains stable at 57%

As of Dec. 31, 2021, we rated €868 billion equivalent of speculative-grade debt from 787 European obligors. We rated €597 billion equivalent of first-lien senior secured debt at year end (including committed revolving credit facilities), issued by 612 obligors. The average recovery rate of all rated first-lien facilities at year end was stable at 57% (see chart 2).

Chart 2


Our expected recovery rate remains on average much lower than the actual average first-lien recovery rate of 73% over 2003-2019 (see "European Corporate Recoveries Over 2003-2019: The Calm Before The COVID-19 Storm," published Aug. 5, 2020, on RatingsDirect).

Recovery prospects differ widely by sector

Chart 3


Telecommunications issuers remain the largest contributors to rated European speculative-grade senior secured debt (see chart 3).

A recovery rating of '3', indicating our expectation of 50%-70% recovery of principal, remains the most common recovery rating for first-lien speculative-grade debt in Europe. Expected rounded recovery of 50%-55% makes up 49%, while recovery ratings of 60%-65% constitute 51% of the total within the '3' recovery rating category (see chart 4).

Chart 4


New debt contribution in the fourth quarter was highest in the 55% and 65% recovery bucket (€12 billion additional debt, or 50% of total additional debt). Healthcare, telecommunications, consumer products, and business and consumer services remained as the most prominent sectors with 50% or 55% recovery, with €143 billion of first-lien debt rated. At the 60% or 65% expected recovery level, the most prominent sectors were telecommunications, chemicals, technology and media, entertainment and leisure, on €157 billion of first-lien debt rated.

Expected recoveries for loans continue to be higher than for bonds

Senior secured loans, on average, have higher expected recovery rates than bonds, irrespective of the rating (see table 2). Bond-only capital structures yield lower expected recoveries due to the presence of super senior RCF, which we treat as priority debt and assume 85% drawn at time of default, as well as marginally higher opening senior secured leverage.

Table 2

Rated European First-Lien Debt Recovery, By Rating Category And Type Of Debt
As at Dec. 31 2021, by value and average estimated recovery
'CCC+' or below rated tranches* 'B' category rated tranches 'BB' category rated tranches
Amount outstanding (Bil. €) Average recovery (%) Amount outstanding (Bil. €) Average recovery (%) Amount outstanding (Bil. €) Average recovery (%)
Loans (excl. RCF) 21 51 297 57 65 64
Bonds 11 49 116 54 49 63
Total 34 51 433 56 121 64
*Excluding 'CC' and 'D'/'SD'. RCF--Revolving credit facility. Source: S&P Global Ratings.

'CCC' category rated first-lien debt has decreased by 18% (€8 billion) due to upgrades to 'B-'. 'B' category rated tranches have increased by €43 billion, due to sponsor-related debt issuance, nearly 80% of which was to fund M&A. 'BB' category issuers have also decreased as they have predominantly resorted to unsecured debt to finance capital needs.

Credit Quality Is Stabilizing At A Reduced Pace And The Default Count Is Low

The year saw more upgrades than downgrades and a tendency toward stabilization across the rating spectrum, particularly in the 'B' category rated issuers. However, the pace of upgrades slowed markedly in the fourth quarter, when we registered neutral net upgrades (see chart 5).

Upgrades and new issuer ratings have replenished the 'B' ratings stock above year-end 2019 levels, at 250 issuers (37% of total versus 40% pre-pandemic and 32% at end-2020). Over 90 European new issuers were added in 2021 alone. (In our count of "new issuers," we include secondary LBOs of rated issues, refinancing resulting in change of rated entity, and conversions from private to public ratings.)

'B+' and 'B' rated issuers account for 48% of the rated universe (versus 41% at the peak of the negative rating actions reached at the end of third-quarter 2020) and have been edging gradually back toward the pre-pandemic level of 53%.

'B-' and 'CCC+' and below rated issuers remain elevated at 29% of all speculative-grade issuer credit ratings in Western Europe, Switzerland, the U.K., and Nordic region, compared with pre-pandemic levels of 22%. This is largely due to the doubling of 'CCC+' and below rated issuers, which comprise 11% of the total compared with 6% pre-pandemic. While the 'CCC' and below rated category has reverted to pre-pandemic levels of approximately 2.5%, the 'CCC+' rated issuers remain elevated at 8% compared with 4% pre-pandemic, and have decreased by only 2% since the peak of the negative rating actions. The lag in recovery in the 'CCC' segment is correlated to pandemic lockdown measures: One-third of the 'CCC' or lower European companies depend highly on travel, lodging, and events-driven entertainment, therefore it is not surprising that the media, entertainment, and leisure sector contributes the most to Europe's 'CCC' rating category by both issuer count and debt amount (see "Risky Credits: Europe's 'CCC' And Below Corporate Ratings Tally Remains Elevated," published Aug. 2, 2021).

Chart 5


First-lien secured debt per rating category saw continued growth in line with the new issuer count, both by nominal amount and percentage of the total issuance (see chart 6). 'B' rated first-lien secured debt rose to €234 billion (€46 billion more than pre-pandemic). 'B-' rated first-lien debt increased by €8 billion, driven by upgrades out of the 'CCC' category, comprising first-lien debt issued by TUI AG, Merlin Entertainment, Piolin Bidco, and Richmond UK Bidco, all of which are leisure sector credits. The amount of first-lien debt rated 'CCC+' or below continued to decline by a further €9 billion, to €34 billion equivalent.

Chart 6


In addition, the reversal of the negative bias (issuers with negative outlook) to stable or positive outlook continued, largely reflecting robust sales and EBITDA growth of the underlying credits (see chart 7).

The fastest rebound and stabilization was observed in the 'B' category, where negative outlooks are below pre-pandemic levels.

Western European speculative-grade corporate issuers with a negative outlook, excluding infrastructure and energy producers, numbered 111 at the end of the fourth quarter. Of these, 69 issuers (62% of total) were rated 'B-' and below.

Chart 7


Five sectors have contributed over half of the downgrades since the beginning of 2020 and account for more than half of the negative bias. Media, entertainment, and leisure, retail (including restaurants), healthcare, business services, and transportation sectors account for 83 issuers, or 75% of all speculative-grade rated issuers on negative outlook (see chart 8). Of these, 72 are rated 'B-' and below.

Chart 8


The reduction of weakest links tapered off in the fourth quarter

Weakest links (issuers rated 'B-' or below, [excluding 'D'/'SD'] with negative outlook or CreditWatch negative) decreased by eight in aggregate, to 69 by year end (see chart 9). Stabilization of outlooks and upgrades played an equal part. While stabilization in the leisure and retailing sector were driven by robust demand and healthier liquidity profiles to weather further pandemic-related turbulence, stabilization in the healthcare sector (the third largest contributor of improving weakest links) was mainly credit specific. Nevertheless, the rebound in the speculative-grade corporate credit universe in Europe is still lagging that of the U.S., which has largely reverted to its pre-pandemic levels of weakest links (see "Default, Transition, and Recovery: Global Weakest Links Fall To Their Lowest Level Since April 2019" published Jan. 26, 2022, on RatingsDirect).

Chart 9


Net positive rating actions run out of steam in the fourth quarter

There were 19 upgrades in the fourth quarter, nine fewer than in the third quarter. The development was driven by an economic recovery that was dented by increasing inflation risk, moderating margin expectations. While upgrades were mostly in recovering cyclical sectors such as automotive and chemicals, media and entertainment names with receding business disruptions from the pandemic were also among the beneficiaries. Six names transitioned out of 'CCC+' to 'B-' this quarter, on back of improved trading, with three of them in the leisure segment (see "Industry Top Trends 2022: Hotels, Gaming, And Leisure," Jan. 25, 2022). Two of the rating transitions out of 'CCC+' were accompanied by successful refinancing.

We downgraded 19 companies during the fourth quarter, up from 12 during the third quarter, seven of which were U.K.-based, reflecting a wide variety of reasons such as debt-funded M&A, fierce competition, and more permanent impact from the pandemic. Two downgrades in the gaming industry (Odyssey Europe Holdco and Safari Beteiligungs) reflected refinancing risk, while liquidity pressures were key downgrade triggers for BVI Holdings Mayfair and Adler Group. The latter were multiple notch downgrades to 'CCC+' and 'B+', respectively.

Chart 10


No defaults in the fourth quarter

No issuer was downgraded to 'D' (default) or 'SD' (selective default) in the fourth quarter. In full-year 2021, there were 14 defaults in Europe compared with 40 in 2020.

Safari Beteiligungs was downgraded to 'CC' during the fourth quarter. This reflected the proposed debt restructuring, including the exchange of senior secured notes into payment-in-kind notes, maturity extension, and incremental debt increase that we will likely view as tantamount to a default if executed, which we expect in the first half of 2022.

Robust Deleveraging Expected For The 'B' Category

Based on our forecasts, we expect nonfinancial 'B' category rated issuers will deleverage at a faster pace than historically (see chart 11). Extrapolating the average deleveraging over four years into the future implies the 'B' category rated issuers in 2021 would take 13-15 years to deleverage to zero, compared with an average of 18-19 years in 2016, 2017, and 2019, for example.

Chart 11


The stronger deleveraging prospects stem from higher-than-historical revenue growth expectations, rather than margin expansion. Based on our forecasts, long-term revenue growth expectations (spanning the first four years from initial rating) have gradually been increasing since 2015, from less than 3%- to slightly above 4% most recently (see chart 12).

Chart 12


Chart 13


Long-term EBITDA margins peaked before the pandemic at 22%, and we expect they will be moderately lower at about 21% across the 'B' category rated universe. This is in line with inflationary headwinds in most sectors (see our "Industry Trends" series published in January 2022), due to supply chain disruption and other operating leverage inefficiencies in the foreseeable future.

Newly rated 'B' category issuers in 2021 were expected to have approximately 0.7x less leverage at the end of the first full financial year (referred to as "initial rating year," see chart 14). By the third year from initial rating, we forecast 2021 new issue vintage will have 1x less leverage than the 2019 vintage new issue ratings. Revenue growth was the largest contributor (see chart 15), as cumulative four-year forecast revenue growth expectations for 2021 new issuers are markedly higher compared with historical vintages, even prior to the pandemic. New issuers include secondary or tertiary LBO transactions, refinancing of existing issuers resulting in a new entity, and conversions from private to public ratings.

Chart 14


Chart 15


Related Research

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 Contributors:Maulik Shah, CRISIL Global Analytical Center, an S&P affiliate, Mumbai
Gregoire Rycx, Paris +33 1 4075 2573;
Additional Contact:Industrial Ratings Europe;

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