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Headline: Reality hits mad merger pricing
Source: Euromoney
Date: July 2000
Author: Ben Beasley-Murray
Secondary loan market takes off
Last year's high-margin financing for Olivetti may have been the peak for fees and prices on the syndication of huge merger loans. But the mergers go on and spreads are getting less wild, more credit-sensitive. A secondary market is growing in Europe, and institutional investors are stepping in to fill a possible gap in bank liquidity. Ben Beasley-Murray reports
The past year has been a trail-blazing period for syndicated lending, with loans of unprecedented size coming to the market. Fees and margins have grown to match, turning a market that for years has been regarded purely as relationship driven into a valuable money-spinner. "The difference between today and two years ago," says Peter Gleysteen, global head of syndicated lending at Chase, "is that today the pricing baseline is in the money."
The market is seeing a little more reality after the excesses of 12 months ago when the uncertainty as to what was possible led to issues being priced over the odds. But with M&A activity and corporate restructuring continuing apace there is no danger of the market going into reverse.
"Margins were up here, fees were up here," says one banker with upstretched arms to make the point. "Now the market is coming back to earth, and banks are getting a more realistic yield."
Several factors combined to drive up prices above all, the scale of lending was so large that prices were bid up to ensure that deals got away. Whereas previously a corporate could rely on a core of relationship banks to provide funding, the emergence of jumbo loans for acquisitions required more attractive spreads and fees in order to find takers. "Once you get outside that group of banks to whom you're giving auxiliary business, you've got to appeal to the banks that are starting to look at this as a true transaction," says Tony Rhodes, global head of syndicated finance at HSBC. "Ultimately it's the price to get in the last bank that matters." As a result, the single-A corporate borrower that might have been borrowing working capital at 20 or 25 basis points over Libor was looking at perhaps 50bp to 75bp if it wanted to raise around $5 billion to make an acquisition. "This kind of hike may be anathema to the corporate's treasurer," says Rhodes, "but to the finance director with a bigger picture of where the company is going, and with a view to the step-change that the entity is achieving, the cost is pretty minimal."
"Clearly we're in an industry where every basis point matters," says another banker, "but at the end of the day the cost of not getting a deal done is so much more than paying a premium to get the money together in an event-driven transaction." Although there is consensus that there will always be a premium on financings centred on acquisition activity, more aggressive pricing is likely in future.
Brenda Mills | "The market is becoming more seasoned," says Brenda Mills, head of syndications at ABN Amro. "The market was tested with the early jumbo facilities and it delivered and got paid for doing so. Now that everybody knows it can support these large financings I don't believe there's so much nervousness in the underwriting decisions. There's no longer any compulsion to price these deals up."
Market players agree that when deals were priced up, they were priced up a lot. An example was the Olivetti deal made last year in the hostile takeover bid for Telecom Italia, which gave an extraordinarily generous margin of 225bp. "This," in the words of one banker, "was a pure reflection of greed." He continues: "But the deal demonstrated that greed worked." Although pitched at e22.5 billion ($24.2 billion) and subsequently scaled down to less than half that, it attracted commitments of $32 billion.
Bank shareholders' demands for better returns drove changes. Also bankers saw that hopes of getting worthwhile ancillary business from borrowers to which one was a low-tier lender were fairly small. "I think people were beginning to get the joke," says Fergus Elder, head of European loan syndications at JP Morgan, "which they should have been getting a lot earlier: if you're one of 25 banks and this is the third time you've got into a syndication for tight prices where you couldn't produce a decent return, and you hadn't seen any ancillary business, the joke's on you."
Relationship banking under strain
Relationship-driven lending is still a factor in syndicated loans, however. The $8 billion Mannesmann loan to acquire Orange last year stands as testimony, although some might suppose it was nearer to an act of bullying than the fruit of a relationship: "That was Mannesmann flexing its muscles and pressurizing relationship banks to do the deal," says one banker. "That wasn't a deal priced to the market," says another "and how smart was Mannesmann to slam its banks? The banks were all too happy to turn on Mannesmann by later lending to Vodafone."
The relationship element frequently centres on the corporate's subsequent exit from the loan. The top tier on a jumbo will consist of relationship banks or people from the advisory side that will hope to have a share in refinancing the deal. "If you're going to put $5 billion on the table you're going to want a piece of the action on the take-out financing options," says Mills. "So those big tickets don't come for free."
More and more, those who help arrange the primary side of syndications are looking to prepare a complete package: "There's certainly added value to the issuer if they get the same people in twice," says Gleysteen.
"There's certainly more linkage these days across the various products," says Tim Ritchie, global head of syndicated lending at Barclays Capital. "It's important to be able to provide a broad range of solutions to clients, because it isn't necessarily obvious from one moment to the next in which market you'll get the best execution for the client. The economics in transactions will tend to be linked to take-out opportunities more and more frequently, so if you're not in a position to take advantage of these opportunities or offer that type of service, then clearly you may not be able to compete effectively to do the initial lending."
It's not simply that banks are demanding that they take part in the refinancing, but they want to see that the loan will be repaid relatively quickly in order to free up their books. "Banks want to be sure," says Rhodes "that if they're financing a bridge it doesn't turn out to be a pier."
Thus far, many deals have been exited before the ink is dry on the loan agreement, but there is an awareness that it is not a foregone conclusion that every deal can be easily refinanced. "The way these deals have been getting done, even the biggest ones, if there really were a spanner in the works and it couldn't go to the capital markets they can either just pay down the debt by simply running their business, or by selling non-core assets," says James Karp, managing director of loan syndications at Goldman Sachs, "They may not like the price, but most of these entities are big public companies and could issue additional equity if they needed."
"I think there was a certain element of nervousness a little back," says Gleysteen "based on overall capital markets volatility and interest rate uncertainty. But the tone has improved a lot. Market liquidity is robust, including in fixed-income markets which have improved a lot. And the fact is that we're generally talking about very high quality issuers with very high quality assets and very deep capital markets access."
But there are those who think that a shock is on its way. "One of these deals is going to go wrong sooner or later," says Dietmar Stuhrman, senior manager of loan syndications for Dresdner Bank Luxembourg. "There's a good chance of one of these jumbos going haywire," says another banker, "and if they do you're all in deep [trouble] because you're all above legal lending limits."
Banks are becoming more cautious, particularly the smaller and middle-range ones that were underwriting large amounts last year. "You're not going to see the level of fees we've been seeing before," says Mills.
Whether a dip in the prices of event-driven loans is occurring is not entirely clear. Some are touting the tighter pricing of the loan to France Télécom, funding its acquisition of Orange, in comparison with that in the Vodafone/Mannesmann deal, as an example of a change. But others point out the difference between the hostile acquisition of a German blue chip and the acquisition of a company, the sale of which was demanded for competition reasons.
One tangible shift is away from pricing to achieve liquidity towards pricing based on credit. Jumbo financings were paying a premium just to get the volume but with increased confidence in the availability of liquidity there is a move towards more credit-sensitive pricing. "There is a decompression across the spectrum, with people beginning to look at these risks in a rather more scientific way," says Nigel Pavey, a director in syndicated lending at Barclays Capital. So although prices for investment-grade corporates are fairly static or perhaps tightening a little, spreads for non-investment grade and leveraged loans are moving wider. "Whereas earlier, the tier of credits in the triple-B range were paying only a little premium over the better-rated corporates, some of them are now paying a multiple of what they were previously," says Pavey.
But although the market is becoming more sensitive to credit ratings, pricing is still anomalous in the leveraged area. "On LBOs pricing hasn't really widened out that much," says Elder, "and it remains an illogical market in that there is no real differentiation in pricing to match differentiation in risk. Something could be a BB+ or it could be a B- and you still get paid exactly the same, which doesn't make sense."
Conversely companies with the same ratings may well achieve differing spreads. "You can see significant variations in the spread performances of companies with the same rating level, dependent on issues to do with how well understood that company is and how well the story has been sold and conveyed in the market," says Patrick Jacob of Dresdner Kleinwort Benson. "There appears to be a very strong differentiation between one triple-B company and another."
Bill Fish | This is partly explained by questions of sector and how the loan is to be used. "Banks are getting much more sensitive about whether something's funded or not, whether it's a bridge to a capital markets issuance, or whether it's a permanent debt," says Bill Fish, head of syndicated lending at Schroder Salomon Smith Barney. In terms of sector, there has, for example, been a rise in prices on non-investment grade telecoms, since banks can afford to be choosy in the rush for financing.
And although there have so far not been major problems involved in clearing the market for a telecom-based loan, there are already murmurs that the forthcoming wave of loans for telecom acquisitions, third generation licences and industry restructuring will prove an unmanageable burden for the banks.
It is estimated that over the next six months, the telecoms sector will be looking for loans as large as the amount raised over the whole of last year. M&A activity is expected to continue unabated, on top of which there is a need for money to pay for broadband UMTS licences. These fees will appear in Germany in August, Italy in the third quarter, France around the same time and Belgium at the start of next year. "There is going to be a real appetite to issue," says Jacob. "Deutsche Telek om's massive bond programme is indicative of the fact that they realize they need to get tooled up now before everybody else does."
Problems with higher prices
In order to grab attention, telecoms deals will have to be priced high, think many bankers, but ironically this could cause problems for the banks as well as the corporates. Banks would need to sell down existing loans to free up their portfolios but at present there are a fairly limited number of buyers for such paper. If primary deals become more generously priced existing components will then be below market price, and so in order to sell them off banks will be forced to do so at a loss. "This will make one either unwilling to sell or forced to demand yet higher returns on new issuance," argues Jacobs.
A challenge that faces syndicated lending is the possible tightening of liquidity through bank consolidation. Whereas two separate banks might, before a merger, be happy independently to put large amounts into a loan, after a merger they will not be prepared to expose that shared amount. Appetite does go up but not in keeping with the new size of balance sheet. This has not pushed liquidity out of the market so far but as more consolidation takes place it could be a problem.
"We're at a pretty positive point in the consolidation process in Europe at the moment," says Ritchie, "in that the smaller players that have merged have tended to want to act like bigger players." Thus localized institutions, such as certain Italian and Spanish banks are now looking farther afield and taking part in more deals elsewhere in Europe.
"The result is," says Gleysteen, "more market capacity than there was a couple of years ago, regardless of consolidation. Some of that capacity is underwriting capacity rather than hold capacity, but as bridges to the capital markets, and assuming that those markets will still be there, that's not a problem."
The next phase of consolidation may cause difficulties, however, if larger bank mergers result in a withdrawal of capacity. The salvation could be the arrival of institutional investors as takers of syndicated loans. "New liquidity is coming in quicker than old liquidity is going out," says Gleysteen, referring to new banks but also to institutional investors. In the US, non-bank investors have been involved in the primary side of loan syndications for some time, but this is only now beginning to be the case in Europe. As it does happen, it will spell an increase in liquidity which, Gleysteen says, "is great for issuers since they get better terms and wider market access, and is great for investors since they're getting more liquid paper." *
Secondary loan market takes off
A take-off in the secondary market for syndicated loans has confidently been predicted ever since distressed loan trading took off in the recession of the early 1990s. Now, after several false starts, a sizable loan asset market is growing up in Europe. "We think the secondary market's growth is going to be exponential," says Bill Fish, head of syndicated loans at Schroder Salomon Smith Barney "and with deals getting bigger, and with banks managing their balance sheets and focusing on returns we're going to see a more liquid and more value-orientated market.
"We've done more trading of loans in this calendar year so far than in the whole of 1999," continues Fish, "and that's been real trading not just selling down."
The secondary market has grown steadily and is now worth around $30 billion. Through the work of the Loan Market Association, which was set up in 1996, a framework has been established through the development of standardized transaction documentation that has made trading of these non-standard instruments far easier than it used to be.
The area that has most potential and has really still to come to life is the leveraged loan market. Partly because volumes are still low enough in Europe to be absorbed by the primary market, there is some way to go before the kind of liquidity displayed in the US leveraged loan market is seen. "Depending on when we see leveraged loans of the scale that are routinely seen in America, we will see a big boost to the secondary leveraged loan market here," says Tim Ritchie, global head of syndicated lending at Barclays Capital. "It also hinges on when we get the same kind of base of institutional investor involved."
Whereas many buyers in the US secondary market are not banks but institutional investors, the percentage in Europe is still negligible. Changing this is seen to be crucial to bringing more activity to the secondary market, as well as to the primary. But with obstacles such as withholding tax and often self-regulatory impositions barring institutional investors, only a handful have yet emerged as significant buyers of loans.
Nigel Pavey | The European market is still at an early stage of its evolution, and is less than a fifth the size of the US market. "The institutional investor base in the states has grown up over more than 10 years or so, and there's every chance that it would take as long as that to grow in Europe", says Nigel Pavey, a director at Barclays Capital.
Despite the fairly healthy increase in their involvement with the high-yield bond market, there is a big step for institutional investors to move from single-A bonds to single-B corporate credit. Additionally, early repayment options make the area still less predictable as an investment instrument.
At the moment, the most actively traded tickets are the investment-grade jumbo loans. Most activity is driven by banks' desire to re-jig portfolios and reposition their investments rather than to make significant trading returns on the transactions. Quick refinancings that have taken place on some of the large facilities have led to moderate levels of secondary trading.
Smaller investors across Europe are finding the secondary market for loans from investment-grade corporates an increasingly important source of assets. Many of them simply aren't able to commit to the bigger tickets that would be expected of them in the primary stage, and the secondary market is the only place they can source these assets. Many expect that leading banks will acquire big tickets that they may soon sell down onto the secondary market. This is because some of the big banks with big primary market ticket, which bring underwriting fees as well as participation fees, can cross-subsidize in order to shift their positions.
"There are small players arbitraging between the loan market and the bond market, which makes obvious sense for non-relationship banks," says Brenda Mills, head of syndicated lending at ABN Amro. "But for the moment, there's not enough money to be made out of trading par loans for the market to become too excited. We are, however, seeing this activity increasing with the pressure on banks to manage their balance sheet more effectively." The proportion of loans receiving ratings is increasing, and it is expected that appetite for credit paper across Europe may spill over into loans. "There are reasons to believe investors will become much more receptive to a much wider variety of maturities and structures of paper," says Patrick Jacob, joint head of global debt origination at Dresdner Kleinwort Benson, "which is going to suit corporate Europe more and more." |