|Illustration: Paul Daviz|
He’s just spent the last 10 minutes explaining in weary detail how Europe desperately needs a deepening of its capital markets to kick-start its economy back to life. Top of his agenda is “a US-style junk bond market – although of course we need a better name for that.”
Ever since the financial crisis, European policy-makers have encouraged a transition of corporate financing away from a bank-dominated, loan-dominated market towards one of US-style corporate-bond issuance. A painful bank retrenchment has forced Europe’s corporates to wean themselves off dependence on a few relationship banks and embrace the capital markets.
But it’s not quite going to plan. Many banks have stopped deleveraging. Loans are back. Corporates are even refinancing bonds at cheaper rates provided by the swollen ranks of suddenly eager lenders.
“A couple of years ago people thought that the bond market would eat the banks’ lunch, but that is now reversing,” reckons Graeme Delaney-Smith, head of European direct lending and mezzanine investments at Alcentra, the sub-investment grade debt manager owned by BNY Mellon. “There is a huge investor base that used to do high-yield bonds that now wants mid-market loans. We will see more primary deals done in the loan market.”
The relative strength of the loan market is increasingly apparent not just in the volume tables but on the ground as well. It is the result not just of the weight of institutional money chasing the loan asset class but also of a phenomenon that according to the more hysterical end of the popular press no longer exists: European banks lending money to corporates and households.
Years of cheap central bank liquidity might finally be bearing fruit. The January 2015 ECB bank lending survey, which took place between December 8 and 20 last year, must be music to Mario Draghi’s ears: credit standards for all loan categories continued to ease with banks reporting increasing competitive pressures across all loan categories. They indicated a considerable narrowing of margins on average loans, though only a slight narrowing of margins on riskier loans, suggesting a further intensification in banks’ risk differentiation.
The survey also found rising net demand for loans related to fixed investment, recording the first significantly positive contribution since mid-2011. “The change in bank attitude became noticeable in the second quarter last year, around the time that the ECB looked at conditionality for the TLTRO [Targeted Longer Term Refinancing Operation],” says Gildas Surry, senior credit sector specialist at BNP Paribas. “The steepest drop in bank lending volumes was between the second quarter of 2013 to the second quarter of 2014. The inflexion point took place there. With the blessing of the ECB some banks realized that they would have a very limited number of excuses to not lend.”
|The challenge for non-bank lenders is to prove they are stable long-term lenders and not just opportunistic credit funds|
Symon Drake Brockman
The bank lending market in Europe is a very long way from being fixed. However, there certainly seems to be a marked shift in attitude. “We are seeing a change in behaviour by the banks in Europe,” says Brian Jacobsen, chief portfolio strategist at Wells Fargo Asset Management. “The banks are beginning to lend to the private sector. We have seen an increase in lending to non-financial corporates and households since November last year.”
The return of the European loan market is, of course, about more than the banks. Institutional investors are increasingly important lenders. In a December report entitled ‘Don’t call it a comeback…well actually, it is’, Barclays analysts forecast between €55 billion and €65 billion of institutional loan issuance across European currencies this year. And 2014 was the first year in which institutional lenders accounted for more lending than the banks in Europe: they now have a 60% share of the loan market.
“Institutional lenders are trying to do as much as they can in non-investment grade syndicated lending,” says Symon Drake Brockman, managing partner at Pemberton Capital Management, a London-based asset manager. Drake Brockman ran the debt and credit businesses at RBS between 2001 and 2009. In July last year Legal & General took a 40% stake in Pemberton and the two formed a strategic partnership for the development of a direct-lending platform aimed at mid-market companies across Europe. “CLOs and credit hedge funds see the fees and opportunities in the non-investment grade market as very attractive,” Drake Brockman adds.
Many banks now find them very attractive too, so the loan market in Europe is the focus of unprecedented attention. “The US high-yield and US loan markets all sold off last year, as did the European high-yield bond market,” observed one loan fund manager at a recent Leveraged Finance conference in London. “The one market that hasn’t moved is European loans. Spreads are tighter and covenants are weaker, so the loan market will be very interesting this year.”
According to Dealogic, in the seven years since 2007 the percentage of investment-grade financing in Europe provided by the bond market has risen from 47% to 55%, while investment grade loans have fallen from 53% to 45%. The pendulum has swung towards bonds – a move that investment bankers in Europe have been calling for 20 years.
However, the vast majority of companies in Europe are not rated investment-grade. And numbers for the sub-investment grade space suggest that – despite a record year in high yield in 2014 – the bond market’s triumphal march across corporate Europe has stalled somewhat. Of the $464.6 billion-equivalent leveraged financing written in Europe last year $307.3 billion, or 66%, took place in leveraged loans while $157.3 billion was financed using high-yield bonds.
Compared to the pre-crisis era, this is big progress for the bond market, which could claim just 5% ($26 billion) of 2007’s $555.9 billion leveraged finance volumes. But its advance seems to have plateaued. The high-yield bond market accounted for 31% of leveraged finance in 2012, 32% in 2013 and 34% last year. Something unexpected seems to be happening.
Starting to bite
Intense regulatory scrutiny of the US leveraged-lending market is starting to bite, and by early December last year volume stood at $524.4 billion, down from $605.2 billion at the same time in 2013. Some analysts have forecast a slump to as low as $325 billion in 2015. The issuance of covenant-lite loans also fell in the US, from $262 billion in 2013 to $239 billion last year.
In Europe the trend of travel is in the opposite direction: €17.7 billion of covenant-lite loans were raised in 2014, more than double the €7.7 billion raised in 2013. New issue volumes hit €78.4 billion last year, up 17% from 2013 and a post-crash record.
The extent to which bank appetite has returned in Europe is, however, a subject of some dispute. “There is an inconsistency between the ECB lending survey data and the hard evidence,” warns Orcun Kaya, an economist at Deutsche Bank in Frankfurt. “If lending conditions tighten and then ease again, then it doesn’t mean that lending is growing. You can’t say that there has been full normalization of lending conditions in Europe.”
Underwriting sub-investment grade loans in Europe has always been fiercely competitive, with up to 12 banks chasing each mandate compared with roughly five in the US. “There are fewer banks in this business compared to 2007, yet many remained steadfast through the turmoil and others have the capital and funding position to re-enter,” explains Edward Eyerman, managing director and head of European leveraged finance at Fitch Ratings. “There is still too much underwriting competition for every deal compared to the US,” he argues.
While many banks compete in underwriting, a growing number are now keen to lend as well. “The banks are coming back in style,” says Carlo Fontana, head of leveraged debt capital markets at Lloyds Bank in London. Fontana joined Lloyds in 2011 from MF Global and was appointed head of its newly combined high-yield and leveraged loan team in October last year. “Many deals have been more bank-heavy than we expected, particularly in the high single-B, low double-B area,” he observes. Indeed, when DE Master Blenders experienced some buyer pushback on the terms of its €4.6 billion term loan Bs backing the merger with Mondolez International last October it simply shifted €1 billion of the loans to term loan As and sold them to its relationship banks.
Gary McMillan, who co-heads the mid-markets business at Lloyds confirms the growth in loan-market appetite for lower rated credits. “Until two years ago even in crossover single-B names would firmly have gone into the high-yield bond market rather than the loan market,” he says.
Today, the appetite for loans is such that the market could soon see a reversal of a trend that has dominated the headlines for much of the last five years: bank loans being refinanced in the high-yield bond market.
“Banks are more interested in lending than they were in 2013, and this year we will probably see loan-for-bond takeouts,” predicts Michael Masters, director of European high-yield syndicate at Barclays. “We believe it will be compelling for issuers to raise term loan Bs to take out bonds. If you look at the capital structure of sponsor portfolio companies from 2010-2012 it is likely that a number of these will be refinanced [in this way].”
Indeed, at the beginning of last year Dutch cable provider Ziggo decided to buy back €2.4 billion of outstanding high-yield bonds and refinance them in the loan market as part of its buyout by Liberty Global. Just a year before when Liberty Global bought Virgin Media the deal involved the (then) largest cable high-yield bond issue in the European market.
Yet others argue that while interest in the loan market is unprecedented, the return of the banks is more muted than first appears. “Banks are returning, but on a selective basis. A minority are asset players. There is a very small pool of banks that want to take on more assets, and the majority are focusing on key clients. But they aren’t doing covenant lite – if it is a covenant-lite deal, the banks would most likely consider participating in revolving credit facilities [RCFs] for core clients,” says Paolo Grassi, head of leveraged capital markets at BNP Paribas. The French bank has been one of the most active in European leveraged lending, writing $32.7 billion-equivalent of loans in 2014, up from $27 billion in 2013 and $21 billion in 2012.
| A couple of years ago people thought that the bond market would eat the banks’ lunch, but that is now reversing|
Delaney-Smith at Alcentra is also circumspect as to the returning bank appetite in the mid-market. “You are seeing five banks doing a deal for £100 million – it is ridiculous. Bank appetite has not come back anything like people say it has. Banks say they are keen to lend, but they are keen to lend £20 million.”
Hold sizes are a perennial problem. “There is definitely bank appetite, but traditional banks are still held back by the size of holds they are prepared to take – £10 million to £30 million,” says Adam Joseph, managing director at Macquarie Lending in London. Macquarie recently closed a £307 million debt financing to back the acquisition of Birmingham’s NEC by LDC. The unitranche deal saw Macquarie take the lion’s share of the deal but bring RBS into the syndicate pre-closing. Unitranche loans combine term loan A, term loan B and mezzanine lending into a single facility and have proved very attractive to institutional lenders. “They [the banks] take such small amounts that you need to bring around five of them into each deal,” says Joseph. “This can create the situation where the financing documentation becomes the lowest common denominator as it has to get through all those credit committees.”
However, as the banks’ renewed appetite for corporate lending faces off against growing institutional demand for loan assets their behaviour may become less disciplined. “The corporate crossover market has become a key focus for European banks over the last 18 months as they seek to generate appropriate yield,” says Adam Wooton, head of corporate loan markets at Lloyds Bank. “Banks are currently accepting return compression and looser protections in order to retain clients. At some point banks will need to recalibrate their focus towards return-on-capital metrics in order to sustain viable long-term business models.”
Delaney-Smith at Alcentra agrees. “Banks have been bailed out and continue to act irresponsibly,” he states. “Banks are lending senior debt for a spread of slightly more than 5%. People have to question that loss leader. It didn’t work in the past and it won’t work in the future.”
For lenders active in the market before 2007 this might all be sounding horribly familiar. However, a senior manager at a large US loan fund manager is quick to dispel suggestions that a new bad-loan crisis is brewing. “Anyone that says that last year in the European leveraged loan market was similar to pre-Lehman wasn’t around pre-Lehman,” he snorts. “Lots of the loan market’s problems have now been dumped into the bond market [as a consequence of widespread refinancings]. In the loan market all deals have cleared. Some may have cleared at a price that was painful for the banks that underwrote them, but rightfully so.”
There have certainly been some sticky moments. Citi and Goldman were forced to increase the original issue discount (OID) on a £210 million loan for UK clothing retailer Fat Face in October last year, while Jeffries, Rabobank and UBS were hit when they had to raise the OID on a €480 million loan backing Advent’s acquisition of Belgian aluminium manufacturer Corialis. The most notorious example of the transfer of risk to the bond market via refinancing was the €465 million issue of senior secured notes by Dutch discount retailer Hema in June 2014 through Credit Suisse to repay credit facilities. Shortly after the bond was sold, the firm revealed that its ebitda had fallen 22% year on year. The bonds tanked.
The years since the financial crisis have seen many changes to Europe’s capital markets, and one of the more important in the sub-investment grade buy-side has been the emergence of multi-asset investing. As institutional buyers have moved away from more-traditional asset classes in the search for returns, more and more have established funds that manage different asset classes – notably bonds and loans – together. This development, together with the convergence of investor protections and the growth in senior secured bonds (which rank pari passu with senior secured loans in the capital structure) is heralding a brave new world of sub-investment grade credit where the distinction between loans and bonds is largely immaterial.
However some in the market don’t seem to have got the memo. Rising volatility in the high-yield bond market in the second half of last year emphasized the differences that still exist between the two products. And the nature of the corporate universe in Europe – which is heavily skewed towards SME businesses – means that Europe may always be a natural loan market. “Some people are realizing that the bond solution is not right for mid-market businesses,” says Joseph at Macquarie Lending. “There isn’t the right liquidity. It doesn’t work for the company or the investor.” Investors that bought Hema would probably agree.
His LMA colleague Nigel Houghton echoes this point. “The European high-yield bond market is more mature than it was, but one well-known default in September effectively closed the new-issue market, while bigger restructuring pain didn’t close the loan market. There is a greater maturity and a greater degree of primary capacity in the loan market. There has been a bit of a wake-up call in high yield since the second half of last year.”
That restructuring pain in the loan market came from a €2 billion write-off at French fashion retailer Vivarte, which had been acquired by Charterhouse, Chequers and Sagard in 2007. One banker says: “Vivarte was a bigger facility, but there were more mouths there willing to feed on the situation than there were with Phones 4U.”
Euromoney meets the corporate finance head at one of Europe’s largest bank lenders for coffee in early January. He is not at all surprised to see the banks’ return to the loan market, adding that their appetite for lending to good corporates has never gone away.
“Once banks regained their footing on the liquidity side it was easy for them to roll out their credit expertise and lend again,” points out Roman Schmidt, global head of corporate finance at Germany’s Commerzbank. “The balance sheets of European lenders were not dominated by loans to German and UK SMEs, they were over levered with structured finance and real estate.”
| We see the market getting aggressive. Anyone who thinks otherwise just doesn’t understand this market. If the banks underwrite an aggressive deal, it all just disappears into Mayfair|
There is another reason that banks like to make sub-investment grade loans: it is a very profitable business. “A lot of banks have rebuilt capital to the point where they have to make money,” says Eyerman at Fitch. “They can charge sponsors a 1% – 1.5% fee and Libor plus 400 basis points or 500bp, so leveraged lending is an ROE-positive business.” It is hardly surprising, therefore, that they are so keen to rebuild their loan balances.
“Banks have realized that they want to grow,” says Keith Taylor, head of European loan syndicate at Barclays. “The inflexion point was last year. Some players that used to be leveraged lenders were hard hit but they have come back in the last 18 months.”
Indeed, despite its capital treatment, leveraged lending is one of the last businesses that banks will pull out of. Bank of Ireland, for example, never completely withdrew from the market even in the depths of that country’s banking crisis. When Nordic Capital bought Britax Childcare from Carlyle in December 2010 one of the two lead banks on the £260 million deal was Bank of Ireland. December 2010 was also the month that Ireland formally applied to the European Commission and the European Central Bank for support from the EU and IMF to partially shore up its banking sector.
So it is their renewed interest in making money that is driving up bank interest in lending to leveraged finance, mid-market and SME clients. “Some banks are seeing their leveraged finance books reduce more rapidly than they would like,” explains Fenton Burgin, head of Deloitte’s UK debt advisory team. “They are seeing a lack of deal flow and are being highly competitive to secure deals.” Deloitte is busily hiring high-yield specialists to its debt advisory business in London in anticipation of US investors looking to enter the direct-lending market in Europe.
The growth of direct lending in the mid market and the return of CLOs, together with an emergence of segregated managed accounts targeting loans will determine the extent to which the newly invigorated banks are able to regain the market share they lost after the crisis. Although the European CLO market has not recovered to anything like the extent that the US market has, issuance of between €20 billion and €25 billion is expected this year, following €14.5 billion of business in 2014. However there is still a large degree of runoff from collateralized loan obligations that were closed prior to the crash, and the market will not be net positive until 2016.
US investors will be key to the trajectory of the loan market this year. Many market participants that Euromoney spoke to for this article remarked on the number of large US bond fund managers that, following the volatility in the high-yield market last year, have now made dedicated allocations to European loans. For example, last September BlackRock hired Aly Hirji, a partner at New Amsterdam Capital, to build its leveraged loan capabilities as part of its Credit Enhanced Strategies Europe team.
“After the high-yield wobble in October, funds now want to deploy capital in senior debt,” says Burgin at Deloitte. The attraction is not only diversification but also increased yield.
“The pitch for a segregated managed account is that while you can get 2% to 3% yield on double-B high yield, a segregated managed account can get you 5% to 6% with loans,” says Eyerman.
However, Burgin warns that the weight of interest in the asset class means that this might be short-lived. “We will see a rebalancing,” he says. “US capital was looking to diversify and achieve a higher yield in Europe. But yields in Europe are now below those in the US.”
Competitive pressure between the banks and non-banks is particularly acute in the mid-market. “The yield differential between what banks will take and between what institutions will take is between 100bp and 150bp,” says McMillan at Lloyds. “It is the widest I have seen it.” This can often be due to the different terms available from the non-banks, particularly with unitranche lending.
“Competition is without doubt increasing,” says Joseph at Macquarie. “But there is still blue water between what a standard bank loan will do and what a unitranche lender will do.”
Many direct lenders that set up in the wake of the financial crisis were hoping to capitalize on the banks’ withdrawal from corporate lending and raised money on the basis of a 10% or more return. What they hadn’t provisioned for was the banks’ determination to hang on to this business, and they were never really able to charge the 4% fee and 600bp over Libor that they were hoping. “The funds that set up post-crisis have high target returns. That is always the position post-crisis – and it is always a short-term position,” explains Delaney-Smith. “We didn’t want to be a credit opportunities fund that turned into a direct lender.”
Towerbrook-owned HayFin, which was launched in 2009, was one of the first direct lenders to establish itself after the financial crisis. The firm, which raised €2 billion in a second fundraising last year, was due to be sold to Guggenheim Partners in a £600 million trade agreed in mid-2014. However, by year-end it appeared that the deal was off, and Towerbrook is now understood to be exploring strategic options for the firm.
Tim Flynn, the ex-Goldman CEO of HayFin, argues that it is the non-banks – not the banks – that are responsible for the aggressive terms now emerging on deals. “In our market the banks never left,” he says. “Nearly all of our mid-market lending is done alongside the banks. The market is more competitive today, but it is not the banks out on the edge of lending today generally speaking, it’s the fund managers that are getting significantly more aggressive. It is just a natural part of the credit cycle – loosening terms.”
Flynn believes that discipline has not broken down at the banks and that they continue to behave responsibly. “The banks are among the most conservative lenders in the market,” he says. “They are really good at lending. We see fund managers doing aggressive things, but the banks are big, disciplined and generally speaking well-managed corporate lenders. They are run by credit committee and are very experienced. Banks don’t mind saying no. We see the market getting aggressive, but it is the funds not the banks. Anyone who thinks otherwise just doesn’t understand this market. If the banks underwrite an aggressive deal, it all just disappears into Mayfair, they don’t hold it. It is the funds that are pushing risk, not the banks.” And that means that the mid-market is now seeing increasingly aggressive deal terms too. “Something gets achieved in a €2 billion deal that then appears in a €200 million deal,” grumbles one loan fund manager. “It simply shouldn’t be there.”
The solution for both banks and institutions may be: if you can’t beat ‘em, join ‘em. Barclays and BlueBay Asset Management seemed to come to this conclusion in January last year when they announced a collaboration to offer unitranche loans of up to £120 million to UK corporates.
“It is a big investment to have a direct lending function,” points out Taylor at Barclays. “Alternative lenders are a complementary source of liquidity to the banks – there never was a gap. There was a period where borrowers looked to the bond market, and most treasurers have learned from the crisis that they need to diversify their funding. The loan piece is where you have banks and alternatives – banks have the relationships and non-banks look for yield.”
By partnering in this way, the fund can take the first loss piece and price it synthetically, enabling it to meet its return hurdles.
Schmidt at Commerzbank emphasizes that the long-standing relationships between banks and their clients will always give banks the edge over non-banks. “It is very difficult to grow a loan book if you don’t have the loan expertise. Regional lenders understand this business very well. If you don’t have expertise, it can be dangerous.”
|Symon Drake Brockman|
Both high-yield bonds and leveraged loans have had a good start to 2015 in Europe, but global high-yield issuance was down 46% year-on-year by the end of January. The likelihood is that loans will prove increasingly popular as the year progresses.
“The two markets are still relatively complimentary and they tend to tap different sources of liquidity,” says Grassi at BNP Paribas. “You still need to have both markets operating efficiently. However, given the favourable fund-raising dynamics and the attractiveness of covenant-lite we expect a rebalancing in Europe towards the loan market.”
And as loans become ever more popular, the battle for assets between the banks and institutional lenders will become ever more acute. The momentum – certainly at the larger end of the sub-investment grade debt market – is with the institutions so far. “The LBO [leveraged buy-out] market is still largely an institutionally driven market – bank investors are not really driving things,” says Barclays’ Masters. “Banks are returning to lend in LBOs, but there is an issue with covenant-lite documentation and banks get timed out on these deals. Most underwrite to an institutional distribution.”
Is it only a matter of time before the banks start to accept weaker covenants in order to rebuild market share? “Banks are responding to competitive pressure, but if you look at the credit functions of the major bank operations there is no ill discipline yet,” says Deloitte’s Burgin. However, loans are more borrower-friendly, more fungible and more mature than bonds and if they are widely available to sub-investment grade borrowers on historically attractive terms more and more corporates will opt for them. And that means that more and more investors will allocate to loans through both CLOs, direct lending funds and segregated mandates. However, there is one thing that they shouldn’t forget about this market.
“The big flaw is the assumption that you can trade out of a credit in trouble,” warns Fitch’s Eyerman. “Only if you are first and if your position is small.”