Borrowing from Peter, paying Paul

If you are a corporate borrower, there is more than a three-to-one chance
that your debt has changed hands and is not held by your arranger bank. Most
probably, it is being managed by a hedge fund, collateralised debt obligation
(CDO) fund or collateralised loan obligation (CLO) fund.

This is particularly true for British corporates, which, as of the first half
of last year, were the largest European issuers of leveraged debt, amounting to
(euro) 33.2bn (25% of the market), compared with (euro) 16.1bn for second-place
issuer Germany. Banks, in fact, retain a much lower direct economic interest and
increasingly see their role as arrangers and distributors in the syndicated loan
market. The presence of these new players and the increased liquidity they bring
to the market has led to higher levels of corporate leverage as well as more
attractive terms. But it has also encouraged lending to lower credit quality
corporates.

The European leveraged loan market has achieved phenomenal growth over the
past five years, with total transaction volumes up from (euro) 80bn in 2002 to
(euro) 200bn at the end of last year. All signs point to another record in the
current year, with telecoms, healthcare and manufacturing showing the largest
appetite for debt.

“The growth of the leveraged loan market has been triggered by a low interest
rate environment over the past several years, which creates a lot of liquidity
for investors, with higher yields than what is available in the government
credit market,” says Edward Eyerman, senior director European corporates
department at Fitch Ratings.

“If you’re a pension fund, for instance, with long-term liabilities that
require assets to be matched at 6% to 8%, this isn’t available in the German
Bund, US Treasury or UK gilt markets. So you have to go down the curve to
achieve that, and that is what non-bank lenders like CLOs and hedge funds can
do,” he says.

Test the limits
This has allowed the market to test new limits, in terms of accepting more risk
and less discipline on the ownership of corporate loans. The implications are
that this decreases the recovery available to all creditors, but in particular
to subordinated creditors. “It also pushes the default rate out as businesses
are re-financing under more favourable terms, hence there is more time for a
business to deteriorate and there are also fewer triggers to compel a default,”
says Fitch’s Eyerman.

In many ways, the most startling feature about the second half of 2006 and
the first half of 2007 has been how some mid-cap corporates have achieved
leverage multiples and terms and conditions that would in the past have been
reserved for far better quality credits. This means that today there is much
greater systemic risk built into the market. One can either believe that banks
are fundamentally better at monitoring risk than was the case three to four
years ago, or that we’re at the top of the market, with mid-caps achieving on a
regular basis leverage multiples of six to seven times debt to EBITDA. This has
clearly created a greater risk environment.

The current aggressive market conditions are unlikely to be dampened until
default rates start to rise. In the short term, loan defaults will probably
surface in legacy deals arranged in the 2003/04 period, but in the longer term,
refinancing risk has increased significantly. Most analysts expect a significant
increase in default rates to feed through this year and next.

Warning bells
Paul Watters, primary credit analyst at Standard & Poor’s, also sounds the
alarm bells over the European leveraged loan market’s bullish performance. He
points out that loan structures have become so borrower-friendly that private
equity sponsors write their own term sheets using their last transaction as the
template for the next.

“Credit metrics have been stretched so far that repaying debt from internally
generated cashflow is no longer required or expected,” he says. “While headroom
under leverage covenants continues to hover around 25%, this has become less
restrictive as leverage has risen.”

Watters cautions that the overall effect on S&P’s ratings assessment has
been highly negative. The statistics are sobering: of the facilities in the
agency’s European Leveraged Loan Index, 88% were in the ‘B’ rated category as of
November 2006, compared with 24% at the end of 2002.

Fenton Burgin, director of European debt advisory group at investment bank
Close Brothers, says the leveraged loan market is still enjoying very strong
liquidity and dynamics, and that recent interest rate rises have not impacted
the syndicated leveraged loans market.

“However, we have continued to move to an entirely distribution-led market
model,” he says. “The majority of banks are now pricing transactions and
structuring deals with the intention of those transactions being largely sold
into the institutional bank market. There is a range of CDOs, CLOs and hedge
funds participating in a market that historically was bank led. We don’t think
that the majority of FDs have fully appreciated the scale of the change that’s
taking place. The impact for the finance director revolves around how some of
these institutions will react to the potential need to change a financing
structure in the future. Importantly, we haven’t seen how some of these
institutions will react in an economic downturn.”

Feel the pressure
The upward pressure on interest rates is going to put a severe strain on the
leveraged loan market, given the huge escalation in the amount of debt that
companies are carrying, particularly those borrowers of poorer credit quality.
By any rational analysis, sooner or later this is going to lead to a fall out.

Fenton says that in a much more freely transferable debt market, FDs need to
focus on transferability, the nature of the underlying institution holding a
company’s debt, the ability to prepay a dissenting lender in the syndicate and
how much information a corporate is disclosing to its lenders.

“Over the past 18 months we’ve seen leverage levels increase to historic
highs as a result of market liquidity,” he says. “We’ve also seen banks willing
to accept less documentary protection to conditions in a credit. The result is
that if you get to a point where there’s a default under your facility
agreement, the FD in today’s environment will find that the banks will react far
more rapidly than has historically been the case to trade the debt. The bank
will take the view that if a default has occurred, it needs to move rapidly to
protect its position and sell that debt in the secondary market. The
implications for the FD are such that today there are a range of investors who
are keen to purchase distressed debt, and seek to use that position of debt to
drive an equity return.”

It has clearly become more difficult for a corporate borrower to know when a
trade occurs, or to whom the economic interest has been sold, given the trading
mechanism for bank debt. The prevalence of non-bank lenders has led to an
erosion of the established rules and framework for dealing with distressed
situations, and these will no longer be relevant in an environment in which
relationship banks hold a small economic interest in a borrower’s debt. The
result is that corporates are at risk of losing sight of the identity of the
underlying economic investors in their loans.