By Joy Ferguson and Michelle Sierra Laffitte
Despite a rally of LBO-related activity in October following the summer shutdown, the leveraged finance market fell into a slumber in the final stretches of 2007, leaving many of the planned deals unsold.
The high-yield and leveraged loan pipelines in the United States are still large, at roughly $80 billion and $170 billion, respectively, with more than three-quarters of that amount backing LBOs, according to Barclays Capital Research.
Not even the surprise pricing in November of an impressive $3.75 billion worth of bonds to back the buyout of the former TXU Corp. could rouse the market. Remarkably, the deal was driven by an order from legendary investor Warren Buffett, who bought a sizeable $2.1 billion chunk divided almost evenly between the cash pay and PIK-toggle notes. Buffett’s interest sparked demand for the deal, but, alas, increased appetite for the broader market didn’t follow in his wake. Investors were taking a long position on Energy Future Holdings, as TXU is now known, not the market itself. Now investors are only targeting small quick-print or well-known corporate offerings.
The depressed market shows little sign of letting up in 2008.
“Not only is the deal overhang a big issue, but even bigger is what’s going on in the entire fixed-income market related to sub-prime, SIVs and the credit availability in the market,” said one portfolio manager. “The combination is going to weigh heavily on the market across all risk assets.”
Most underwriters will start out in 2008 cleaning out the leftovers from 2007 before signing up any sizeable new financing commitments. “I expect a continued reduction of the pipeline,” one banker said. “Until the market digests that, it will be tough to bring in new issues.”
Meanwhile, market participants are keeping an eye on deteriorating macroeconomic conditions. Last month, the 12-month issuer weighted default rate edged lower to 1.0 percent from 1.1 percent, the lowest it has been in more than two decades, according to Moody’s Investor Services. But that’s bound to change, according to Moody’s, which has predicted the default rate will jump to 4.7 percent by November 2008.
“Our baseline forecast incorporates a slowing U.S. economy in 2008 but no recession,” said Kenneth Emery, director of corporate default research for Moody’s. “If a recession were to materialize, default rates could increase to near double-digit levels.”
Impressive issuance totals for 2007 reflect the easy financing conditions throughout much of the year. Leveraged loan issuance soared to record highs despite the souring market sentiment. Through the first week of December, year-to-date leveraged loan volume hit $1.02 trillion. Issuance for 2006, 2005 and 2004 came in at $755.3 billion, $593 billion and $496.1 billion, respectively, according to Thomson Financial, publisher of Buyouts.
High-yield bonds took up less space in 2007, however, most likely reflecting the prominence of second-lien loans in the first half of the year. They have since vanished with the decline of the credit market. Year-to-date high-yield issuance through the first week of December totaled $132.1 billion. Issuance for 2006, 2005 and 2004 came in at $152.4 billion, $97.9 billion and $142.2 billion, respectively.
Market players predict a supply reduction in all forms of leveraged lending in 2008, particularly as underwriters limit new commitments as they clear out the pipeline. That, in effect, will lead to a better demand-supply dynamic, which may be seen within six to nine months, according to one investor.
“I would say if we do see some stability in the broader markets—investment grade, equities, liquidity markets—and depending on what the Fed does, we could see these deals chipped away over the coming months,” said the investor. “If housing takes another leg down, there’s going to be a big overhang still.”
At the very least, returns are hoped to be better than the 2.1 percent recorded for high-yield through to the end of November, according to Barclays Capital. Barclays forecasts 4 percent high-yield total returns in fiscal year 2008, driven primarily by rising interest rates and modest default losses.
Joy Ferguson and Michelle Sierra Laffitte cover leveraged lending for IFR, a sister publication of Thomson Financial.