Buyouts: Secondary trading in leveraged loans is starting to reflect economic realities. Will primary pricing follow suit?

The growth in secondary trading has been one of the biggest developments in Europe’s leveraged loan market in 2003. Bankers estimate leveraged loan trading has increased by up to 40% over last year’s volumes of €5bn, with €3.5bn traded by June and an annualised 2003 rate estimated at over €7bn.

Although this is still a fraction of overall trading volumes of €25bn in the first half of 2003 and €36bn for the whole of last year, according to Loan Market Association (LMA) statistics, it shows the secondary market for leveraged paper is growing in size and depth. About 60 leveraged names are now routinely traded, compared to just 30 last year.

More and more banks are devoting resources to leveraged trading, either by setting up desks or by making substantial carve outs for leveraged loans. Whereas just two years ago there were only a few major leveraged loan trading desks in Europe, most notably Deutsche, CSFB and JP Morgan, today there are at least 10 desks giving the market non-investment grade prices on a daily basis.

“The secondary market for leveraged loans has undergone a huge transformation since 2001, evolving from almost nothing two years ago into a fully functioning and liquid market today. There is still a long way to go, but it is developing rapidly,” says Stan Sokolowski, head of European loan trading at JP Morgan in London.

The increase in the institutional investor base is a major driver of leveraged loan trading. Institutional investors, comprising mainly collateralised debt obligation (CDO) vehicles, now account for over 20% of Europe’s leveraged loan market, mushrooming rapidly from under 5% of the market in 1999. There are about 40 CDO vehicles now in existence in Europe, compared to just three in 1999.

Although CDOs are not compelled by regulators to mark to market, many often do so due to internal investor pressure. Thus unlike many banks in Europe, they do not merely buy to hold. Instead, CDO funds actively move assets in and out of their portfolios to maximise their returns and are far more diversified than banks in terms of their asset base. In addition, when a fund becomes fully invested, it is compelled to sell assets in its portfolio to make room for any attractive new assets it wants to buy, thereby boosting secondary volumes still further.

“Institutional investors are driving the increase in leveraged trading. In particular, CDOs are growing and they trade their portfolios as part of ongoing portfolio management. Investment banks perceived this need for liquidity, hence the number of leveraged trading desks has materially increased over the last year,” says Mike Ramsay, head of leveraged finance at Prudential M&G.

Shift in bank strategy

However, institutional investors are not the only reason for the growth in leveraged trading volumes this year. Banks have been even more instrumental in growing the market and have been responsible for the lion’s share of trading. This is because, although overall leveraged loan volume is up on 2002, substantial demand from banks for leveraged paper is outstripping the supply of deals this year.

In addition, banks can buy across the leveraged loan platform, spanning LBO loans, leveraged corporate and fallen angel financings. CDOs are largely limited to LBOs, as usually fallen angel and leveraged corporate deals carry insufficient pricing and corporate information levels for them.

Bank demand for leveraged assets is stronger than ever. Primary deal flow has failed to meet banks’ desire for assets this year, so they have turned to the secondary market to pick up paper. “There is a huge imbalance in the supply-demand ratio in Europe’s leveraged loan market. Banks are being driven into the secondary market as they cannot satisfy their buying requirements in primary,” says Stan Sokolowski.

In addition, portfolio management is becoming increasingly important for banks, following the losses they incurred after the telecom crash and the alarmingly rapid migration of so many credits into fallen angel territory. More and more banks are looking to sell down some of their exposure in the aftermarket. “More banks are turning to secondary due to regulatory and shareholder pressure to increase their return on capital,” said Mike Ramsay.

In addition, many banks are refocusing away from clients that have not historically delivered meaningful ancillary business towards those that have. Some smaller banks at the bottom of the banking food chain are fed up with missing out on ancillary business and are starting to act more like asset managers than relationship managers.

Thus although relationship lending is still very much entrenched in Europe and shows no signs of abating, most corporates have seen their bank groups shrink, with the remaining relationship banks still accepting very fine pricing while increasing their ticket sizes. An increasing number of smaller banks, meanwhile, are focussing their attention on the secondary market, where they are often finding they can pick up paper at a significant discount to primary.

The growing secondary market has already started to change the way investors behave. This summer’s groundbreaking €3.2bn financing for Italian yellow pages firm SEAT Pagine Gialle highlighted this sea change, which first came to light in 2002’s mega loans. Increasingly, lenders are holding back at least a third of their desired take from primary, where they think the paper will trade outside fees in secondary.

SEAT has set a new standard for how banks and funds behave for deals of size and, going forward, the split ticket is likely to be a common strategy. Fear of making enemies of influential mandated arrangers and underwriting groups, coupled with the need to see the full information package through a primary invite, means few lenders will side-step primary altogether, however.

Diverging from primary

As the secondary market has expanded, so it has slowly started to diverge from the primary market in pricing methodology. Primary pricing in Europe’s leveraged loan market remains irrationally static.

Almost all LBO loans in Europe carry spreads of 225bp, 275bp and 325bp over Libor across the seven-year term loan A, eight-year term loan B and nine-year term loan C tranches of debt, irrespective of relative value, investor liquidity, credit quality, deal size or wider market occurrences. Similarly, pricing for non-LBO leveraged credits hardly ever reflects the true quality of the credit and can be as low as 125bp for corporates with significantly lower ratings than an LBO.

Even the largest ever European leveraged loan, SEAT’s €3.2bn package, bore the standard 225bp/275bp/325bp spread blueprint, with no pricing premium, despite its size.

Europe’s primary leveraged loan pricing system stands in stark contrast with that of the US, where pricing resembles the fixed income capital markets in nature and movement and therefore fluctuates widely. The rationale behind Europe’s illogical primary pricing system lies in its bank-dominated investor base. In the US, institutional investors now comprise over 65% of the leveraged loan market, while in Europe, despite the increase in the fund investor base since 1999, banks still account for nearly 80% of the market.

Funds require rated paper, liquidity and are more driven by yield than credit. As a result, the US market prices risk in a far more sophisticated manner than Europe does. There is usually at least a 100bp difference in the spreads of a Single B and those of a BB+ rated credit in the US. Europe, meanwhile, still makes no pricing differential between the two very different credit risks.

Similarly, in a bull market, US borrowers can knock spreads down by well over 1%, while when market conditions are less favourable and investor liquidity is low, spreads can double in some cases.

However, as it has grown in liquidity and size Europe’s secondary market has diverged away from the region’s archaic primary pricing blueprint. Relative value driven pricing fluctuations are still rare, given the enduring disconnection between the loan and the fixed income markets, but secondary pricing is now technically driven. Over the past two years, it has started to fluctuate in line with investor liquidity and, to some extent, with credit quality, rating and performance. Although this movement in secondary leveraged loan pricing started in 2001, this year, pricing has fluctuated far more quickly than ever before.

In some respects the jumbo loans for Legrand and Jefferson Smurfit at the end of 2002 were the catalysts for this development. Both deals have undergone dramatic pricing movements due to substantial changes in investor liquidity. Having left some primary lenders long, on reaching secondary at the end of last year, prices on both Legrand and Smurfit tanked. Legrand hit a low of 97, while Smurfit plummeted to 96, as supply flooded the market but demand from investors was scarce. Since then, a number of other deals, including Demag, Telediffusion de France, Vivendi Universal and Elis, have also suffered from oversupply.

However, since the summer, the investor liquidity tide has turned. Repayments have risen due to a spate of refinancings and a rash of CDOs started warehousing and ramping up. In addition, as the second half of the year progressed, banks’ need to book interest income to make budget increased. The result is that prices across the leveraged board have risen dramatically since August. Even the over-supply names such as Smurfit are now at historical highs, with Legrand trading in the 99’s by late September.

As well as investor liquidity, secondary pricing is also starting to fluctuate in line with wider market events, ratings and economic performance. Vivendi Universal’s three-year term loan A, which changed hands in the low 98’s just four months ago, was by October no longer available under par. The rally is not just due to a lack of supply or to strong demand for the paper, but rather to the fact that the company has got its debt under control, diversified with a convertible bond and also made a series of disposals including Vivendi Universal Entertainment.

Knock-on effect to primaries?

As the secondary market grows and secondary pricing becomes more volatile, bankers are pondering if and when this will have a knock-on effect on the primary pricing of leveraged loans.

As deals become larger, the trend for portfolio management becomes more prolific, institutional investors grow and more general syndication players wait for secondary, so more banks could be left long in primary.

If enough underwriters have to reduce their over-exposure outside fees in secondary, it seems natural that this will eventually impact primary pricing. “The secondary market will eventually influence primary pricing. When enough underwriting banks have been hurt after mispricing a primary loan and seeing the paper plummet in secondary, they will start to price risk correctly in primary,” says Tom Johannessen, senior loan trader at Dresdner Kleinwort Wasserstein.

So, in time, many bankers expect the growth of trading to force a more rational primary pricing system. “The development of a more active and sophisticated secondary market will encourage more relative value assessment and will in time be one factor which leads to differentiation in primary pricing,” says Tim Ritchie, head of global loans at Barclays Capital.

Other factors will also bring about more logical primary pricing. If the overall leveraged loan market grows, so liquidity in the market rises in turn this will be a further catalyst for change in primary pricing. “The pace of development of the leveraged market will be a major determining factor in the growth of the institutional investor community. If deal sizes and overall volumes continue to increase, the market will attract institutions more quickly. This and the resulting growth in secondary activity will speed the development of a more price-sensitive market,” says Ritchie.

Loan ratings and Basel II will also encourage credit differentiation through pricing in the primary market. Although at present institutional investors have to make do with shadow ratings, as their ranks swell and their influence grows, so too will demands for public loan ratings. Public ratings will highlight the differences between individual credits; differences that are currently only illustrated in Europe through leverage levels. As this happens, so primary pricing will have to start to distinguish between a BB+ rated credit and a single B credit.

Some bankers are extremely bullish about the length of time it will take for secondary to start to impact primary pricing. “Sponsors need to think about the impact that primary pricing and execution will have on secondary performance. If a sponsor’s deal trades down to the mid 90’s, banks will think twice about supporting its next deal. Secondary hasn’t impacted primary pricing yet, but it will within the next 12 to 18 months. The only limiting factor will be if the supply-demand imbalance continues,” says Stan Sokolowski.

Entrenched culture

However, despite encouraging secondary market developments and the growing conviction that in time the face of primary pricing will change, there are still substantial obstacles to a more rational primary pricing system in Europe.

Firstly, it is far from certain whether the leveraged loan market will ever grow sufficiently to even out the supply/demand imbalance. Secondly, even if Europe’s leveraged market does continue to expand, institutional investors are unlikely to reach US levels. Europe’s fund market is dominated almost entirely by CDOs and lacks the mutual and prime rate fund base that makes up a substantial part of the US institutional investor base. CDOs alone are unlikely to outnumber Europe’s vast banking community.

The only reason funds were able to rise to dominance in the US was that the banks there could not absorb the high level of supply. In contrast, not only is Europe over-banked, but also its banks are still extremely enthusiastic investors in leveraged loans. So even with progress in bank consolidation, it could take 10 years or more before mergers reduce bank numbers to a level that would allow the fund market to gain supremacy.

And, competition for leveraged mandates is so intense in Europe that there will always be some banks that agree to maintain the 225bp, 275bp, 325bp primary status quo in order to bag business and retain sponsor relationships. Similarly, most leveraged loans are still strongly supported in general, with local banks ploughing into local deals irrespective of pricing and oversubscriptions routinely raised. Low default rates have reinforced appetite for the asset class, since banks have not suffered sufficient losses to compel them to demand higher pricing.

With banks set to dominate Europe’s leveraged loan market for the next five years at least, it is hard to see primary pricing moving to a more rational footing. Banks’ inability or aversion to price risk correctly and the culture of relationship lending is just too entrenched. Until banks stop their relationship lending and start to price risk correctly, secondary pricing appears unlikely to create a more coherent primary pricing system in Europe.