Measuring LBO risk

The silence in the European leveraged loans market is deafening. Following the change in market conditions, initially triggered by rising delinquencies in the US sub-prime mortgage market, primary activity has come to a near standstill – creating a backlog of approximately €66bn of leveraged loans that continue to languish on arranging bank’s balance sheets. While the turmoil in the global credit markets has had a similar impact on the pipeline across the Atlantic, US arrangers are more aggressive in their tactics to shift their inventory, as well as structuring and pricing new transactions in line with prevailing market conditions.

Flight to quality

Having seen volumes at record levels of €118.4bn during the first half of 2007, the overheated leveraged finance market witnessed liquidity evaporate and price volatility spike in late July. As economists scaled back their growth forecasts for both the US and the global economy, sentiment in the global leveraged finance market shifted from a state of credit amnesia to credit paranoia.

The more limited investor funds that are available are looking for defensive, stable cash-generative businesses, conservatively structured, with pricing set appropriately to reflect the underlying credit risk and the lower risk appetite of the market.

So, unsurprisingly, there has been a significant fall in the new issue volume of ‘single-B’ rated US institutional loans – from 42.6% in Q2 2007 to 14.5% in Q4 according to Standard & Poor’s Loans Commentary Data.

A transatlantic divide

However, we are yet to see any evidence of a similar flight to quality in Europe because there has been very little new issuance, with the few deals that have been syndicated largely comprising small to mid-cap relationship style bank transactions.

While arrangers would argue that the lack of investor appetite is the major problem we would contend that the inability of the primary loan market to systematically differentiate pricing between loans based on credit quality, as well as taking proper account of the pricing signals provided by the secondary market, means that the European market is substantially handicapped when trying to attract the global investor.

Illustrating the problem, despite the very sharp repricing of risk and flight to quality seen in the secondary market, the one-size-fits all primary market new issue spreads for European institutional loans have risen by 40 to 50 basis points (bp) to the traditional, but somewhat arbitrary, levels of 275bp on tranche ‘single-B’, and 325 on tranche ‘single-C’ – as seen in recent deals such as Drie Mollen and SAG.

In contrast, as shown in the table below, new-issue US institutional spreads widened by between 75bp to100bp in the second half of 2007 but importantly the credit curve between ‘double-B’ and ‘single-B’ credits also steepened with the risk premium demanded for buying ‘single-B’ rated new issue paper as opposed to ‘double-B’ widening out to an average of 80bp from an average of 60bp in the first half of 2007. The greater volatility in pricing and new-issue spreads reflects the fact that the US loan market is, in essence, a capital market.

Biting the bullet

When necessary, the US market also demonstrates a greater determination to keep the wheels in motion by offering leveraged loans at a discount to par – enticing investors by eating into their own underwriting fees. This enables arranging banks to sell down positions from their balance sheets more easily. Strikingly, original issue discounts (OIDs) were seen on all new-issue transactions in the US in Q4 2007. However, in Europe the use of OIDs remains sporadic and less transparent – being applied to less than one quarter of all new loans in the same period according to Standard & Poor’s LCD.

The need for transparent benchmarks

At Standard & Poor’s, we are convinced this difference in market behaviour stems from the broader range of investors within the US who are typically less relationship focused and more motivated by commercial risk-return considerations. In other words, in most market conditions liquidity can be obtained if the price is right.

In Europe, by contrast, there is an evident lack of leveraged loans being systematically benchmarked to either public ratings or observable secondary prices. As a consequence, new-issuance for larger deals risks being left high and dry with the arranging banks until either investor liquidity recovers or until the arrangers can demonstrate that the underlying credit quality of the company and the structure of a deal is attractive on a relative value basis. Until then, do not be surprised to see that scarce investor funds will flow to whichever asset class, in whichever region offers the best expected returns adjusted for risk. If change is not forthcoming now that the credit cycle has turned the European leveraged loan market may drift back towards the safe haven of the ‘club’ market – prolonging the silence.