Just a month into the new year and flexibility is fast establishing itself as a guiding principle in the leveraged loan market. A recent spate of European LBO financings have been launched without an A tranche or have undergone radical structural flexes after syndication.
European leveraged debt structures used to be formulaic but over the past 18 months those structures have been fine-tuned to suit particular circumstances. However, the number and regularity of increasingly unusual structures indicates a double shift for the European market.
At a basic level, the trimming or eradication of the A tranche highlights the hugely expanded impact of non-bank lenders that invest in all other parts of the capital structure, and the unpopularity with many sponsors of amortising tranches that eat into cashflows.
The amenability of bookrunners and investors to the re-ordering of capital structures after launch suggests that the changing investor base is pushing the market towards a public markets model in which structure and pricing are set in the market and books built rather than run.
Sponsors are armed with huge amounts of money at the moment and competition among them is driving up buyout prices, so the ability to finance deals with minimum impact on borrower cashflow is of growing importance.
“Banks in turn are competing among each other fiercely to create terms and conditions that will best suit sponsors’ interests,” said Edward Eyerman, managing director and head of the European leveraged finance team at Fitch.
Charlotte Conlan, head of leveraged finance origination at BNP Paribas, agreed. “Sponsors have always sought the best available package but this is now increasingly driven by highly flexible investor attitudes and never-ending liquidity,” she said. “As a result, the leveraged finance market is now a much more investor rather than a credit-driven market.”
Conlan said structural flexes on deals helped establish new market norms. “Structural flexes are being used to find the market level. Where a structural flex has worked – removing the A, or switching subordinated debt into senior, for instance – the new structure sets the bar for how future deals will launch,” she said.
Sponsors, however, are not the sole beneficiaries. “Key pressure for flexible structures comes from sponsors, but back-ended repayments can also suit institutional investors and hedge funds that don’t want to be repaid in the short term,” said another banker.
That KION’s €3.5bn loan supporting the largest ever German LBO has just been launched without an A tranche shows that these new structures are becoming mainstream, especially as it comes after the TdF’s aggressive structural flex.
Some see the absence of an A tranche, in particular, as a potential credit issue because the lack of amortisation creates back-ended repayment structures, potentially storing up trouble for later, especially if higher interest rates start to bite. Bankers acknowledged that there was risk of credit deterioration but played down the impact.
“For the creditor this does mean additional risk, though with default rates low and the economy strong that is not having an effect on investor appetite. Banks also have been happy to join the B and C tranches where the A is not available,” said one banker at Morgan Stanley.
And changing debt structures do not have to lead to weaker credits.
“In credit terms, the key is to have mandatory pre-payment from excess cashflow,” said Michelle De Angelis, senior director of leveraged finance at
“Changes to the capital structure do not necessarily have adverse implications for credit quality,” she said. “What can be a credit issue, however, is the absence or diminution of an early warning system. Without amortisation, for example, it is easier for a borrower to continue to fulfil just its interest payment obligations when a business might be struggling and consequently delay the opportunity for lenders to take action.”
However, amortisation is not the only way to reduce leverage. Borrowers can use increased cashflow to reduce debt, or use cashflow to expand the business and deleverage through earnings growth.
With investors unfazed by credit deterioration fears and the market moving towards less rigid approaches, a new dynamic is clearly developing.
The real impact of heavy structural flexes is the changing way in which the market is processing syndications. Investors are increasingly not only accepting changes but even factoring the potential for flexing and reordering into their initial responses to deals.
“Investors now anticipate flex when a deal comes to market, which effectively means the debt is being sold on a bookbuild basis, even if informally,” said Conlan. “This suggests we are moving in the direction where deals are priced in the same way as the bond or equities markets. There is nothing to impede that drift, and nothing to deter a bookrunner from coming to the market with a price range and letting investors set the correct price up front.”