Review of 1999: Institutional loans ready for take-off

Progress was made during 1999 in the development of Europe’s institutional loan market. Step changes occurred when PPM, the global asset manager for the UK’s Prudential Corporation and an active participant in the US loan market since the early 1990s, established a leveraged loan group. Last year also saw Intermediate Capital Group (ICG), the publicly quoted mezzanine finance arranger, launch a euros 356.5 million CDO issue investing inter alia in European senior secured loans. These institutions complemented longer standing institutional investors in the European market from the US such as MetLife and GE Capital.

With the GBP585million Cinven/Investcorp-backed loan for Zeneca Speciality Chemicals, we have seen increasing participation in major large European leveraged loans during 1999 by mainly US-based institutional investors. However, institutional participation in the European market has remained thin when compared with the US.

Given its advanced state of development, we believe it valuable to an understanding of how the European institutional loan market might develop by understanding the principal types of non-bank investors in the US and the size of the institutional investment market in the US.

US non-bank investors

In the US there are around 150 different types of non-bank investors (insurance companies, funds and CLOs, as well as specialist finance companies) that actively invest in leveraged loans. There were only approximately 14 in 1993 and just 64 in 1997.

The principal types of institutional investor are:

Insurance companies – diversified into loans after initially investing in bonds, then private placements in the 1980s and,via high yield bonds, taking up leveraged loans in the 1990s. Active investors include MetLife, Mass-Mutual, Prudential of America, New York Life and Conseco.

Funds/asset managers – primarily prime rate funds, which have recently targeted retail funds. Some fixed income mutual funds and hedge funds invest on a limited basis in leveraged loans and examples include: Eaton Vance, Pilgrim Prime Rate, Cypress Tree. Some mutual funds also invest in leveraged loans, as for example, Apploosa Management or Alliance Capital, which has been active in Europe.

CLOs /CDOs/CBOs – the fastest growing segment of the market representing about 25 per cent of the non-bank investor base permitting funds, banks and specialised finance companies to pass through a potential balance sheet exposure to a tax-efficient securitisation vehicle (ie balanced high yield, ING income preservation offering). This is an area of potential growth in Europe.

Bank/investment bank managed funds – there are many bank owned/managed funds: eg DLJ leveraged loan fund, Merrill Lynch senior floating rate fund, etc.

Specialised finance companies – consumer finance, equipment leasing companies, which often support their major clients acquisitions with funds or lend against a spin-off business: for example, CIT, Capital Business Credit, Citizens Business Credit, Orix USA.

Finance arms of large corporates – eg GE Capital, Boeing Capital, IBM Credit.

Others including pension funds and trusts, savings and loans and boutique specialists – small category investors usually with a sector or distressed debt focus.

Institutional investors in the US (estimate based on Loanware and Loan Pricing Corporation data)

Notes

* It is difficult to provide a true picture of the CLOs/CBOs market share as many funds set up CLOs/CBOs in 1998-1999 and transferred their assets into such vehicles. The same relates to banks, insurance companies (eg MassMutual) and even specialised companies (eg Angelo Gordon – distressed debt broker).

* The high level of specialised companies and corporates market share is influenced by the active role of GE Capital.

* The level of market share for insurance companies is also distorted by a select number of active players, such as MetLife,MassMutual and Pacific Life.

Recent information from Loan Pricing Corporation indicates that leveraged lending in the US market for 1999 reached volumes of US$320 billion with HLT issuance of US$190 billion. The importance of the institutional investor in the US is demonstrated by the fact that in 1999 volume records were shattered with B, C and D tranche issuance of approximately US$57 billion, an almost 27 per cent increase on 1998 levels.

Given the level of corporate activity envisaged for Europe in the rapidly globalising, post-euro landscape, we believe it is only a matter of time before the institutional loan market in Europe also develops as a prime financing resource. This sector is key to the healthy growth of the European leveraged loan market. It holds medium-term implications for the traditional syndicated loan market and for private equity providers’ investor relations and financing aspirations.

Why should the time be ripe for investment in this asset class by institutional investors?

* Euro: The creation of the Euro has created a vast single currency pool and removed fund managers’ ability to arbitrage the different European government bond markets and foreign currencies. Market convergence has led to an increasing concentration on credit-based returns. This has fuelled demand among European institutions for high yield bonds with over US$17 billion issued in Europe during 1999 with an increasing component placed with European end investors. We believe it is only a matter of time and education before the loan becomes an asset class that is considered by European institutional investors on a relative value basis, ie how does the risk /return profile on a loan compare with that on a bond?

The single currency also facilitates US institutional leveraged loan investors by limiting their need to hedge exposures, thus making Europe a more attractive investment opportunity. A number of recent CLOs issued in the US market incorporate provisions for non-US dollar denominated assets from non-US issuers.

* Dealflow momentum: Mergers and acquisitions, corporate restructuring activity combined with private equity capital. Record capital raising by private equity funds with a European investment focus has led to 14 funds of over euros 1 billion being raised, according to a Morgan Stanley Dean Witter study for the period 1997 to 1999. This has contributed to a high volume of leveraged buyout activity in 1999 with much larger transaction sizes (eg Grohe, Zeneca Speciality Chemicals, William Hill and Hillsdown Holdings). The combination of this private equity capital pool with existing under-invested funds and the expected M&A and corporate restructuring activity (particularly in Germany, France and Spain) during 2000 will require a buoyant debt market. The need for increasingly large amounts of debt financing will create its own momentum.

* Larger deal size: Pan-European activity permits fund managers greater opportunity for portfolio diversity . The new dealflow will provide a platform for the issuance of CLOs/CDOs and provide greater portfolio diversity away from heavy concentrations on telecoms buy and build financings into more industrial-based investment categories.

* Bank consolidation : The loan syndicator’s investor base has shrunk as banks across Europe have merged, thereby reducing the number and total of absolute investment amounts available from large and retail based bank investors. Participation amounts by individual lenders also are modest in size as portfolio management techniques take root with greater concerns for risk-adjusted returns and portfolio and sector concentrations. Alternative sources of distribution will be required.

These converging elements should mean that a number of the macro factors are in place to develop the market.

Attractive investment characteristics

Below are some of the reasons why the leveraged loan market is an attractive proposition for institutional investors:

* Most senior position in the capital structure. Default studies indicate that the recovery rate for bank loans is much higher than that of senior subordinated bonds. Recent Fitch IBCA studies indicate that the average recovery rate for senior loans is 82 per cent versus 45 per cent for senior subordinated bonds.

* Protective financial covenants in well structured senior debt agreements provide protection against material credit deterioration and should trigger an early warning’. Effective financial covenant packages can provide notching upwards of credit ratings from the entity’ or unsecured rating, which measures the likelihood that the borrower will default on its debt.

* Security can provide higher recovery rates, although this will depend on structure, nature of collateral and extent of coverage. The impact of insolvency regimes in the different European jurisdictions will also affect the probability of default and the severity of loss.

* Floating rate interest payments provide protection against interest rate risk. Interest payments on loans are linked to London interbank offered rate (LIBOR) and maintain a fixed credit spread without investors having to make guesses about the yield curve. Loan funds can be a safe haven in poor bond markets and also offer higher returns than money market funds.

* Lower volatility of returns. A September 1998 Fitch IBCA report compared the annualised total returns of six bank loan funds to the Merrill Lynch high yield index. Although Merrill’s high yield index provided a superior return compared with bank loans – 9.16 per cent per annum versus 7.38 per cent per annum – it did so with eight times the volatility. Fitch IBCA studies have also shown that the average monthly return on distressed loans is actually positive as compared with that on distressed bonds .

How do we jump start institutional investor interest both from European and US institutions?

* US institutions seem poised to become active investors in the European market either through new CLO-based structures or as part of their existing portfolio diversification. However, a narrowing of the price differentials between the US and European markets is needed to generate real US interest. While US investors are prepared to lend for longer maturities, they will require higher returns than European-based structures placed primarily with banks.

* Pricing in Europe has tended to be relatively static’ historically for leveraged transactions as compared with the greater volatility demonstrated in the US. More dynamic pricing movements with greater focus on credit differentiation within sub-investment grade transactions in Europe will be necessary to generate greater US institutional interest. A recent Portfolio Management Data study including the first three quarters of 1999 demonstrates this.

At the same time, private equity groups will need to accept that the larger transaction sizes will require institutional monies and consequently a higher cost of debt financing.

* Tailored institutional tranches – Lead arrangers need to be more creative and tailor specifically structured institutional tranches to help create a market. Arranging banks will also need to syndicate the revolving credit tranches to traditional bank participants rather than to institutions and structure tranches for distribution on a non pro-rata basis.

* Greater use of bank loan ratings – Use of bank loan ratings, usually a requirement of CLO-based structures, will provide greater comfort to both US and European institutions that currently have limited analytical resources available for the European leveraged loan product.

Rating agency work on insolvency and recovery rates in default situations in different European jurisdictions will also be required. Education by the rating agencies, leading lawyers and bank and investment bank arrangers of the issues and the historic loss experience will also be important in developing the pan-European market.

* Greater liquidity – Leading arrangers and secondary market traders will need to improve secondary market liquidity by market making. This will be very important for fund managers with an active trading mentality’. Conversely insurance companies have less interest in secondary market liquidity.

* Benchmark indices – In order to broaden the market it will be necessary for benchmark indices to be established so that fund managers can measure their performance against such indices.

As with the development of the securitisation market in Europe and the high yield bond market, investor education is key to the development of a European institutional loan market. Traditional loan syndicators will have to adapt to a loan capital markets model already embraced by those out of the old Bankers Trust’ school where relative value becomes essential to ensuring successful distribution. The private equity houses will need to be prepared to develop new investor relations with non-bank investors and to tailor their financing structures to accommodate them. This is the future!

Simon Hood is managing director, syndications at Greenwich NatWest and Herman Guelovani is assistant director, syndications at Greenwich NatWest. The authors write in a personal capacity and the views represented in the article do not necessarily represent those of Greenwich NatWest and/or the NatWest Group.