To say that European leveraged market conditions are strong is rapidly becoming an understatement. In recent weeks, more than €3bn of high-yield bond issuance, an imploding hedge fund and nuclear tests in North Korea have all failed to dent sentiment even slightly. Moreover, the last few weeks have seen a glut of new CDOs come to market, adding further to the already ample liquidity.
With borrowers firmly in charge, sponsors are continuing to press arrangers to improve the terms of their deals. In structural terms, this has meant issuing more debt at the senior end of structures in order to take out more expensive junior debt.
One of the biggest impacts of this has been seen in the market for second-lien loans, where there has been an explosion of new issuance this year. According to Thomson Financial’s figures, this year’s second-lien issuance will be more than double its 2005 total. By Q3 of this year, US$10,809m equivalent of second lien debt had been issued, compared with only US$5,476m for the whole of last year.
From a sponsor’s perspective, second lien’s main disadvantage over more junior instruments – cash drain – appears to be outweighed by the reduction in overall interest costs. However, issuing debt further up the capital structure requires corresponding changes in the buy-side.
According to David Yeoman, head of structured loan origination at RBS, this is exactly what has been happening: “A lot more buyers now accept second lien as a discreet asset class – there is less need to bundle it with other tranches. Most demand comes from banks or hedge funds, although there is also some demand from mezzanine investors. CLOs can also put second lien into their subordinated baskets.
“The asset’s popularity can also be seen in the fact that the vast majority of issues are very heavily oversubscribed, which has led to heavy reverse flexing on pricing,” he said. Where arrangers used to have to dig deep on the marketing front, distributing second lien has become much easier.
As with so much of the market’s recent innovations, the growth in the number of multi-strategy funds is one of the key drivers of the change.
“Some investors believe second lien currently represents the best value in the capital structure, especially hedge funds that may be able to achieve more effective leverage on the asset than mezzanine. They may be giving up some yield, but they are in a safer place in the capital structure and can borrow against the asset more cheaply,” said Richard Howell, co-head of leveraged finance at Lehman Brothers.
However, as ratings agency Fitch noted in a paper released last week, the fervour surrounding second lien has led to the resurgence of a “quasi-mezzanine” form of the asset, where it is the most junior element of the capital structure.
This year has seen a series of transactions – including deals for Versatel, Dorna and Center Parcs – without any form of cushion between the second lien and the equity.
The shift in investors’ attitudes is perhaps most evident from the pricing that these transactions have achieved. Versatel had the juiciest coupon at 600bp over Euribor, while Dorna’s piece was the tightest of the three at 425bp, and Center Parcs came at 500bp.
Although Fitch has summed up the market’s general view of these deals as aggressive, in fact only Versatel experienced pushback during syndication, and even that deal was wrapped up without any serious resistance. This is in sharp contrast to last year, when the absence of any debt junior to the 450bp second lien on Debenhams’ controversial Q205 issue led to protests that the second lien was simply mispriced mezzanine.
While these developments suggest that investors’ expectations surrounding the risk-reward profile of second lien has begun to settle, the fact remains that much of the demand for second lien still comes from hedge funds, rather than the buy-and-hold CLOs and dedicated mezzanine funds that underpin the markets for senior or mezzanine debt.
Subsequently, the appetite for second lien may prove volatile. As Fitch pointed out last week, we may be looking at one of the key bellwethers of the market’s stability.