S&P sounds default warning

The risk of default in the European leverage buyout market has risen sharply over the past 18 months and the market may be at the height of its frothiness, according to three new reports from ratings agency Standard & Poor’s.

Given that default levels are near historic lows, and the extent to which leverage levels have risen and structures loosened, in S&P’s opinion it is “inevitable that the default frequency will pick up in due course when underlying economic conditions change for the worse”.

According to the agency, the combination of a big increase in money allocated to private equity, the availability of large buyout candidates, a large rise in underwriting capacity from commercial banks, and a benign economic environment, has created an intensely competitive market in Europe. This has pushed acquisition prices and leverage levels sharply higher. In short, buyouts are being structured based on market demand rather than credit fundamentals.

Against this backdrop and with default levels near record lows, S&P said that it was “increasingly important to assess the quality and seniority of the security, and ultimately the recovery prospects, that underpin leverage finance transactions in Europe”.

The rise in innovative debt structures, including subordinated debt instruments such as second lien, mezzanine and junior PIK notes, and institutional investor-friendly senior debt structures (namely those heavily weighted towards the B/C tranches), all point to the market being near its top, the agency said. S&P also noted the rapid trend towards early recapitalisations.

Data from the agency’s own ratings support the view that the risk of defaults is rising. In the first quarter of this year, 78% of loans that the agency reviewed were in the B category. That compares with figures of 58% in 2004 and 25% in 2002, and suggests a clear deterioration in credit quality.

The predicted increase in defaults depends on economic conditions changing for the worse. S&P expects “the continuing strength of the euro and oil prices to create a challenging economic outlook in Europe”, and said lenders “should place greater weight on downside scenarios for new LBO transactions”.