Where angels fear to tread

With Eircom senior debt trading in the 70s, ProSieben opco debt in the 50s, and TDC and Virgin Media in the 80s, prices on offer in the secondary market look like compelling value. Indeed, recent weeks have seen banks circulate pitch books aimed at new types of investor, hammering home the outsized returns available in the asset class.

Mid-market sponsor Electra Private Equity is eyeing opportunities to buy debt, according to chairman Sir Brian Williamson, commenting after the firm reported results for the year to end-September. However, even with the prices on offer, the experience of those that have taken the plunge suggests investors seeking easy money should proceed with caution.

The one sizeable bid attracted to the asset class over the past year were from hedge funds and private equity-backed funds that made large-scale investments in portfolios of unsold 2007 vintage debt. Those transactions were in many cases financed with up to three times leverage by the vendor banks.

As prices continued to fall, the banks that financed deals are making margin calls as these assets fall below triggers, in many cases set 20 points below the sale price. Investors such as Apollo and Blackstone-owned GSO have had to seek new equity from investors to keep their initial investments above water.

So far, they have been happy to top up their structured debt with the small amounts of new equity required, comfortable that underlying loans continue to perform. But the implication must be that the initial equity has already been wiped out as assets slipped below what were considered worst case scenario levels.

“In hindsight, deals shifted from the overhang at 85 now look like great value for the banks,” said one senior banker.

Bankers warn that while prices may look low, it is the economics of the loan market, not historic performance that investors need to assess.

“Investors’ entry price has to reflect both return requirements and a discount to ultimate recoveries, which for 2007 vintage deals are likely to be in the 70 to 75 range at best, and as low as the 50s and 60s for all senior deals,” said Edward Eyerman at rating agency Fitch.

For the loan market, Eyerman sees buy-and-hold investors prepared to own loans through potentially lengthy and value-destroying restructuring procedures as the only appropriate buyers of secondary deals.

“Leveraged loans are very different to equity investments, the market is illiquid and loans are private instruments with little disclosure or reporting and very wide bid/ask spreads.”

The performance so far suggests that investors need to consider not only the strength of the underlying credit but also to factor in refinancing risk. As the market now stands, few, if any, recent vintage deals will ever deleverage fully through paying down debt, and with little prospect of refinancing in the near term, exit options are limited.

Senior loan defenders point to their resilience in previous downturns. However, these previous recoveries were based on characteristics where senior debt was a limited part of a wider capital structure, covenants were tight and where the senior debt paid down.

Those characteristics were hugely diluted in the bull market by stretched senior structures, lack of amortisation, loose covenants and high debt multiples.

“Add the fact that deals were arranged within a year or two of what many believe will be the worst recession in at least 25 years and it’s clear investing in leveraged credit is not for the faint of heart,” adds Eyerman.