European Leveraged Finance Roundtable 2007: Part 1
IFR: Let's begin by looking at the events over the summer that caused the wholesale closure of the global leverage space?
Eric Capp (RBS): The theme that has been used is rolling contagion, which had its genesis in the fallout in the sub-prime market. And I think it is interesting that the market exhibited some unusual behaviour this summer, at least in the leveraged loan market, where formerly the paradigm was emerging market equities fell over and western equities would follow, there would be a fight to quality, treasuries would rally, the iTraxx would then go out and the high-yield bond market would trade down. But the senior loan market would just stay basically where it was; in fact, it probably rallied during those periods where there was so much liquidity in the market, much of it coming from institutional investors.
But this summer you had a very strong equity market but also the US sub-prime issue. That basically cast a lot of doubt on the structured credit market as a whole, which ultimately spilt over into the CLO market. At this point everyone said, "well equities are still strong but what really could hammer us even further is if equities trade off". Then over the summer equities started to weaken and though equities are still fairly strong there is renewed debate on the strength of the US economy based on spillover effects from the housing crisis. And then there were problems in the interbank market and the commercial paper market and altogether this has affected the structure of the credit markets.
People use the term "rolling contagion" as this has caused credit investors to reprice the senior secured and subordinated asset classes, and look at them in light of what is happening in the broader structure of the credit market. That repricing in the leveraged loan and higher bond asset classes has been severe.
David Slade (Credit Suisse): It was an absolute drawing in of liquidity. A lot of professionals had been seeing what had been developing over recent months and knew that there was going to be a stage where the market would not be able to main its momentum. Leverage could not inexorably rise at the same time as covenants were being removed while price continued to go down.
The sheer volume of demand for assets outweighed any rational issues in terms of structure and almost anything went. We were all beginning to say we have lived through oil prices going to US$70, we have lived through terrorist events, we have lived through flattish economies both in Europe and in the US, and still there has been this inexorable rise in the loan market. And I think people were beginning to say: "the only thing you can really see changing is if liquidity disappears".
Nobody could foresee what that liquidity event would be, but because of all the external shocks that the market simply sailed through, it was always going to be a supply/demand issue that was going to change it.
The problem is you had a gushing tap in terms of supply and demand for assets, and that tap, in the space of two or three weeks, was switched off.
Something happens in sub-prime, that affects investors in sub-prime CLOs. Those investors in sub-prime CLOs are similar to investors in leverage loan CLOs. Suddenly the pricing goes through the roof, the economics don't work any more for CLOs because the pricing has been going down in the meantime on the assets. Suddenly the CLO market gets closed, so a lot of the banks that had been arranging the CLOs switch off liquidity lines, warehouses, TRS programmes. Suddenly the CLO funds found their only liquidity was in their existing portfolio. And that massively shrunk capacity. And then with the secondary market going down, why would a fund sell an asset anyway to buy another asset?
So you get complete bifurcation between primary and secondary. That switches off primary, and you can see how rapidly it spread through the market. That is essentially where we are today.
IFR: The speed was surprising and it hit everybody. What was the actual trigger? Was there a single event that caused the dominoes to fall?
Charlotte Conlan (BNP Paribas): It had been happening quietly for a while, it's just that nobody started to put the pieces together. I mean, for the last few years lenders were confident that in making a commitment of €100m they would be allocated €10m. So a great amount of the liquidity was artificial, but it suited everybody to let that game continue.
What we started to see was lenders were committing €100m and were starting to get closer to €100m. So as bank and fund investors started to see their allocations getting fuller, money started to evaporate. Then, there was a withdrawing of liquidity from the CLOs. And we had all become, on the arranging side, incredibly reliant on that part of the market to place all parts of a transaction.
David Slade: It wasn't one specific thing, but the signs started in the US.
Two or three deals in the US started sticking. Thomson Learning and US Food Service were some of the first signs that all was not well in the loans market. And because you now have global investors, it spread very, very quickly.
Nick Jansa (Deutsche Bank): If you want to pinpoint one catalyst, though it wasn't necessarily the reason for the downturn, there was a change when S&P specifically came out with their view on incurrence-based covenants. That was the day when people were genuinely very nervous with sub-prime and what was happening. There was concern among CLO equity investors and portfolio managers that they didn't fully understanding how much of their portfolio was tied up in this. The pressure on Thomson Learning, US Food Service and more or less everything else started the next day. So a lot of the guys that were previously willing to commit, decided to pull back and wait and see.
These weren't fundamental concerns; these were all sentiment-type issues where equity investors started to question some of the underlying principles of what their portfolio managers were doing. The portfolio managers, therefore, take a more conservative stance.
All these things trickled in at the same time that you have the huge supply/demand imbalance. People were becoming more and more nervous every day in the US with every new public to private deal that was announced. Every week there was another US$20bn to US$40bn P-to-P announced. So people's concerns were heightened on the technical picture.
Eric Capp: The other data point was the secondary trading on the ProSieben deal, which was a large transaction and heavily oversubscribed. And when it broke in secondary, it traded down almost immediately. It looked more like a high-yield bond deal than something seen in the senior loan market. The focus was then on secondary performance and on whether it made sense to buy deals in primary if in secondary they could trade down two or three points.
John Foy (Prudential M&G): Eric makes a good point on ProSieben and it stretches not just to hedge funds, but to institutional investors as well. You do get fed information by the investment banks on the size of the book, whether it is a real book or a fictitious book. We had been increasingly nervous over the last six to 12 months with the froth in the market.
We didn't really know what the true state of the market was and we didn't really know how big a book could be built and could be sustained, particularly when you've got the mark-to-market vehicles. And with an asset that was supposedly heavily subscribed breaking at the levels it broke at meant a lot of investors lost a lot of confidence in the information that they were being fed by the investment banks.
IFR: That's what happened but where does that leave us today? What is the depth of the market? Is a €1bn leveraged loan possible today in Europe?
Charlotte Conlan: Yes, just about, if things are running correctly. But there is not much interest. Arrangers are nervous about launching deals because they fear being crushed by investors or that it will be far too expensive. And for all these great credits, nobody wants to pay an enormous amount of fees to place what underwriters think are good deals. And so, until there is some confidence on the part of investors, and on the part of the investment banks to bring these deals to market, we are all going to stand there and look at each other.
John Foy: I would probably start at closer to €500m than a €1bn. I am pretty downbeat after seeing the reaction to a number of transactions from some of our counterparties and the amount of capital they can deploy. Given that the warehouses can be switched off and are fully ramped, there isn't an awful lot of liquidity in the institutional market.
Eric Capp: I think you have to disaggregate. The questions are: what is the size of the institutional market? And: if the institutional market is zero, what kind of deal can you put together outside of the institutional CLO market?
There are pockets of liquidity in the bank market, whether that be regional banks who have not really been affected by the CLO meltdown or other commercial banks around the region who generally sat out the last six months of deals. Some banks' internal credit committee said: "leverage is too high, there are no covenants, we are not going to do it". Pricing may be less of an issue for those banks, but there are plenty of banks that sat out the market, and so there is bank capacity.
Now, the leverage levels associated with that capacity may not meet buyers' or sellers' objectives in the current M&A environment and that needs some adjustment, but there is liquidity there. Dedicated mezzanine funds haven't been doing much for a couple of years and they have plenty of capital available to put to work at a price and leverage point.
The high-yield market is damaged, but it is not nearly as damaged as the CLO market. We do think there is some liquidity there for good deals, so as arranger banks we have the ability to put together deals. It is a question of whether they fit into what buyers need in terms of their equity returns and what sellers need in terms of where they will sell assets. That adjustment process takes a little bit of time – until sellers come down to prices that buyers can pay.
David Slade: It is impossible in today's market to put a figure on what is the capacity because I think there are some games being played by both sides. There are some funds which do not have access to liquidity – and don't want us to know – that are saying: "I am just waiting until the market settles down; I have money to invest but I am just going to wait and see." I question whether they do in fact have liquidity.
There are other funds which do have access to capital, but they are trying to call the bottom of the market, and there is no confidence at the moment that the bottom has been reached. No one wants to buy an asset one day and find it is down by one or two points the next.
A lot of guys are not yet calling the bottom of the market, and until they feel they have reached a threshold below which generally you are not going to go, they are very nervous about investing.
I am taking the view funds are closed. So anything that a fund gives me is a bonus – icing on the cake. So you focus on banks. You therefore have to look at the structure of deals as they were done several years ago. But as is normal in difficult times, it is harder for many banks to read their credit committees, because I think there is always going to be a view at some banks of, "why are we the last man standing, why are we the only ones lending?".
But I think it naturally follows in terms of capacity that if you have a bank-only market your capacity has massively shrunk. ProSieben is an interesting case. We were involved in ProSieben and, frankly, we still scratch our heads as to what exactly happened in the secondary market because we know it was oversubscribed – all the funds were heavily scaled back.
So in terms of the solidity of the book, although we always prod investors we are not going to second guess them in terms of what they say they actually want because it was always the case that the funds would phone up various bookrunners and say, "that is a real number – I really want that number, don't scale me back". So it was a very disappointing secondary performance, but we were wondering what was going on there because we knew what the real book was, and it was very, very well covered.
John Foy: The other bit we are ignoring is that there is a massive overhang here as well. We have some US$240bn in the US of product that needs to be scrubbed, reworked and sold down. So whilst on the one side we have some institutional buyers playing games, you've got people on the other side saying, "yes, we are open for business but here is the offer", knowing full well it's not going to work. I would suggest that the number of banks really putting out credible offers is very small.
Nick Jansa: In addition, banks are only there selectively and this is not only a credit issue but it's also down to higher cost of funds. For example, although Deutsche Bank sold a 10-year bond issue recently, the yield was much higher than it would have been a few months before. When you start talking to, let's say, some of the German landesbanks, or some of the Spanish banks with real estate issues, their cost of funding has increased fairly dramatically. So the returns they need to meet their return-on-equity requirements have moved substantially since even April or May. That is fundamental when you are looking not only at the investment credit lending world which has been impacted, but also all the way through to subordinated leverage transactions.
So we've got to be mindful here that the banks are open but they are being more selective with their use of capital. And that goes across the credit products, not just for leverage: they are looking at their balance sheet and where they want to utilise it. That means they are open but they're not there in the size they may have been two years ago.
Charlotte Conlan: Or even that people thought they might be earlier in the summer. Everybody thought even if the fund number was zero, we have a lot of banks out there who can all do deals – as long as the structure is right and the leverage is lower, they will still buy the deals. But they are not buying; at least not in either the same numbers or same amount.
Banks are being very selective for return reasons, and as in the investment-grade world the relationship card is played. Banks want to know what other ancillary business there is when previously they were just purely an asset-taker. There was a relationship with the sponsor, maybe even with the borrower, but they were asset-takers Now they are looking more broadly at playing in a deal because they have a choice. So if they're going to selectively put money to work in X deal versus Y, there has to be a greater reason, and if that means a little bit more ancillary business then that helps the overall return from putting that capital into a transaction.
David Slade: Banks are behaving more like asset investors. Again, we had all had banks coming in to see us over the last several months, saying, "gone are the days when I am going to sub-underwrite and hold €75m to €100m". And frankly, in the current market, particularly with sponsors, relationship does not really count for an awful lot. Banks said to arrangers, "you are coming up with structures that are very fund friendly, so I am going to start behaving like a fund. I might commit on a hold or commit on an underwrite, but I am not necessarily going to hold €75m; I might go down to €25m. Now I will take that risk in the secondary market, but I am going to behave more like an asset manager."
So what we are now finding with some credit committees – going back to the point about how reliable a credit committee is – even if you take a deal to a credit committee and they say," I am happy with that deal". A credit committee will now possibly turn around and say, "fine, you have got approval to do that primary deal, but if you had a pool of money to put into the cable sector right now, what about these two or three secondary market deals which are currently trading at 95? Why wouldn't you put your money into that?"
The banks have got far more sophisticated over the last 12 months or so because effectively they have been forced to because of the way structures have happened. So they are not now going to switch that light off and suddenly go back and say, "we will just lend to these deals as normal deals". They are asking the same questions of us as fund investors are. And it is that huge gap really between primary and secondary pricing that is the absolute break on primary markets at the moment, because they can play the secondary market as well.
Nick Jansa: I think the other thing you have to realise is that the leverage finance market has always managed to stay fairly low profile and it is no longer low profile. So there were many banks with board members, senior committee members that understood what was going on in their leveraged finance business, but they didn't necessarily monitor it quite as closely as they have started to do over the summer when it was pretty much in the newspapers every day.
Banks are becoming more sophisticated. Number one, because they had to; number two, because they need to because they need to be able to answer to their investors, if they are public banks, what their exposure and what their understanding of this leverage market is that they never used to have to do before. So the banks have moved forward in their sophistication: one, to survive; and secondarily, to actually understand and be educational and show to their investor base that they know what they're doing. That has changed dramatically.
Bank sentiment has changed dramatically in the last seven or eight weeks – more than their fundamental credit analysis, which had already changed in the way they operated. But I have never seen as many banks worry about what senior management thinks about the leveraged finance products as they currently do, and that is a fundamental change in our market that I think is now here to stay.
Click here for Part two of the Roundtable.