European Leveraged Finance Roundtable 2007: Part 2
IFR: You've brought up a point about secondary. Prior to ProSieben, the market seemed to have been permanently bid at par or 101.5. How important is the secondary market? How closely do investors and banks look at pricing and how does it impact on the high-yield space? If covenants have disappeared from loans, surely the two markets would merge?
Eric Capp: Being a high-yield person, the disappearance of covenants in the leveraged loans space was purely a pricing and structure issue. Are investors getting compensated for higher leveraged and fewer covenants with increased pricing? The market wasn't necessarily differentiating leveraged pricing and covenants at its peak. Covenant-lite deals were getting done at similar margin levels to deals with covenants.
That being said, there is an element of control that covenants have which give the borrower some rights that bondholders just don't have with incurrence-based covenants. Those have always been important to banks. They have been important to funds, but funds are heavily influenced by the amount of capital they need to put to work, and at the end of the day what investors are saying now, whether it is a bank or fund investor, is, "covenants aren't important to me".
The original part of the question was the importance of secondary. Secondary has always played a big role in the bond market because bond prices have been a lot more volatile than senior loan prices.
Senior debt investors are going to pay very close attention to secondary for the foreseeable future until the market comes back to a situation where everything is trading at par or 101, which probably will take some time. So there will be a lot of focus on secondary. We are making the argument that there will be some differentiation in secondary which will be between new deals and old deals. The reason I say that is that I think the new round of deals that come into the market will have better structures: they will have covenants, they will have lower leverage points, they will have better margins, they will not necessarily have the taint that is associated with failed deals. So a tainted deal was basically priced at par, traded down to 95 and then never saw par again.
David Slade: I think everybody is being naive if they think there is going to be this flood of new structures because, right now, banks aren't underwriting anything and everybody has to work through this back log. Sponsors are going to have to take their share of the pain, arranging banks certainly will take their share of the pain and investors as well will have to take a view. Because, until that log jam works its way through, there are a number of banks in the market who are not going to have the capacity to underwrite new deals.
I think there is no doubt with a secondary market that it has been heavily oversold compared to the fundamentals. If you look at what happened in high-yield, if you look at what happened in equities, the declines that they experienced were well within historical parameters: not as bad as 1988 or even 2001. But there has been a 5 percentage point decline in the secondary market for loans. It is absolutely unprecedented. So I think that is why you are now seeing a lot of funds being very open about the fact that they are raising new amounts of money because they think it is a great opportunity to invest.
To pick up a point John made, I think there are a number of those funds, hedge funds in particular, who are very interested in the overhang paper because they are prepared to take the high risk, if you like, of higher leverage and looser structures because they are going to get a better price. So I think there is going to be money to invest in those.
The problem right now is, even when you look at someone like Oaktree who said they have raised US$5bn, when you have got a US$400bn overhang, it is still a drop in the ocean. And I think you are always going to have that massive imbalance. So I think there will be some tough discussions but all those deals need to work their way through before we have these nice bright shiny new deals.
IFR: How deep is secondary liquidity?
David Slade: On the secondary side we went through a period of two or three weeks during August and early September where you might have been doing one or two trades a week. Now, if you took the view that at its peak you were probably doing 50, 60 trades in a day, liquidity dried up completely. Ironically, in the last week or so, there has been a lot more activity in the secondary market. Now, again depending upon what happens elsewhere there might be a lot of sales and not many buyers. But I guess activity is activity.
If you look at the secondary market in isolation, banks who have active secondary desks were actually making pretty good money, because whereas a bid-offer spread was sometimes lower than an eighth or even flat in a bull market, now you could take as much as a point for the trade as people try to do price discovery.
Nick Jansa: I think some of it is interesting because many trading desks did step back and a couple stepped up in terms of actually increasing the flow. And if you look, the volumes in the market had dropped dramatically but the market share of certain players also changed dramatically because from 15 active secondary desks there were probably two or three. And even if the volumes are down to 20% or 30% of what they were, if you have only got two to three active market makers that is a hell of a lot of volume being put through. In terms of liquidity, it shifted the market materially if somebody had a US$50m buyer order. So there is not such a depth of liquidity that we are talking about hundreds of millions of dollars. There were US$10m, US$20m and the occasional US$50m across the portfolio. That moved the markets by one, two and three points in the space of two days.
So the volumes are down. They are probably concentrated in fewer names than they were, more in the flow names. And I think what you are seeing in terms of depth of bid is clearly less than it was before and there is more sell-side pressure. But I wouldn't say there are hundreds of millions in the secondary markets being put to work every day on the buy side; it is 10s 20s, those types of numbers.
IFR: Will the secondary market get worse before it gets better?
David Slade: The great concern is portfolio liquidations and warehouse liquidations, and we saw a number of those take place in the immediate aftermath [of the crisis]. It then quietened down a bit but, again, in terms of people calling the bottom of the market, there is a concern that as time moves on and the market doesn't improve, there are going to be more warehouse or portfolio liquidations. And that clearly has a massive dampening effect on the secondary market. There was a case recently where a €300m portfolio suddenly became available and that has a real downbeat effect on the secondary market.
Charlotte Conlan: That is what is still constraining the primary market. People think it is going to get worse before it gets better. So before Christmas we are going to have another tough time and therefore if you have a limited amount of cash to put to work and you have a credit committee that is breathing down your neck, then you will stop and wait because there could be better opportunities. When we saw ProSieben sell off followed by a wider trade off people dived in because they hadn't seen prices like this for absolutely years.
They had been forced to buy everything at 101, 102, and all of a sudden they could buy at 99. It was amazing. So they dived in and unfortunately prices continued to decline. So a lot of people are disappointed that they invested at that point – they should have sat on their money a little longer and waited. They don't want to make that mistake again. So there is a lot of sitting on the side lines. So that is why we are not really seeing much activity because everyone is still waiting because they believe it is going to get worse.
Nick Jansa: Most of the activity is in the large flow names, even more stable credits and most of the buying is coming from banks who have gone and got increased credit lines to go and buy – at what they view as decent prices – credits where they already have exposure. And that is where most of the buying activity has occurred.
I would say there has been very limited buying from the institutional investor community. Firstly because they felt that they'd stepped in too quickly initially, and now because of their lack of liquidity. They have used up a lot of the liquidity quite early on and now it is no longer there.
IFR: The market has then failed to produce a clearing price for senior or junior debt from a primary point of view?
David Slade: There has been a 180-degree change. The only way that funds could get par assets was in primary; as the minute we are free to trade we went up to 102. So if you were trying to pull a portfolio together with secondary market assets, you were always going to struggle on returns. Suddenly you have the secondary market going down and you could buy at 98, 97, 96. So why would you buy anything at par?
But the problem was, you were having fuel added to the fire through the portfolio trades which would send the secondary market down further and further. I think there are certainly funds that have access to liquidity who, when a particular name gets to 93 or 94, suddenly say, "look, I'd put my own personal money into this particular deal with this particular structure; in terms of how it is going to perform. If I am going to make six or seven points in capital gains just because I sit on it for two years and I get repaid – I don't need to worry about what happens in the secondary market from that perspective."
I think, as I said, the only concern is where you really have limited liquidity and it is all going to be about the relative investment. So doing a particular name in isolation absolutely is going to be a great trade and ultimately, in terms of portfolio, it will be good. The only thing people worry about is if instead of going from 93 to par it goes via 92 or 91, or suddenly something else comes into the market which is just relatively more attractive.
John Foy: I think the problem is, as we alluded to earlier, all news that is coming out is having a dampener on secondary prices. We put tens of millions to work last week and we went to three counterparties to bid for 10 flow names, and actually only one of those counterparties gave a price on every single one. I have never seen that before. Flow names, you normally get ten prices: bam, bam, bam. So that is not happening. It is like catching a falling knife. When do you grab it and when do you jump in?
And you do look foolish if you buy at 98 and a week later – because you know full well you have figures coming out next week and at the end of the month – the price may well be 92. But you don't know. So you almost have to. I guess our strategy is to buy and slope down.
So you price-average down. So you put a point in here, we bought some at par, we are now lower so average prices come down; we've got some more and we've got some more cash, and we think there is more to come so we will buy some more even lower. Now it is virtually impossible. If we could all second guess where the bottom of the cycle was, we wouldn't obviously be sitting around this table.
I think it is a very difficult market to try and second guess, with volatility which is unprecedented. We have been through cycles but we have never seen the secondary market drop to the extent it has dropped, and it is very difficult to try and second guess irrational behaviour. You have further margin calls potentially between the dampened prices. I am worried about the overhang from the fund perspective, and I do worry about banks' year-end.
Eric Capp: I think that is right. I think smart investors, as you say, are averaging down because it will be virtually impossible to call the bottom of the market over the next three months because there are so many market-moving pieces of information which are going to come into the market, whether it be bank year-ends or FMOC meetings or earnings releases, economic data. Just on Friday you had the jobs report in the US which went from expectations of 100,000 net new jobs to a 10,000 or 20,000 loss and the equity market tanked and iTraxx traded off 10 basis points. And there is going to be tons of that over the next three months including, you know, price discovery on some primary deals coming into the marketplace.
There is going to be lots of data points which will move the market and the market will probably bounce around to a certain extent, the same way as it bounced around for the last few months, because there will be pieces of good news and there will be pieces of bad news.
David Slade: You go through sort of five days when the equity market thinks, "we're through", and then somebody gets some new information and suddenly they're off again.
The problem with the equity market is you can take two direct opposing views. One, you can say it is still hugely overvalued because, for all but the very largest companies, there was an implied private equity premium in there because everybody was a target, which has largely gone away now. But on the alternative, on the fundamental P/E basis it doesn't seem that overvalued. But then you have to ask the question: with everything that's going on in the markets, particularly with the housing market in the US, does that spill into the economy? Therefore are we more bearish about earnings or companies going forward, and therefore should P/Es be coming down?
And although it seems to me the equity market was, frankly, the last to wake up in terms of everything else that was going on, it is now a leading indicator, so when you see equity market crashes that would just have a negative impact on every other company.
IFR: Just in terms of what is happening in the US with the overhang being worked through, is there potential for a faster recovery in US than in Europe or do the two have to happen in tandem now?
David Slade: I think the US is in a far more difficult situation. One, because both avenues are full – loans and high-yield – and as Eric said earlier, there is basically no high-yield pipeline in Europe. That doesn't necessarily mean it is going to suddenly fill up but at least it is not full. In Europe you have a mezzanine market and it is a very active mezzanine market because to a large extent they had been crowded out of deals over the preceding six months.
So there are alternatives and there are pockets of investors here that you can use which you don't have access to in the US. Secondly, it is just the sheer size in the US and the fact that the vast majority of those deals are structures and prices which people aren't really interested in.
Covenant-lite had started over here but there are literally a handful of deals that are covenant-lite. Almost every deal in the US is covenant-lite. So I think the problem is far greater over there. And so I think the pain is going to be far greater.
There is also a problem with sub-prime and getting the confidence back in the market is, if you look fundamentally at sub-prime mortgage volumes, the resetting of those mortgages has not peaked yet. The peak is the middle of next year in terms of all the mortgages that were issued in 2004, 2005 and 2006. So if you are looking at that particular sector, you have to believe there is worse to come, and I think that has a very direct impact on the US market and obviously US CLOs, and therefore a ripple effect on us.
IFR: So is Europe reliant on a US recovery before things can start to get better here?
Nick Jansa: I think unfortunately, yes. When you think about recovery, what are you looking for in recovery? Europe is not reliant for €200m to €400m LBOs on the US. Europe is reliant for anything €750m to €1bn-plus on the US recovery because, to get to get this size of LBO, you need banks to be stable and comfortable, and you need an institutional bid to come back into the market. And for that to happen, you need the US pipeline in some way to have found a price; you need them to have cleared a bunch of their paper because there are a large number of global investors that are simply going to sit in the US for the next four, five, six months and pick off everything over there. They are not going to rush back into Europe.
My personal view is that Europe would probably take longer to come back in terms of the large end of the LBOs than the US will because the US will take the pain earlier, they will work through this pipeline. Some of the deals may or may not happen. Not all of them are definitively going to happen in that US200bn of pipeline. There are a number which are subject to regulatory approval.
So the US market will probably get worse than Europe and then will come back, I think, faster than Europe, which will move along on a very sort of steady and unattractive small LBO basis, to try to clear the pipeline we have got. And in terms of the large deals coming back, that is going to take longer because we need the banks to re-engage properly and more aggressively, and we need the institutional investors to re-ramp and raise more money to come back into the market, and bring the US money back across from the US – a lot of the global managers removed their assets back to the US. You need them to start putting money back into Europe, as they did 18 months to two years ago.
So Europe could end up taking longer to get back to the large LBOs than the US does. It certainly took longer to get there in the first place. I don't see why it is not going to take longer to get back there again, despite the technical picture being better in Europe than it is in US.
David Slade: I think for the larger LBOs, fundamentally you are right. The advantages we have in Europe is our active bank market. Banks had been more abundant than in the US for a number of years, so we have that pocket. We have a mezzanine market. So there are lots of things acting in our favour and we have a smaller overhang.
For the bigger deals, you need those global investors and they are going to look at relative value in the US, they are not going to be doing the good deals in Europe for a while. So I think as you go up in size terms, it does become more and more difficult, and the US becomes the leading indicator.
Charlotte Conlan: You have always had smaller mid-markets European deals. A deal done in Spain is quite different from a deal done in the UK or in France. We do have, you could say, now the advantage of a multi-jurisdictional continent in which to operate as opposed to the homogenous US market, and that will mean that you can do a deal in Italy because Italian banks still want to support Italian borrowers.
But we are not talking about very many deals. I am sure all of us have got a complete reduction in deal flow. I should think it is running at about 20% to 25% in terms of the numbers of deals we were traditionally working on at this point in the year. And if we are quiet now, that means we are going to be quiet in the first quarter of next year, if not the second quarter of next year.
So it will be slow to return. But for a deal done in Italy or Spain or France, a mid-market deal, the US is interesting but mainly irrelevant. And you are right: the mezzanine market is still here and the mezzanine market actually is the kind of glimmer of hope in that it is very active. It is always interesting to translate a marketing call on a Monday morning into a commitment on a Friday afternoon. But nevertheless, they say they are still very much open for business and wanting to invest, and for some of them, invest in size, because yes, as somebody said earlier on, they haven't done much in the last 18 months. But it is going to be a very regional focus to transactions for the next few months.
Nick Jansa: And if you think about mezzanine transactions, you can probably put together €200m to €300m fairly quickly and with some lead orders you could probably put €500m to €700m together with banks. So you can see a European LBO market of €1bn coming back without any institutional money. It is not a bad deal size. That is where I think you are going to be, in this €200m to €1bn range, and that is where Europe can continue to operate without any influence from the US. It is just over and above that type of size – I think you then get into a very interesting discussion.
The difficulty is going to be convincing people to put assets on the block. Sellers aren't selling, private equity is not seeing many auctions start, they're not seeing many assets come free; therefore they haven't got a lot to work on. So the debt markets flow through to the M&A markets and that slows down. So we can all say that Europe may be open for €200m to €1bn-type transactions at some point in the next couple of months; the question is, are any of those assets actually going to come through and are the opportunities even going to be there?
It may not be where the seller wants to sell. They may say, "well, if the debt markets really aren't that good, do I really want to go through with this transaction? Do I not want to wait six months? I am performing very well, the company is performing well, why rush now?"
So there are a lot of things that are correlated to each other that you can't necessarily control and I think one of the key things to remember from the start is this is a much bigger picture that we are playing in. The leveraged finance issue that is there at the moment in terms of the technicals is just one element of a much bigger picture, and we are not going to suddenly drive the solution out of the leveraged finance market. If the CP market hasn't resolved itself, you are not going to necessarily have a leveraged finance market that returns very quickly.
Click here for Part three of the Roundtable.