IFR Top 250 2007: Convergence increases
In an extension of a trend first seen in the US, the European leverage loan and high-yield bond investor bases are converging. As a result, lending terms and pricing are under real pressure right across the leveraged finance market. Michelle Sierra, Donal O'Donovan and Joy Ferguson report.
As liquidity continues to slosh around the debt markets in search of a home, financial sponsors have taken the opportunity to push for terms as favourable as possible on three key borrower issues: lower pricing, freer cash flows and ever more flexible borrower terms.
Behind this drive is an imbalance in the relative strength of borrowers and lenders, with relatively few new money deals being chased by a significant oversupply of liquidity. Changes are also taking place in a context of exceptionally low default rates, where risk has been increasingly discounted by lenders.
This dynamic is reshaping the leveraged finance market, bulldozing the traditional differences between high-yield and leveraged finance investor bases and practices.
While relatively new to the European market, this convergence has been a topic of constant discussion for a couple of years in the US. It is perhaps most notable in what many investors see as the bellwether issue of the spread of high-yield style, incurrence-only covenant packages to the loan market – the so-called "covenant-light" approach.
The practice spread from the US to Europe in 2007, and became an established market practice when bookrunner JPMorgan came to market with its €1.161bn deal to refinance World Directories for sponsors Apax Partners and Cinven. The deal was followed with a £675m mandate to arrange the debt supporting Apax's acquisition of a 49.9% stake in Trader Media Group.
Leveraged loan covenants typically test interest cover, leverage, cashflow and capex. Traditionally maintenance covenants test each of these on a quarterly basis, but the shift to incurrence covenants means the same tests are triggered only on the incurrence of new debt or payments outside the bank's security net.
The US experience suggests that covenant-light can take a number of forms, ranging from a complete absence of maintenance covenants to credit agreements with fewer or looser covenants. Financial sponsors favour the practice because it stops the ongoing information flow traditionally available to loan investors that has provided the basis for proactive risk repricing – trading out of a credit or opening restructuring discussions in the event of deteriorating performance.
Ratings agency Standard & Poors is among those to voice fears that the practice raises the real prospect of deterioration in credit quality. This is especially true given its popularity on the senior secured loan tranches that have traditionally been the least risky parts of any capital structure, thanks in part to the strong hand held by lenders protected by maintenance covenants.
Issuance of covenant-light deals shows no sign of weakening in the US and is certainly growing in Europe. In the more mature US market such loans accounted for roughly 15% of the leveraged loan market as of April/May this year, according to Bear Stearns. And further record-breaking, covenant-light financings are on the way in both the US and Europe.
In the US, Kohlberg Kravis Roberts & Co. is looking for a US$16bn covenant-light loan to finance the buyout of credit card payment processor First Data Corp, while in Europe a covenant-light – or at most covenant-loose – facility will back the £11.1bn buyout of Alliance Boots.
Loan investors dislike the trend, seeing it at best as "unfortunate but necessary", and at worst as: “A trend that prays on CLOs who can’t access the market without participating in covenant-light deals,” according to two European CLO managers.
“There has been plenty of negative press concerning covenant-lite transactions and what they might mean for the next credit cycle,” said Thomas Newberry, head of syndicated loans at Credit Suisse.
“I think investors are more highly attuned than they have been previously.
I think that the market is generally trying to be discriminating about what types of transactions or credits they want to see in a covenant-lite structure, or at the minimum they want to make sure they get compensated accordingly if they are going with a covenant-lite structure.”
Toggle-to-PIK notes and potentially loans come to Europe like other trends and instruments, after being developed and accepted in the US leveraged finance market. As with covenant-light, these instruments tip the balance of power in favour of borrowers by giving them greater control over their balance sheets. The toggle instrument works by allowing issuers the discretion to either pay interest in cash or opt to convert cash-pay notes into PIK notes with the interest accrued added as new debt securities. There is generally a third, 50:50 cash pay/defer option.
Like other instruments that can cut the cost of regular debt servicing, the ability to free up cash earmarked for amortisation makes the toggle especially attractive in cyclical industries.
In the US, investors have seen it employed across a number of credits and sectors. Realogy, HCA, Hawker Beechcraft, Univision, Neiman Marcus and US Oncology have priced toggle notes or loans in the past two years in particular since the second half of 2006. While this is a change from traditional terms, the practice does at least pay a premium to investors to compensate for the increase in risk.
Compensation for risk has been another victim of both liquidity and of the convergence of loan and bond markets. Few examples illustrate the comprehensive repricing of risk and contemporaneous convergence of loan and high-yield markets as well as the May refinancing of Cognis.
Key to the deal was the aggressive repricing. Bookrunners Goldman Sachs and JPMorgan split the new, €1.65bn-equivalent facilities into four tranches: €610m and US$293m in bonds rated B1/B (stable/stable) plus €610m and US$293m in due 2015 loans, each paying the same coupon of three-month Euribor/US Libor plus 200bp. All four tranches are covenant-light, but the key to the deal was the slashing of the cost of debt, repaying as it did first- and second-lien debt and up to €350m of PIK notes.
As a simple comparison, the repaid senior facilities paid the same 200bp over Euribor on the A tranche, but 237.5bp on the B and 287.5bp on the C tranche, while the second-lien notes paid 475bp over Euribor and the PIK notes paid 900bp over Euribor.
The deal was the first senior facility to be priced and allocated with both loan and high-yield priced on the same bookbuild basis. The public as opposed to market feel of the deal was reflected in the split between notes and loans being decided in the market alongside the pricing.
The same pricing dynamic has seen mezzanine finance come under real pressure. While second-lien loans have continued to rise over the past year, margins have been squeezed and more expensive mezzanine has taken a big knock after years of growth.
In Europe in particular there now seems to be little or no premium available to investors offering subordinated debt. Typical of the trend was bookrunners Goldman Sachs and RBS structural and pricing flex on the €2.74bn LBO financing of French retailer Vivarte. That flex saw €245m of mezzanine 825bp over Euribor scrapped in favour of increasing the second-lien and senior B and C tranches. Instead of reflecting the decrease in seniority, each of these tranches saw margins cut.
As pricing has come down, sponsors have taken the opportunity to push for a trimming of the number and size of the traditionally less expensive amortising tranches, trading the now only slightly higher margins on non-amortising tranches for enhanced free cash-flow. In the loan market this means that A tranches have been cut down or are absent altogether – again allowing sponsors more freedom to redirect cash flow away from debt repayment.
The practice also reflects the increased volume of non-bank lenders now able to invest in all other parts of the capital structure, who are less concerned with regular returns that with simply putting capital to work. In the bond market the increasingly popular senior secured FRN serves the same purpose, and with covenant-light deals on the rise, the main difference between the two – quarterly maintenance tests – is increasingly eroded.
In Europe, the convergence of the leveraged loan and high-yield markets is affecting market practice as well as dynamics, notably in the manner in which loans are being priced.
The bookbuilding trend has developed quickly in Europe since it arrived from the US. In March, bookrunners Deutsche Bank and JPMorgan used a structural flex on the €1.22bn debt package supporting CVC's secondary buyout of French freight vehicle-hire group Fraikin to introduce a book built, six-year B loan priced at 250bp over Euribor from price talk of 225bp to 275bp. That has been followed by book built tranches on a range of deals, including the dual loans/bonds Cognis refinancing mentioned above.
As well as reflecting high-yield practice, part of the impetus for this bookbuilding comes from heavy price flexes that have the effect of slow-motion bookbuilding and have changed the way the loan market processes syndications. Investors have been unhappy with the slow pace of syndication, in particular, the delay between commitments going in to bookrunners and such deals eventually funding.
The practice of bookbuilding also goes some way to address tension between bookrunners and investors on deals where several underwriters are under pressure to ensure allocation to multiple investors who end up with minimal allocations. This multitude of investors looking for loan allocations is again a function of the great rise in liquidity and funds.
There are pros and cons to bookbuilding according to one institutional investor: “Its an efficient practice and likely to take some of the steam out of secondary pricing but there is an issue in where the bid is coming from, because investors with a lower cost of capital are put at an advantage.”
A driver of convergence that is more particular to the US than to Europe is the allure of the private debt market for issuers looking to skirt Sarbanes-Oxley compliance costs. That is not only enhancing the leveraged loan market but has also seen high-yield bond that reflect private market practice in the form of 144a-for-life deals. These ensure the bonds will never be registered, and the companies are not subject to Sarbanes-Oxley reporting requirements. According to Thomson Financial, 144a-for-life issuance totalled US$16.4bn in the year to the end of May, compared with US$14.7bn for full-year 2006.
Perhaps the most important driver in the leveraged finance space is its very dynamism. Every structure and price seems to be superseded almost as soon as the ink is dry, and bookrunners, investors and sponsors are more alert than ever to the possibility that the next loan or bond deal will push the bounds of innovation as far as the market will bear.