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Thursday, 14 December 2017

Leveraged Finance: View from the peak

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Global leveraged finance has rolled on in 2007 with mega jumbo financings becoming common in the US, structures becoming aggressive in Europe, while in Asia the nascent leveraged finance market continues to develop. Despite all of this growth, the big question that looms is whether the market is going to crash. Nachum Kaplan reports.

There is a general sense that globally the market is looking very toppy on just about all measures – valuations, rising leverage, falling equity contributions, disappearing covenants and increasingly back-ended amortisation structures to name but a few.

Perhaps the biggest concern is that default rates are virtually zero – against a historical average of 4%-5% – and that the economic cycle has now firmly entered a phase of rising interest rates on both sides of the Atlantic. Bankers, however, are struggling to posit exactly what could burst the bubble.

Default rates are certain to rise but they are so low at the moment that even a return to historical averages, which would result in many more default situations than there are present, would hardly be enough to do anything more than trim the market of some of its excesses. Default rates would need to increase beyond their long-term trend rates for the market to crash.

What could cause such a crash? Over the past few years global leveraged finance markets have shrugged off major terror attacks, wars, corporate scandals like Enron and Parmalat, hedge fund meltdowns like Amaranth, sustained high oil prices and several years of interest rate rises and none of these have had any meaningful impact.

Few people buy into the notion that a new market paradigm is at play, one that says that there is now so much liquidity in the system - and so much liquidity from non-banking sources in the form of institutional investors - that conventional wisdom no longer holds. There is now so much liquidity right down the credit curve that there are buyers at any price that it removes lenders' traditional fear of being left holding paper on a deal they do not want.

More realistically, there are many reasons to believe that market fundamentals have not changed at all and that current structuring practices are just storing up future trouble.

So what are these dangerous practices? The erosion of covenants is one. Covenants act as an early warning system to lenders that a borrower is in trouble. The looser a deal's covenants, the later lenders find out when that borrower is in trouble. This has two effects. Firstly, as a trend, it delays any market meltdown. There could be all sorts of companies that are struggling right now but not showing up on anyone's radar because covenants are so lax that they have not yet been triggered. Secondly, it means that once lenders find out that a company is struggling, it will be so much harder to rescue that company.

The arrival of so called "covenant-light" deals in Europe is a dangerous development for the market and one that is liquidity driven rather than driven by economic fundamentals.

These structures began in the US, have made their way to Europe on deals like World Directories and Trader Media Group and even as far as Australia on deals like Qantas. It is worth noting that such structures are now in retreat in the US market, suggesting that caution is on the rise there, even as it is being thrown to the wind elsewhere.

Back-ended amortisation structures are another cause for concern, especially in a rising interest rate environment. There are a glut of deals in the US and Europe where amortisation does not begin until two to four years into a financing's life. This means that lenders have no idea whether these borrowers can meet their repayment schedules. Certainly, this can be beneficial to a company because it frees up cash flows shortly after it has been bought out but it does store up trouble for later and interest rates could well be substantially higher when amortisation kicks in.

Then there is the trend of subordinated debt being replaced with institutional senior debt, namely much larger B and C tranches. This makes sense for sponsors because it cheapens the debt so, they argue, makes the business more viable.

The problem, however, is that subordinated debt in all its forms - mezzanine, second lien, high-yield and all their variations - create a buffer zone between the senior debt and the equity, giving senior lenders the comfort of knowing that they will not take the first, and sometimes not even second hit, in the event of a default. The removal of this buffer means that being a senior lender is much riskier than it has ever been and, given that pricing is falling pretty much everywhere, risk that is not sufficiently rewarded in terms of pricing.

All these factors combined mean that it will not take anything as dramatic as a terror attack, war or corporate scandal to sink the market. All that is required is for interest rates to keep rising and for enough time to pass. Those two things look like certainties.

Despite this worrisome backdrop, however, the aggressive deals just keep on rolling. Firstly, deals just keep on getting bigger. Globally, there has been a string of bona fide mega jumbo LBO financings such as the US$45bn buyout of TXU and the US£38.3bn buyout of Equity Office in the US, the circa £11bn buyout of Alliance Boots in the UK and the A$11.2bn buyout of flag carrier Qantas in Australia.

The reason that deals keep getting bigger is two-fold. Firstly, private equity houses now have so much money that there is almost no company too big for them to buy. Private equity raised funds worth US$400bn in 2006 and there are expectations that as much as US$500bn will be raised this year. Given that leveraged buyouts can multiply this by five to seven times, conservatively, sponsors are under great pressure to put their money to work.

Secondly, the leveraged finance market has changed from a bank market to one driven by institutional investors, which means there is more liquidity than ever before. The US market has long led the way here and banks account for only about a quarter of lending to US LBO financings. In Europe, the split is about 50/50, which is remarkable given that it was almost a pure bank market as few as five years ago.

Asia is still lagging on this front with a true term loan B market yet to emerge but there are signs that it is going to happen. Institutional tranches have started making their way into financing structures in Australia, while the US$430m loan backing the acquisition of Huawei-3com in China was re-cut and marketed to US institutional investors after a poor take-up in the Asian bank market.

Combined, this means that sponsors not only have the ability to write enormous equity cheques, they also have the confidence of knowing they can find someone to lend them the money. Likewise, banks are willing to underwrite such large deals because they know that they can distribute the paper to institutional investors. It is a perfect liquidity storm.

Convergence between the US and European markets - both in terms of standard practice and the investor base - means that is getting easier to syndicate loans globally, which also means that bigger deals can be financed.

So the buoyant market continues despite the dangerous backdrop. There is hope, however.

Deep liquidity really does allow much larger and much more complicated deals to get done and that can continue to happen as long as sensible financing structures are used.

The US market, always a leader, could show the way. The rising aversion to covenant-light deals in the US suggests that, despite the liquidity, investors are becoming uncomfortable with overly aggressive structures. Europe is well behind on this front with covenant-light just arriving as a concept but even European lenders - banks and institutions - can follow the US route and say 'no' to aggressive structures when they are not appropriate then the correction, when it comes, will be substantially less severe.

Asia, which is the least developed of the three big region's markets, is, ironically, best equipped to stand firm against dangerous structures. This is because there is no Asian market in the sense that there is a US or European market. There are deals that happen in Asia, in places like Australia, China and India, but because the differences between these jurisdictions is so great, it cannot be said to be a single Asian market

The Australian market is booming and the most aggressively but regulatory hurdles in India and China make LBO financings very difficult to structure and make lenders extremely wary of lending to them. The high political and legal risk in these markets mean there might not be much tolerance for too much structural risk.

All this means that global LBO markets can keep on developing but that more conservative structures have to return if the growth is to be sustainable.

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