Prospects for the European investment-grade loan market look better than at any time over the past four years. The long-awaited revival in M&A has arrived and looks set to rescue loan banks from the tightly priced refinancings that dominated the market up until the middle of the year. Nachum Kaplan reports.
Overall, this has been a good year for the investment-grade loan market. Year-to-date there have been 410 deals worth US$490.57bn, well up from the 365 deals worth US$311.537bn booked in the same period last year, according to data from Thomson Financial.
Bankers were not so optimistic when the year began, however, as the main developments of the past few years continued unabated and if anything in more exaggerated form. In short, the excess of liquidity compressed pricing, pushed tenors out and loosened documentation. There were too few new-money deals and those deals that did come were generally poor yielding.
Bankers spent much of 2004 trying to postpone the inevitable return of seven-year money with the structure of a five-year revolver with two one-year extension options at the end of the first and second years, but that was pretty much abandoned this year in favour of seven-year tenors. Pricing, as well as tenor, remained under pressure, with margins, commitment fees and utilisation fees falling from their already razor-thin levels.
Gaz de France helped kick off the refinancing flurry with a €3bn seven-year loan at just 13bp over Euribor with a paltry 4bp commitment fee. This proved that the market was ready to accept seven-year money, and paved the way for a slew of seven-year loans. Other borrowers included German chemical giant Merck, which tapped for a €1bn seven-year revolver at 20bp over Libor with a commitment fee of 30% of the margin, and French utility Suez with a €4.5bn loan at 17bp over Euribor drawn and 5bp undrawn.
"The first half of the year really was more of the same," said one European syndicate desk head. "Liquidity pushed pricing lower, tenors became longer and we were all left wondering where it was going to end. Pricing can probably still get tighter, but the focus has now moved on to winning M&A mandates and away from just shaving off a basis point here and there."
Swiss food giant Nestle marked the pricing low point with its €3.2bn refinancing – split between a €2bn seven-year loan for parent company Nestle SA and a €1.2bn extendible five-year line for Nestle Deutschland. The €2bn paid a drawn margin of just 7.5bp over Euribor, which is lower than some lenders' cost of funds, making the deal a pure relationship play. Pricing on the €1.2bn loan was more in line with the market but still very thin, at 12.5bp over Euribor drawn and 3bp undrawn.
Theoretically, tenors could be extended even further with the return of the evergreen, but this seems unlikely given that evergreen loans usually feature financial covenants, and covenants have pretty much disappeared on corporate revolvers, except for seriously weaker credits.
"Cross-default covenants, MAC clauses and the like have been a thing of the past for more than a year now, but with tenors out to seven years it brings the whole issue of downside protection into focus," said the same European desk head. "Everyone agrees that the whole thing will end in tears, but that's the market, and you have to play in it if you want to play at all."
While these developments were not new for loan banks – having characterised the market since the end of the boom in 2001 – what has been different this year is that after three years of pain, banks have developed some strategies for making money in a declining fee-income environment.
These strategies include lending further down the credit curve – where returns are higher along with the risk – and to smaller companies, where the cost of capital is higher. Middle and smaller companies are inherently more dynamic so often create lucrative ancillary M&A business.
Banks have also looked to increase lending to higher-yielding regions such as Russia and the Middle East. While pricing has also been squeezed in these places, the compression lags Western Europe, and the region's borrowers still generally have to pay more.
Lenders have also looked to structured loans, hybrid loans and crossover names in their search for additional yield.
"We have noticed a recent increase in hybrid deals that do not fall into neat boxes," said Chris Baines, head of European distribution at SG CIB. "These crossover transactions tend to cover several areas and require various skill sets. They typically rely on cash flow generation as well as other sources of repayment such as asset disposals and are neither LBOs, real estate financings nor pure corporate deals."
These type of deals include crossover credits – formerly leveraged names now making their way into investment-grade space – structured real estate deals, leveraged buyout-type deals where the target does have strong cash flows but is thought to have undervalued assets, and telecom deals where pricing no longer reflects the deleveraging progress that has been made over the past few years.
"One of the key issues for success is pricing and structuring these hybrid deals for the right audience. By nature, they do not have natural ports of calls within banks and so the challenge for leads and investors is to be able to think outside the traditional product silos of LBOs, structured telecoms, real estate or corporates. Getting comfortable with these transactions requires looking at the credit story, not the label of the deal type."
M&A revival
As banks have now worked out ways to make money in this pricing climate, the long-awaited return of M&A has finally begun, for two main reasons. First, corporates that have been deleveraging over the past few years are now sufficiently debt free that they are again thinking about acquisitions. Secondly, as pricing has fallen, the cost of money has become so low that it has rarely been cheaper for borrowers to pursue acquisitions.
Since early August there has been an explosion of M&A deals. Saint Gobain tapped the market for €9bn to support its acquisition of Britain's BPB, Spohn Cement has secured €2.6bn to back its bid for Heidelberger Cement, Linde and BASF have both been linked as possible suitors for UK gases group BOC, while Germany utility E.ON has declared its interest in making a circa £10bn all-cash bid for Scottish Power.
Data from Thomson Financial confirms the major surge in M&A activity. Year-to-date there have been 122 acquisition-linked loans worth US4157.78bn, way above the 91 deals worth US$83.9bn posted in the same period last year.
M&A loans provide an opportunity for Europe's overcapitalised banks to put new money to work. However, pricing on acquisition facilities has fallen along with broader market pricing, meaning that such loans do not carry the premium they once did – unless special circumstances warrant it. There is still a premium, but a single M&A deal is no longer the guaranteed fee bonanza it once was.
One deal where circumstances did warrant more generous pricing has been Gas Natural's €7.8bn loan backing its €22.5bn hostile bid for compatriot Endesa. First, the deal was hostile, with Endesa claiming the offer undervalued the company. Secondly, the bid's hostile nature means that some banks will be conflicted, so the MLAs will need to entice them to put their relationship with Endesa at risk to support Gas Natural.
The deal was clearly priced and structured to do just that. Paying 37.5bp over Euribor out-of-the-box with a short, two-year tenor, extendable by one year, the loan is generously priced for what will be a short-term loan to an A3 rated credit. Joint lead arrangers were asked to sub-underwrite €800m with a €500m target hold for a 7.5bp sub-underwriting fee and 13.5bp upfront. Arrangers are invited into the deal on a €400m take-and-hold ticket for 12.5bp upfront.
As the acquisition is hostile, if it does not proceed the joint lead arrangers will earn a 5bp drop-dead fee and arrangers will get a 3bp drop-dead fee. Fee income without capital commitment – making budget surely does not get any easier than that.