Top 250 2005 - Bets hedged
The European leveraged loan and high-yield markets started 2005 where they left off – riding a wave of exuberance driven by ample liquidity. But that all changed as a turbulent start to the second quarter sent speculative investors running for cover. As the recovery gets underway, a two-track market has emerged, meaning weaker credits could still face a tough time. Adrian Simpson and Kate Haywood report.
As leverage has spiralled upwards, seven times, not five, now defines aggression, and the fixed pricing norms typical of the European credit-driven approach to lending are rapidly being replaced by flexed margins and US-style bookbuilds. The heady mood has been supported by a torrent of recapitalisations and secondary buyouts, adding bulk to steady primary deal flow. The year's leveraged loan tally stands at 95 deals worth US$77,447, project finance excluded, according to figures from Thomson Financial. And with the first two months of Q2 contributing US$31,345m, compared to US$36,400m for the whole of Q2 last year, the second quarter appears to represent a growth spurt.
The fact that Q2's total was achieved with just 27 deals demonstrates a key change in the market. Average deal size has been increasing for some time now, fuelled in part by the glut of institutional money flowing into financial sponsors' funds. So far this year, a buyout fund for GS Capital Partners 5 closed at US$8.55bn, and a combined US/European effort from Carlyle crept just over the US$10bn mark. Moreover, sponsors are increasingly prepared to team up in order to tackle prey that would hitherto have been beyond their reach. The auction for Spanish telecom provider Auna shows how far the boundaries have shifted, with bids from two consortiums putting the price tag at a vertiginous €12bn.
With sponsors in bullish mood and banks entering the leveraged space due to high liquidity and lack of profitable investment-grade opportunities, one could mistakenly assume that almost any deal would meet with success in the current market. Yet as the second quarter drew to a close, some borrowers were finding conditions far more challenging, especially for deals that are either highly leveraged or based in difficult sectors, such as retail.
Changes in the buyside
The reason for this change is based in the changing nature of the buy-side. Paradoxically, the market’s recent vigour and present bifurcation appear to have the same root. The traditional combination of leveraged-focused bank and specialist investor has rapidly been replaced by a diversity of investors, including CLOs, CDOs, and perhaps most tellingly, hedge funds.
Historically, hedge funds have not had a large influence in high yield, particularly leveraged loans. However, the hike in prices of distressed securities in 2003 left traditional distressed hedge funds with few opportunities, forcing many to look to the wider high-yield market. As a result, hedge funds developed into real players in Europe's leveraged finance market in 2004 and now have close to US$1tn in assets under management globally. In addition, the growth of the credit derivatives market has given hedge fund investors the opportunity to synthetically buy or sell risk. While this trend has been restricted to the bond side, recent moves from loan houses to create CDS products and loan-related indices promise to allow even greater access to the leveraged product.
Where and how hedge funds choose to invest has had implications for traditional European high-yield investors, with hedge fund investors accounting for significantly more than 50% of the investor base on some deals. One of the most striking effects has been the emergence of refinancing, as opposed to recapitalisation, as sponsors take advantage of the extra liquidity to cut their borrowing costs while leaving the overall structure unchanged, with no dividends paid to the sponsor.
SEAT Pagine Gialle, which came to market in early April, was the prime example of this tactic. Not only did that deal slash blended yields by 65bp, it also hit investors on their participation fees, which, at 62.5bp, were only half the fee payable on the original top ticket. Although investors grumbled about SEAT’s lacklustre performance since the original LBO, most recognised that the deal still represented good value. With little in the way of credit committee hurdles to surmount, investors have been happy to rejoin at the lower pricing and the deal has done well in syndication. Whether the refinancing trend catches on longer-term remains to be seen, although lead banks are already reporting a large number of enquiries from private equity houses with strong credits in their portfolios.
As the credit market remained attractive throughout 2004 and the early part of this year, the bond market saw structural innovations primarily led by hedge funds such as PIK and floating rate instruments, which are not contained in conventional high yield indices. On the loan side, arranging banks have been only too happy to join in the creative spirit. The last year has seen a huge rise in the use of second lien paper, a relatively new product in Europe. Tranches on deals like Eutelsat, Sanitec and Debenhams have priced at around half the all-in yield of mezzanine, much to the consternation of traditional European investors who have become accustomed to the higher-yielding mezzanine product. Given that mezzanine already plays the role of second-lien in US structures, its easy to see why some investors have claimed that arrangers are using cheap second-lien to target hedge fund demand, instead of pricing paper according to risk.
The pain of aggression
If these investors are right, we may be about to see the arrangers of some of the more aggressive structures get their comeuppance. In March this year, high yield lost its glitz as concern about the fall-out from the auto sector and subsequent volatility surrounding the correlation trade with Ford and GM ripped the market apart. So far most of the impact has been felt on the bond side and on the subordinated loan tranches. The freefall in the secondary bond market ended more than a year of spread tightening as hedge funds and other leveraged players began to pull large amounts of cash out of the asset class. The sell-off pushed average yields on junk bonds to 8.57% on May 17, the highest level for exactly 12 months according to JP Morgan. The decision to unwind their positions inevitably raised questions about their long-term commitment to junk.
On the loan side, Eutelsat, which completed its syndication in early April, was arguably the last second-lien piece to get through before the market suffered its correction, with the ensuing weak demand in the secondary market causing the paper to plummet to the 96s before starting a slow recovery. At the beginning of June, leads on deals for Debenhams and Sanitec, both of which have second-lien tranches in primary syndication, were still feeling the effects of the drop in liquidity for those tranches. The sudden stranding shows how vital funds involvement has become to any high-yield strategy, which begs the question of when, and how, they will return.
Fortunately the return is already beginning, albeit on the funds' own terms. Credit strategists suggest that the technical picture looks far better than in the first quarter and all the signs are that hedge funds will continue to look for opportunities in the high-yield space. The fall in investment grade bond yields has seen investors gradually roll back into junk in search of better returns. Indeed, investors pumped a surprisingly large US$1bn into high yield mutual fund during the week ending June 3 – the largest net inflow since February this year and the largest since September 2003.
"Strategic hedge funds, which have an ongoing commitment to the asset class, are in for the long haul. There has been a large number of US hedge funds that have set up secondary offices in Europe and the growth of European credit hedge funds has been huge," said one London-based investor at a large hedge fund. "However, tactical and non-credit investors which invest in the yield curve have been blown away because of disappointing returns in other parts of their investment strategies."
"Globally, hedge funds have approximately $1trn under management, so to suggest that they're completely pulling out of the high-yield market is a bit extreme," agreed David Ross, a director in Deutsche Bank's high-yield capital markets group in London. "There are many types of hedge funds out there. Some hedge funds will by nature remain more opportunistic about all asset classes, but it’s clear that the group as a whole will continue to be a very meaningful part of the high yield investor base."
But while hedge funds and traditional long-only accounts are returning, only companies at the higher end of the credit spectrum are likely to be able to take full advantage in the near term. "Hedge funds will go where there are opportunities and if there are opportunities in high yield that's where they will be," one hedge fund manager said. "It's good for the market that some of the non-credit investors have hung up their shoes, it means we can re-focus on 10-year non-call five bond deals, tighter covenants, leverage multiples and pricing."