All of the themes that made the European loan market tough for loan bankers over the previous 18 month have continued to plague the market this year. Pricing has kept falling, structures have kept loosening, and M&A activity – despite showing signs of improvement – has remained muted. Nachum Kaplan reports.
Going into 2005, loan banks had spent 18 months working out ways to make money in a declining fee-income environment. This year they have had the chance to put those theories to the test, as all of the market themes that have eaten into their income have become more exaggerated.
The year began much as last year ended, with huge amounts of liquidity pushing pricing lower and tenors out. Electricite de France set the tone by securing a ?6bn revolver at just 12.5bp over Euribor – well below the headline margins in the lows 20s that were the norm towards the end of 2004.
And if the headline pricing was not eye-watering enough, the deal carried a clean seven-year tenor. If 2004 was the year that marked the introduction of the de facto seven-year loan – that is five-year loans with one-year extension options at the end of the first and second years – then this year has been the year of the straight seven-year line.
EdF's loan told the market not only that pricing was not yet at the bottom of the cycle, but also that French borrowers, which had dominated the 2004 refinancing calendar, would again be the mainstay. In fact, so many French corporates secured cheap money on de factor seven-year terms in 2004 that many feared there would be a lack of French deals year. However, as the EdF loan showed, pricing had fallen so far so quickly that it made sense to refinance again on even cheaper and looser terms. A plethora of French names soon followed, and by mid year, French retailer Carrefour looked set to borrower over seven years at just 10bp over Euribor.
So conducive to borrowing has the market been that even German corporates – which traditionally do not refinance until the fourth quarter because of their back-ended refinancing calendar – started tapping the market early. EnBW, Volkswagen and BASF were just a few of the German names that borrowed in the first half.
The UK market, meanwhile, has remained very much a club market with very few full-blown syndications relative to the market's size.
CDS differentials
The continued fall in loan pricing has prompted a huge decoupling of loan pricing from the wider credit markets, especially the CDS market. This has prompted banks to frame questions less in terms of how far loan pricing can fall, but rather as how long can such pricing can remain so misaligned with the CDS market.
Two recent deals in Europe that highlight this trend are France Telecom's ?8bn seven-year refinancing and Volkswagen's ?12.5bn five-year refinancing.
On a drawn basis, France Telecom is paying 14.5bp over Euribor drawn for the first five years, rising to 17bp over Euribor in the final two years. This blended all-in seven-year average of 16.75bp is starkly misaligned with the five-year mid-point France Telecom CDS of 43, and even more so against the less liquid seven-year mid-point of 53. Similarly, Volkswagen is paying 20bp over Euribor drawn, with a 21.5bp all-in to arrangers. This is also starkly out of kilter with a five-year CDS mid-point of 78 in the name.
The differentials are even more startling when compared with undrawn pricing. The commitment fee on France Telecom's loan is just 4.25bp in years one to five, rising to 5bp in years five and six. Volkswagen pays just 6bp undrawn.
A technical analysis would suggest that such large differentials mean that loan pricing is near its low point and should start to rise again soon, thereby re-aligning with the broader credit markets.
However, more than technical factors contribute the loan market pricing, and many loan bankers are not convinced that this pricing correction will happen anytime soon.
"Convergence is more to do with market cycles than anything else," said Francesco Carobbi, head of European syndications at Bank of Tokyo-Mitsubishi. "Loan market cycles are generally longer than cycles in other markets, partly because lenders are driven also by relationship considerations rather than purely risk return considerations on individual transactions.
"It is a less jittery market than the equity, bond or CDS markets. A few months ago the credit environment was more stable and the more stable the markets, the greater the convergence. But now we've had GM and Ford, things have become more unstable, credit spreads have widened but not loan spreads, and that's where the relationship nature of the loan market becomes clearer."
All of which suggests that CDS pricing is not a leading indicator of loan pricing and that there is no reason to expect loan and CDS pricing to converge too closely.
"The difference in CDS and loan pricing at a particular point in time is best explained by the value lending banks give to corporate relationships," said Chris Baines, head of distribution at SG CIB. "All else being equal, the greater the difference, the more ancillary business one can assume that banks are getting – or expecting to get. The borrower wallet of ancillary is not infinite, and so the current widening of CDS prices may be a leading indicator of rising loan prices, although there is not yet any sign of this in the market."
M&A revival
While loan bankers have suffered from falling pricing, they have been able to take some solace from the improved M&A environment. M&A volumes are a long way from their 2000 peak, but prospects look better than they have at any time over the past four years. According to year-to-date data from Thomson Financial, 104 M&A loans worth US$127.65bn have been done so far this year, against 105 deals and US$86.90bn in the same period last year.
Lost in these figures is the fact that first quarter M&A numbers were down on last year, which shows there has been a marked increase in activity in the second quarter. Smaller and middle-sized companies have been the most active on the M&A trail.
"We continue to see a steady flow of M&A financing transactions. There is a substantial amount of enquiry from middle-sized companies about acquisitions," said Kristian Orssten, co-head of debt capital markets at JP Morgan. "Many corporates are feeling more confident than they have been about growing externally through acquisitions. They are, however, facing fierce competition from the private equity community."
France has been the busiest M&A market, with 20 M&A deals worth US$29.02bn so far this year, up from 15 deals and US$23.25bn in the same period last year. The UK market, which is far more club oriented, has seen an increase in the value of deals but a drop in the number of deals compared with the same period last year. Year-to-date there have been 33 UK deals worth US$30.40bn, versus 40 deals valued at just US$23.49bn for the equivalent period last year. M&A activity in Germany, meanwhile, was much slower, with just 15 deals worth US$7.39bn, down from 13 deals worth US$15.4bn for the equivalent period last year.
Bankers attribute the lag in German M&A to the fact that German corporates are behind their French and UK counterparts in the deleveraging cycle. All across Europe companies have been repaying their debts and eschewing new borrowing over the past few years, but German companies are not as far advanced in this process and so not as well placed to pursue acquisitions.
Making money
The improved M&A outlook is good for highly liquid banks because it provides the opportunity to lend new money rather than just refinance existing debt. The problem, however, is that the market is so liquid and pricing so tight that M&A deals no longer carry much of an acquisition premium. As a result, banks are still left with the challenge of how to make some money.
This has prompted banks to look for alternate places to lend money and the Middle East and the emerging markets of eastern Europe have been many banks' focus.
In the Middle East, financial institutions have provided some better yielding deal flow, with National Commercial Bank and Saudi Fransi each tapping for US$500m. Appetite was strong, both deals raising oversubscriptions and Saudi Fransi increasing its loan to US$650m. Investment banks were particularly attracted to these deals because of the large amount of ancillary business – especially derivative mandates – that they have to offer.
Eastern Europe still provides more attractive returns than western Europe, even though pricing in the region has been falling steadily as countries like Russia have risen to investment-grade status.
Russian gas giant Gazprom was the standout borrower, raising a US$250m oversubscription on its US$972m unsecured loan. That loan was the largest and longest clean syndicated loan from a Russian borrower. It was split between a US$700m three-year-and-three-month tranche paying 125bp over Libor, and an up to US$272m five-year trace at 150bp. These margins are a full 100bp above what most deals in western Europe are paying.