IFR hosted its first leveraged finance roundtable on September 14 and, much like the leveraged market itself, things got hot pretty quick.
Liquidity – on both the demand and supply side – and its far reaching effects were the main topics raised. Private equity houses came in for particular stick – partly because they have taken advantage of the flush market to force banks and investors to accept pricing levels and leverage multiples that was unthinkable just 12-18 months ago, and partly because there were none present to defend the industry's honour.
Lower returns and rising leverage was of concern but it was the erosion of downside protection, such as stringent financial covenants like cross-default clauses, which seemed to be of particular worry.
While the loss of such protection is proving to be a worry to all creditors from senior lenders right down the capital structure, it is the rapid growth of subordinated debt instruments such as mezzanine (warranted and warrantless), second lien notes and PIK notes that has really brought the issue into focus. In short, holders of these subordinated debt pieces have no idea how much protection they have should things go bad on a buyout - which they inevitably will.
It was not all doom, however, for while the demand of accommodating this liquidity has posed challenges, it has also created opportunities. Deals for good companies with racy debt numbers can now attract capital in a way that was just not possible 18 months ago, making for a more exciting and dynamic market.
There was also much talk about the growing sophistication of all players in the market and how they have responded to these unprecedented levels of liquidity. Initially supply and demand – rather than a credit's quality – was the main determinant of leverage and price. But fears over where this approach inevitably leads has made banks and funds alike take pause.
Lead banks that have taken huge underwriting risks will naturally structure deals to sell rather than meeting stringent credit requirements only to find they cannot move the paper off their books. However, as investors have become more aware of the risks involved in investing in some of these new instruments – and there has been pushback on some high profile deals this year – the pressure is on lead banks to get deals right.
View diverged, however, on exactly what the role of a lead bank should be. There seems to be general agreement that a lead bank being willing to hold a large chunk of its own deal meant stronger credit work and that a successful syndication of the senior debt boded well for the subordinated debt and secondary sell down. Others seem to think that a successful syndication was not the be all and end all because if a deal struggles in syndication, the demand may still be there – just not at that price.
That, in essence, is what the European leveraged finance market has become – a dynamic market in which a growing pool of investors is willing to buy an expanding range of debt products at any price the market will take. Things are heating up.