European leveraged finance: From surviving to thriving

Leveraged loan and high yield bond markets in Western and Southern Europe saw a major resurgence in the past 12 months, driven initially by refinancing, followed by almost unprecedented M&A and buyout issuance, and setting the stage for, on balance, a productive year ahead

As our latest leveraged finance report reveals, the first quarter of 2022 finds the European leveraged finance market relatively well-positioned, driven by the momentum that began early in 2021.

In 2021, leveraged loan and high yield bond issuance in Western and Southern Europe reached the highest annual total value ever seen on Debtwire Par record. Leveraged loans in the region jumped from US$259.6 billion to US$343.3 billion year-on-year, while high yield bond markets were even more enthusiastic, with issuance for the year climbing from US$113 billion in 2020 to US$175.9 billion in 2021.

There was a clear shift from survival to growth strategies among many lenders and borrowers in the past 12 months, but can this pace continue?

Behind the growth

Obvious drivers prompted this record-breaking increase in activity. First, low interest rates and pricing—coupled with rumors of future interest rate rises in Europe—sparked a wave of refinancing in the first half of the year.

Issuers in the region locked in lower rates as the average pricing for pro rata and institutional loan debt shifted from over 4% in Q4 2020 to below 4% by the end of Q2 2021. The high yield market followed a broadly similar pattern, as pricing in Q1 and Q2 came in below the 4% threshold.

Leveraged loans intended for refinancing, repricing and amendments reached US$160.1 billion in 2021 (up 74% year-on-year), while high yield bond issuance for this purpose was up 34% during the same period, hitting US$101.5 billion.

Refinancing issuance slowed in the second half of the year as pricing began to climb, but it still accounted for half of overall leveraged finance issuance by the end of 2021.

While refinancing slowed, M&A activity surged, driven by pent-up demand, a surfeit of capital and attractive prices. According to Mergermarket data, Western European M&A deal value reached US$1,319 billion in 2021—closing in on the all-time high-water mark of US$1,364 billion recorded in 2007.

Mega-transactions played a significant part, from the €24.8 billion merger between German real estate groups Vonovia and Deutsche Wohnen to Parker Hannifin’s €8.4 billion take-private of UK aerospace and defense group Meggitt, whetting investor appetite for big-ticket European corporate M&A.

Buyout activity also took off during the year, as significant private equity (PE) dry powder was finally released. European exit and buyout value reached US$613.2 billion in 2021—the highest annual total on Mergermarket record.

Buyers hit the market aggressively, better prepared to assess whether a potential target was likely to struggle or grow after operating for more than a year under pandemic conditions.

As a result, buyout loan issuance in Western and Southern Europe soared more than 80% year-on-year to US$78.6 billion in 2021, with high yield bond buyout provision during the same period jumping from US$7.9 billion to US$18.3 billion.

The debt packages that will be required to fund the current pipeline of buyouts—from Clayton, Dubilier & Rice’s £10 billion buyout of supermarket chain Morrisons to KKR’s €33 billion bid for Telecom Italia (should these go ahead)—will keep lenders busy well into 2022.

Challenges on the horizon

Despite these positive signs, there are still reasons to be cautious.

First, we are not out of the COVID-19 woods yet. The Omicron variant seems to be less damaging than the first waves of the pandemic, but any hint of new restrictions may force some companies to hold on to their reserves, especially if they struggled during previous waves of the pandemic.

Second, inflation continues to climb and interest rate rises are a real concern. The UK got the ball rolling with its first interest rate hike in three years in December 2021, followed by a second increase two months later. It now sits at 0.5% and that is not likely to be the last increase this year.

The EU may well follow suit in 2022—despite protestations by the European Central Bank. In November 2021, European Central Bank President Christine Lagarde insisted that the “conditions to raise rates are very unlikely to be satisfied next year.” By February 2022, she was refusing to rule out a rate hike in 2022, stating that the "situation has indeed changed."

As debt becomes more expensive, decisions around M&A and buyouts, as well as their financing, become more complicated. Some may pause while others—from companies in good financial shape to PE firms with money to spend—may decide to invest in a post-COVID-19 future.

Third, supply chain disruptions are still on everyone’s radar. These could be temporary bottlenecks, prompted by an uptick in demand as COVID-19 restrictions were lifted, but they may also be a red flag for lenders in the months before a transaction. Any snags can increase business costs as well as cause delays and extend delivery schedules, which can drive customers away.

Supply chain risk and its potential impact on credit quality will likely feature in any assessment of borrower exposure. The same applies to global commodity shortages, from carbon dioxide to oil, and essential components like semiconductor chips and labor shortages in logistics and shipping.

Borrowers may need to review their supply chain, from finding more local options to building a stockpile to stabilize prices until any bottlenecks are worked out.

Finally, environmental, social and corporate governance (ESG) criteria remain highly relevant. Benchmarks launching in 2022 such as the EU’s Sustainable Finance Disclosure Regulation are already making waves.

Europe’s CLO market, in particular, has taken note. ESG objectives are converging at pace, giving CLOs access to the vast and rapidly expanding pools of capital earmarked for ESG-linked investment. As a result, new CLO issuance in Europe reached €38.5 billion by the end of 2021—up 75% year-on-year and peaking in November 2021 at €6.3 billion, its highest level on Debtwire Par record.

What does this mean for the year ahead?

In the next 12 months, lenders sitting on significant pools of capital and searching for yield may cast their nets even wider, backing the right lower-rated credits to lock in yields despite the risks. The process has already begun: B-rated credits accounted for a larger share of overall issuance in 2021 than in 2020. 

At the same time, credit quality will influence terms and documentation. In 2021, there was an increase in the number of margin flexes in syndication processes. Flexibility will remain the order of the day when it comes to documentation on popular credits. But, if there is an increase in lower-rated credits on the market, then lender and sponsor views on their quality will decide what terms and pricing are made available. Market participants are likely to be more prudent when it comes to deals involving more risk. Pragmatic mid-tier sponsors may accept tighter documents and higher prices to get deals done.

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