Having navigated extreme market dislocation due to COVID-19 for the past six months, leveraged loan activity in the United States and Western and Southern Europe is giving cause for optimism.
Quarterly leveraged loan issuance in the US reached US$158 billion in Q3 2020, up 9% from US$145 billion in Q2.
Despite a sharp decline in Q2, overall issuance in the country is down less than half a percent year-on-year, from US$632.5 billion for the first nine months of 2019 to US$630 billion over the same period in 2020.
And while loan issuance in Western and Southern Europe was noticeably lower this quarter at US$45.1 billion—down 36% compared to the US$70.5 billion seen in Q2—year-on-year issuance is up. Over the first three-quarters of 2020, issuance reached US$186.3 billion, rising from US$170 billion over the first three-quarters of 2019.
Lenders look beyond immediate cash needs
Leveraged loans have been coping with increased competition from high yield bonds for deal flow since COVID-19 lockdowns began. Many investors pivoted toward high yield bonds, which are not linked to floating interest rates and offer the promise of better yields in the current low-interest rate environment.
As a result, high yield bonds have taken a larger share of overall leveraged finance activity than in previous years. So far this year, in terms of value, they account for a third of total leveraged finance issuance across North America and Western and Southern Europe, up from 24.7% in 2019 and 13.1% in 2018.
Despite this trend, borrowers continue to turn to leveraged loan markets—and not just to meet short-term liquidity needs, as was the case in the months immediately after COVID-19 lockdowns began.
The use of proceeds has broadened to include more refinancings and amendments. In a market still burdened by COVID-19 uncertainty, a reopening of financing for M&A and dividend recaps has also been encouraging.
Recaps (including deals where at least a portion of the deal was for dividend recap purposes) worth US$13.9 billion proceeded in the US in Q3, up from a meager US$70 million in Q2 in the immediate aftermath of the pandemic—the highest quarterly recap value (including dividend recaps) since Q1 2017. A similar story played out in Western and Southern Europe, where recaps were up from just US$150 million in Q2 to US$2.5 billion in Q3.
Issuers taking advantage of renewed lender appetite for recaps in the US included Radiate Holdco with a US$4.6 billion loan and bond financing to refinance existing debt and pay a dividend to private equity sponsor TPG Capital. Shearer’s Foods priced a US$1.075 billion term loan B (TLB) and a US$340 million second lien facility, also to refinance debt and pay a dividend.
Loan financing for M&A (excluding buyouts) in the latest quarter moved higher in the US and Western and Southern Europe as well, to US$30.3 billion and US$10.5 billion, respectively—up from Q2 figures of US$20.7 billion and US$5.3 billion. In the US, loan financing for buyout-backed transactions was only marginally lower in Q3 2020 when compared to Q2 2020.
M&A transactions that successfully secured leveraged loan financing include the purchase of PCI Pharma in a deal funded with a US$920 million TLB and a US$300 million second lien term loan. In Europe, French nursery chain Babilou took out a €487 million term loan for its acquisition by infrastructure fund Antin.
The fact that these M&A deals secured funding shows that investors have appetite for new deals—CLO managers are particularly eager to deploy funds into new transactions. The flat M&A market, however, means that the supply of new money deals for investors to consider has been tight. As such, when dividend recap and M&A opportunities have come to market, lenders have been primed to support them.
Market moves back toward borrowers
The appetite among investors for new deals means that pricing and terms have moved back in favor of borrowers post-lockdown, despite the risks posed by a second wave of COVID-19, unwinding government financial stimulus and the US presidential election.
According to Debtwire Par, pricing tightened in the US in Q3 2020 as a result, with the average margin on institutional term loans falling to 439 basis points (bps) from 494 bps in Q2. The prevalence of LIBOR floors above 0%, which guarantee lenders a minimum interest rate coupon should headline interest rates fall, also moved more in favor of borrowers. Roughly 48% of institutional loans in the US in Q3 included LIBOR floors of 1% or more, down from 59% in Q2. Together, these factors contributed to a tightening of institutional loan yields from 6.4% in Q2 to 5.3% in Q3.
The post-lockdown recovery in investor demand has also supported a revival in secondary markets, after prices fell by as much as 20% in March when primary deals dried up. Term loans are now trading closer to pre-pandemic levels. According to Debtwire Par, 70% of term loans were bid at 95% to par or above in September, up from just 3% at the height of pandemic uncertainty in March.
Outlook uncertain, but optimistic
Although leveraged loan markets staged a recovery under the shadow of COVID-19, lenders and borrowers still face headwinds. Ratings downgrades remain a feature of the market, with Debtwire Par counting 136 downgrades in Q3. Although this is an improvement on the 452 downgrades recorded in Q2, it is still cause for concern. Default rates also crept up to 4.5% in September on a 12-month trailing basis from 4.3% in August. Defaults in the US now total US$55.6 billion for the year-to-date, with more coming.
Still, the Q3 recovery suggests leveraged loan markets have the potential to end the year on a much stronger note than expected at the start of the pandemic.