The flight to quality in European issuance

The European leveraged finance market remains resilient following a year of unprecedented hardship, as lenders dissect credits to determine the best possible deals, from business fundamentals to pricing and documentary terms

In March 2020, as lockdown restrictions took hold, European leveraged finance markets momentarily ground to a halt. As our latest leveraged finance report reveals, many feared the worst, as leveraged loan issuance dropped significantly that month and high yield bonds saw virtually no activity.

Borrowers and lenders alike held their breath, shoring up their finances and waiting to see what might come next.

And then, just as quickly, investor sentiment began to improve. By the end of Q2 2020, overall issuance had returned to pre-pandemic levels. And while activity slowed in H2, as new waves of COVID-19 swept across the UK and Europe, the final tally confirmed the market’s long-term resilience.

Overall European leveraged loan issuance for 2020 was up more than 10%, year-on-year (even though institutional loan issuance dropped more than 20% over the same period).

High yield bond issuance was equally resilient—up 10% on 2019 figures to US$113 billion—and could well retain the market share won from loans through the course of 2020, especially lower down the capital structure, with unsecured high yield bonds pricing competitively against second-lien loan debt.

Pricing on loans and bonds widened in 2020 and, despite tightening in Q4, lenders expect to see pricing hold in their favor in the months ahead, as fewer opportunistic credits hit the market for a repricing than seen in prior periods.

Average yields to maturity on high yield bonds widened from 3.8% to 4.7% through the course of the year, while the average margins on institutional leveraged loans increased from 338 bps in Q1 2020 to 401 bps in Q4.

There are several examples of deals that were able to raise financing but at higher pricing, including BlackRock-owned Creed Fragrances, which priced a €250 million institutional loan at 5% over Euribor, and Blackstone-backed Building Materials Europe, which secured a €220 million refinancing at the same cost.

In the loan markets, lenders secured further pricing enhancements through deeper original-issue discounts (OIDs—the discount from par value at which a loan is offered for sale to investors) and, in some cases, improved LIBOR floors. The share of new loans with OIDs of 99 and below increased through the year, representing more than a quarter of new deals.

With regard to LIBOR floors, which lock in a minimum interest rate for borrowers even when interbank lending rates fall, the share of loans with floors of between 0.5% and 1% increased slightly in 2020, although 0% floors still account for the bulk of issuance.

Government moves kept restructuring down

While new waves of COVID-19 pose ongoing challenges for the market, the rollout of vaccines, along with a US change in administration, have raised hopes for improved deal flow in 2021. Vast quantitative easing programs introduced by the Bank of England and the European Central Bank injected large sums of liquidity into capital markets, which banks and investors will put to work.

Additional European government employment support schemes—which received applications from more than 40 million workers—and various state-backed loan schemes brought further liquidity into the marketplace when it was most needed, injecting billions into European economies.

These measures, combined with low interest rates, allowed many lenders to get their capital deployment targets back on track. Government and central bank action also supported existing credits through the most volatile stages of the year, which meant that many borrowers could avoid restructuring scenarios. As a result, only US$3.6 billion of leveraged loan issuance was secured for restructuring in 2020. Restructuring activity, however, could still increase as government support measures unwind.

Buyout rebound on the horizon

Private equity deal value in Western Europe reached its nadir in Q2 2020, totaling US$32.3 billion—the lowest quarterly figure since Q3 2013, according to Mergermarket data. Private equity deal volumes for the year, meanwhile, declined by approximately 10% year-on-year.

This hiatus in private equity deal activity following COVID-19 lockdowns weighed heavily on LBO debt issuance. Even though European high yield bond issuance for LBOs was strong—up more than 35% year-on-year—the region’s much larger leveraged loan market saw LBO issuance decline over the same period, according to Debtwire Par. Financial sponsor deal activity, however, bounced back at the end of the year, pointing to improved deal flow going into 2021.

For all the uncertainty imposed by COVID-19, lenders remain eager to deploy capital. This was true throughout 2020—when the limited deal flow and LBO deals came to market, appetite was robust.

Banks underwriting the debt for the €17.2 billion carve-out of ThyssenKrupp’s elevator division by Advent and Cinven, for example, were able to sell €8 billion of loans and bonds to finance the deal, despite pandemic uncertainty. The banks behind TDR Capital–backed pub chain Stonegate, meanwhile, sold down £1.2 billion of bonds in July to finance Stonegate’s takeover of the UK’s largest pubs operator, Ei Group.

European deal activity could take off in 2021, but financial sponsor-buyers and lenders may remain highly selective—they will likely coalesce around high-quality assets and distressed companies, where investors can buy in to sectors directly impacted by lockdowns at low valuations.

CLOs: A mere flesh wound?

European collateralized loan obligations (CLOs), meanwhile, ploughed through the worst of the cycle in 2020, despite COVID-19 uncertainty, ratings downgrades and loan pricing volatility, with CLO managers returning to market to secure investor support and resume normal dealmaking following the onset of the pandemic.

European new-issue CLO volume in 2020 fell by about a quarter, year-on-year, according to Debtwire Par. CLO refinancings played a big part in this decline, dropping to zero in 2020.

Some may have feared the worst when leveraged loan prices plummeted, but CLOs have shown yet again (as they did in the aftermath of the 2008 recession) that they are designed to operate smoothly through economic cycles. By October 2020, the primary CLO new issuance market was back in near full swing, when €4 billion of CLO new issuance was priced from 12 deals—the highest monthly level since October 2019. News of vaccines provided another boost across European markets, with reset and refinancing activity expected to return to Europe in force in 2021.

CLOs have also held firm thanks to other features of the product’s structure, including the typical requirements for 90% of a portfolio to comprise senior secured loans, portfolio diversification by borrower and by industry, restrictions on illiquid loans and the increasing prominence of environmental, social and corporate governance (ESG) criteria, which have protected CLOs from investments in riskier sectors.

What does all of this mean for 2021?

First, the influence of COVID-19 will continue to be felt, even as vaccines are rolled out across Europe. Sectors knocked back by the first wave—including entertainment and leisure, hospitality, retail, oil & gas and aviation—will struggle to secure financing, having already done what they can to survive.

Within those sectors, those that require financing and are able to secure deals are likely to have to pay for the privilege, with leveraged debt either becoming more costly for those whose credit has taken a hit or only being made available on tighter terms.

Second, and in contrast, lenders will turn their attention to high-quality credits or sectors that found new avenues for growth during COVID-19, such as technology and healthcare. Lenders will mitigate risks by analyzing deals even more closely in search of quality credits—which will in turn affect pricing. Any weaknesses or loopholes in documentation will be scrutinized and lenders may be more cautious in their forecasting.

For the most part, lenders reacted to the pandemic as a short-term, albeit undeniably dramatic, concern. Depending on the sector, businesses that were viewed as trustworthy credits before COVID-19 continued to be viewed as such, and this was reflected in amendment processes in 2020, which tended to focus on liquidity and enhanced reporting alongside a reset or suspension of covenants.

Third, as we’ve witnessed in 2021 already, loan supply has become a hotly contested marketplace for the right credits, and we anticipate that this will continue. For those well-positioned companies, this flight to quality will continue to offer favorable terms and pricing, and the light-touch covenant packages that were the norm pre-pandemic should remain in place with ongoing pressure for more aggressive terms. We expect to continue to see a liquid market for primary issuances, refinancings and re-pricings—perhaps sprinkled with some dividend recaps.

And finally, the issues that were front of mind pre-pandemic will continue to influence borrowing and lending decisions, especially ESG factors—investors, issuers and underwriters are all taking a positive view of credits that incorporate ESG criteria in a meaningful way. This will no doubt drive this trend in the months ahead as recovery takes hold and global debt markets return to growth.

After years of warnings about maturity walls, impending cliff edges, downturns and interest rate hikes that failed to emerge, COVID-19 was the event that brought everything to a temporary standstill—but there’s every chance that the markets will remain highly competitive and active in the months ahead.

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