Pwc debt market update 2011

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This may cause a surge in volume in the first few months of the year as treasurers look to lock in yields at what they anticipate may be an inflection point in pricing. The leveraged loan market witnessed a strong recovery in with volume significantly higher than Refinancing was a principal driver of activity in the corporate loan market in We expect to see banks continue the trend of underwriting larger transactions as syndication committees gain more confidence around levels of market liquidity.

Underwriting for mid-market transactions may remain less frequent unless new entrants appear in greater numbers to add depth to the market. We believe that club deals are likely to remain typical in this segment of the market. If the European leveraged finance market is to continue an upwards trajectory it will require new investors to enter the market.

The CLO market grew rapidly in the credit bubble years becoming the largest single source of debt financing for private equity backed buyouts. However, the CLO new issue market, along with most of the structured finance market, closed during the financial crisis and has struggled to re-emerge in the postLehman world.

Barriers to renewed CLO issuance remain but the launch of some new vehicles in the US coupled with growth in leverage loans offer reasons for optimism. The combination of more robust primary debt markets and improving macroeconomic conditions led to a post-Lehman low in the corporate default rate in There were only 21 defaults in the European leverage market in compared to 90 in Our overall view is that, barring external factors such as a sovereign default restructuring activity levels are likely to remain in line with Beyond we expect the rising quantum of maturing leveraged loans to lead to increased levels of restructuring activity.

The sheer volume of borrowers needing to refinance in the coming years suggests there is merit in companies beginning to plan their refinancing strategy now. The more highly leveraged companies need to consider how they can reduce their debt to levels capable of being refinanced in the current market.

When the liquidity provided by these vehicles disappeared, the LBO market immediately stagnated. In this article, we examine the issues that have prevented the re-emergence of CLOs and how and when these can be resolved.

In our view, there are encouraging signs to suggest new CLOs will come to market in Europe in the next months. However, the stigma that remains around structured finance is likely to prevent CLOs regaining their previous dominance and other sources of capital e.

These funds are used to purchase a portfolio of leveraged loans. Cash flow from this portfolio of loans is then used to pay interest on the CLOs debt, with the surplus being used to fund equity dividends. Effectively, equity value is created through an arbitrage on the margin that is achieved on the asset side of the vehicle the loans that the CLO invests in and the margin it pays on its debt.

The ability to pay dividends to the equity tranche depends on the available cash flow and the ratio of collateral i. In the period up to spring , CLOs provided a lot of the growth in the European leveraged market. However, later that year, investors lost confidence in mortgage backed CDOs, which then spread across the entire industry.

As a result CLO issuance collapsed. Chart 1: CLO volume since In essence, a Special Purpose Vehicle is created that raises funding in the form of debt and equity.

Recent performance of existing CLOs Over the past 12 months, CLOs have started buying new leveraged loans again, recycling cash from the repayment of other loans in their portfolio. However, overall CLO activity is constrained by the lack of new investment vehicles. This issue holds back the entire European leveraged market given the importance of the CLO sector to previous levels of loan issuance and the contraction in the banking sector over the last four years. Furthermore, the current recycling of cash into new loans by existing CLOs will come to an end in the next years as their re-investment periods close, just as the well reported maturity wall of pre vintage leveraged loans peaks.

This will put further pressure on the leveraged market. The question therefore is what is preventing new vehicles coming to market. Barriers to new CLOs One of the key drivers of equity returns in the boom years was the level of leverage in CLO vehicles, often debt represented c.

This suggests that the leverage problem can be overcome albeit examples so far are limited. While secondary spreads have come down from their post-crunch peaks, they remain at over bps.

Current economics therefore work against the creation of new CLOs. Whilst the loan margins on new leveraged loans are much higher than the pre-crunch level, improving the arbitrage spread, there is a concern that they could tighten in the future, squeezing the returns to equity.

The leveraged finance market is constrained by the lack of new CLO structures. The question therefore is what is blocking new vehicles coming to market. Implications for borrowers Indeed, achieving an acceptable equity return is a key brake on new CLO issuance.

The problem is exacerbated by the fact that equity in existing CLOs is trading at a discount providing a more attractive return than potentially available on a new vehicle. Such a solution is unlikely to be attractive to all CLO providers. For the economics to work, a CLO needs to raise mm and invest it quickly in new leveraged loans.

The lack of dealflow over the past couple of years clearly has hampered this process. There is a chicken and egg problem here: the leveraged loan market needs more CLO activity to grow, but the latter is predicated on a larger overall level of new loan issuance. Regulators have also sought to align the interests of the originators of the CLO e. As a result, both in the US and Europe so-called skin in the game regulations have been prepared.

Potentially this could lessen appetite of banks to arrange new deals. Appetite for new leveraged loan paper from existing CLOs is currently quite strong.

There is an argument that borrowers should make use of this window before it closes because there is still uncertainty as to what will replace it, albeit the high yield bond market is currently taking up part of the slack. Similarly, when planning refinancing strategy, borrowers should also look at their existing loan syndicate to understand the importance of CLOs in their lender base.

These lenders will probably not form part of any refinancing in the medium-term creating a funding gap which will need to be filled by bond issuance or other lenders. Improving conditions could spell return of new CLOs There are a number of encouraging signs which are likely to support an opening up in the market in Europe over the next months. A small number of new CLOs have recently been launched in the U. These new vehicles appear to have been able to increase leverage again to c.

Apollo priced the AAA tranche of their most recent deal with a spread of c. Additionally, as reinvestment periods in existing CLOs begin to close, this could put upward pressure on underlying leverage loan margins, adding a further boost to the CLO spread arbitrage. The European leveraged market grew significantly last year and the pipeline for new deal flow suggests will build on this momentum. A bigger leveraged finance market will address the ramp-up problem described above.

Although the skin in the game regulations could be a barrier for some arranging banks, on aggregate it doesnt necessarily have to be a major obstacle to increased CLO creation.

Banks are looking to put capital to work again and senior CLO paper is attractive compared to similarly rated securities.

In a way, this could actually help boost issuance as potential investors find comfort from the originators retaining an economic interest. However, the stigma that surrounds structured finance has not completely lifted. If new CLOs do make in-roads again in Europe, they are unlikely to be as dominant as they were in the previous cycle. Rather, they may sit alongside other institutional vehicles e. Key trends The loan market ended strongly with market sentiment positive going into The wider loan market continued largely unscathed by Irelands debt woes and Q4 European volumes demonstrated strong growth over both Q4 and Q3 Lenders remain keen to win new business and are increasingly willing to use their balance sheets to underwrite for the right deals.

This trend has been more apparent in larger deals where banks have increasing confidence in overall market liquidity.

UK Mid-market liquidity has seen some improvement through the increased activity of certain overseas banks, but in general deals need to be completed within a fairly narrow group of lenders which continues to lead to more club deals within this segment of the market.

Outlook for The corporate loan market proved resilient to external shocks in such as the euro zone debt crisis, the UK Comprehensive spending review, global macroeconomic concerns and Basel III negotiations. These themes are likely to continue to be in focus in However, barring a systemic shock, such as a Spanish sovereign default, we expect the corporate loan market to continue the trends seen in , ie. Total value at 35bn was double the Q3 level if one excludes the loan raised to finance BHPs failed bid for Potash Corp from the figures.

Mid-market pricing has remained more sticky driven by the relatively small number of banks active in the market. Ancillary fee opportunities are as important as ever to lenders as they seek to boost overall yields to generate a return over continued high funding costs. In terms of tenor, the typical maturity on mid-market corporate loans has lengthened to 4 years from 3 years, whilst 5 year deals are increasingly seen in larger deals.

Client considerations Our view is that whilst Banks are certainly open and keen to do good business, an overall cautiousness in the economy remains which can lead to less predictable approval processes. Our advice to mid-market companies seeking new financing would be to approach more banks than would initially appear necessary in order to maintain flexibility in the loan raising process.

High yield ends on a high, but overall market may soften through as inflation expectations build up. Key trends The UK bond market supported a steady rate of issuance in , in line with the trend seen in the second half of In contrast to the overall trend, the high yield segment exhibited strong growth.

The market shrugged off the Eurozones woes with final quarter volumes in line with the high level of activity in first quarter. The continued strength of the high yield market is key to borrowers ability to tackle maturing leveraged loans see page 28 for more details.

The start of has already witnessed strong volumes, driven in particular by borrowers concerns that coupons may increase later in the year in response to rising inflation expectations.

There continues to be a steady stream of new issues in the less volatile private placement market. Volumes Whilst quarterly volumes remained broadly steady in compared to the second half of , full year issuance of As investment grade spreads narrowed slightly over the whole year albeit with peaks and troughs , this suggests lower volumes were broadly a function of borrower demand rather than lack of investor appetite.

Indeed, the high yield market showed strong growth in volumes in the UK and across Europe precisely because of the demand from corporates to tackle maturing leveraged loans, as well as in some instances to part-fund leveraged buyouts.

High yield bonds used in LBOs represented ten times the level of new mezzanine issuance in , demonstrating the formers dominance in the market for junior debt capital. Investment grade bond issuance in was down on prior years, but this was principally a function of demand. Whilst sub-investment grade spreads fell during , they remain significantly above precrunch levels.

BP led the way in October with a 2bn A rated bond which was the largest single launch, but which was followed by three separate issues from BG m, m and m and one Thames water m.

Pricing The fourth quarter of saw a narrowing of spreads between investment grade and speculative grade bonds. This principally reflects a decline in high yield bond as investment grade pricing only marginally tightened over the last 12 months.

The fall in sub-investment grade spreads has led to some speculation of a nascent credit bubble. In reality, whilst all-in coupons have fallen during the year, the spread over government debt remains significantly higher than the peak of the pre-crunch credit boom.

The UK construction sector, one of the biggest casualties of the UK recession, was again represented through Taylor Wimpey m , Eversholt m and European Metal Recycling m and there were major bond issues from the transport Motobility - m and chemicals sectors Bunzl - m. Table 1 summarises recent UK issues. As the table indicates, PP investors are able to accept relatively small issues e. Logica, Northern Foods and will invest in a wide range of sectors. This enables corporates who are not keen to issue a bond either because they do not want a credit rating or their debt requirements are smaller than a typical bond issue to tap longer maturities years.

PP investors typically tend to focus on borrowers with leverage of up to 2. Therefore, for smaller highly leveraged companies, they are not a substitute for the high yield bond market. Client considerations The bond market remains an important tool for mid size and larger borrowers to diversify sources of capital and spread the maturity profile. Companies with relatively high levels of leverage, but not in financial distress, should consider the high yield market to address upcoming maturities.

Some corporates have been using HYBs as an alternative to IPOs since they offer both a means for shareholders to realise value and raise new money without the uncertainties and dilutive impact of equity issues. With credit ratings a key driver to the pricing of corporate bonds, the positioning of the business in front of the agencies is critical to obtaining the best possible rating.

Borrowers with a smaller level of long-term core debt should consider the private placement market to replicate some of the benefits of tapping the capital markets. This partly reflects concerns around the impact of rising inflation expectations on bond yields, which may temper volumes later in the year. The other key theme for the bond market this year is the continuation of the Eurozone crisis.

The high yield market coped with this in and our base view is that it will continue to remain open unless there is a major sovereign default. Indeed, demand is likely to continue to remain strong in this segment as the quantum of maturing loans from buyouts completed in the boom years begins to climb. This may put some upward pressure on yields, but for borrowers access to the market is likely to be more critical than price.

The majority of ABL advances circa 12bn relates to pure invoice financing, with the remainder being more comprehensive ABL where senior debt is secured against a range of assets in a single structured finance package. Yet despite this growth in market share, ABL has not really broken into new areas of the debt market following the credit crunch, as some predicted. And with improving liquidity in traditional cash flow corporate and leveraged lending, it could be argued that ABL has missed this opportunity, as is born out by our experiences in two different areas of the debt market.

For corporates with strong credit ratings, the potential pricing advantage of ABL facilities e. In the private equity buy-out market, it is relatively rare for ABL alone to provide sufficient leverage to make the transaction attractive, and a material slice of top-up debt, usually mezzanine is often required.

With the improvement in liquidity in the leveraged market, the ABL plus mezzanine option is becoming less competitive. Additionally, lack of capacity resulting from complications in clubbing or syndicating ABL deals, can be an issue in both of the above examples, and this combined with short supply of quality deals, is driving an increase in hold sizes up to m now being considered by some major ABLs.

Despite the above comments, ABL remains competitively-priced, although margins now appear to have stabilised following a gradual decline over the last year.

Average margins for receivable and inventory lines now stand at to bps over LIBOR and to bps for term debt secured over property, plant and machinery. Lenders continue to typically be willing to advance up to 85 per cent of receivables with lower advances for plant and machinery up to per cent of day realisable value , property up to 50 70 per cent of day realisable value and inventory up to per cent.

Fixed asset realisation values, particularly for plant and machinery but also for industrial property, have fallen significantly over the last two years. This has reduced the quantum of finance available against these assets. Client considerations Despite the many attractions of ABL, potential borrowers should be aware that a marked downturn in trading can have a particularly strong impact for an ABL-backed business.

It will not only suffer trading losses, but also a reduction in working capital assets to fund against. In addition, it is critical to an ABLs funding criteria that advance rates are sufficiently conservative for it to be confident it can recover its lending in full in the event of an insolvency. Therefore, once lending requirements go beyond those advance rates, the right commercial decision for the ABL will be to recover its lending rather than to advance further funds.

This is one of the reasons why a relatively high failure rate is experienced by ABL backed businesses, although the failure rate is also significantly influenced by ABLs willingness to back turnaround businesses, and so their clients will, on average, be higher risk.

For some companies, particularly those which are asset-rich and cash flow poor, ABL may be their only remaining source of debt funding. Key trends Although we remain far removed from the peak of the market in , the past year has been a positive step forward for leveraged finance.

Refinancing activity was the key driver of volumes, representing nearly two thirds of total issuance. This compares starkly with the pre-crunch market, when new deals and recaps dominated the market. Lenders have become more confident over the course of the year evidenced by rising leverage, the reappearance of underwriting for borrowers generating over 50m of EBTIDA and even a small number of dividend recaps typically financed through the bond market.

CLO managers, who were the single largest source of liquidity in the pre-crunch era, have re-entered the market, investing proceeds from the repayment of other loans in their portfolio. However, their overall activity is constrained by the inability to set up new investment vehicles see p5 for more detail. Partly filling the gap has been the buoyant high yield bond market. A turning point Leveraged loan volume in was significantly up from the low, from This was further amplified by the large issuance of HY bonds, which resulted in a combined volume for loans and bonds of However, the use of funds was markedly different.

Partially this was the result of investors returning to the primary leveraged loans market, as secondary prices have rebounded driving down yields and CLOs received repayments from refinancing to re-invest.