Recent months have seen clear signs that a scramble for assets is undermining credit discipline in the European leveraged finance market. Although default experience has continued close to cyclical lows, the deterioration in the credit quality of leveraged buyouts (LBOs) in Europe has been marked. In these circumstances, Standard & Poor's Ratings Services believes that the soundest way for lenders to protect against downside risk resulting from a cyclical tightening in credit conditions, while continuing to benefit from the market's longer-term growth prospects, is to take a more considered and discerning view of recovery prospects in the hypothetical event of default.
Defaults Are Low, But It's Wrong To Be Complacent
When reviewing the credit outlook for the European leverage market it is important to analyze recent trends and appraise the risks that might lie ahead. In recent years, the default incidence for LBOs where institutional investors provide debt funding has been very low. In the European private credit estimate portfolio, the annual default rate has been 2% or lower in 2003-2005.
This situation is mirrored in the default statistics for speculative-grade industrial companies publicly rated by Standard & Poor's. At 1.33%, the 12-month rolling global speculative-grade default rate remains at its lowest level in more than eight years and is a fraction of its 1981-2005 average of 4.65%. The European speculative-grade default rate fell to zero at the end of February 2006 because there have been no European defaults in the last 12 months among publicly rated entities.
We believe, however, that it is wrong to be complacent about the credit risks pertaining to highly leveraged industrial companies, particularly private equity-owned LBOs, because our rating statistics have shown a consistent deterioration in prospective default risk. Standard & Poor's European Leveraged Loan Index, which comprises 327 facilities with a par value of €57 billion, tracks leveraged loans held in European CLO portfolios. At March 30, 2006, 77.3% of the index was rated 'B+/B.' This continues the deterioration observed since the start of the index at the end of 2002, when only 13.8% was rated 'B+/B.'
Our concerns are corroborated by an increase in the number of companies breaching covenants at a relatively early stage in their existence. Recent research by Standard & Poor's shows that as many as one-third of transactions that breached covenants in 2005 were launched less than a year before (see "Broken Promises: Covenant Breaches Litter the European LBO Landscape," published on Feb. 2, 2006, on RatingsDirect, Standard & Poor's Web-based credit analysis system at www.ratingsdirect.com).
The financial risk profile plays a dominant role in determining the default rating assigned for LBOs. The total amount of debt, its maturity profile, and the cost of debt service are compared with the ability to generate consistent free cash flow for the purpose of servicing debt on time. Average total debt for LBOs in Europe, for example, was 5.9x EBITDA at the end of March 2006, according to Standard & Poor's Leveraged Commentary & Data (LCD), up steadily from 4.0x in January 2004. A mitigant of the increasing debt burden is the changing repayment schedule for the senior debt, which usually provides 50% of the total funding. Although 43% of the senior debt supporting LBOs in 2005 comprised term loans with bullet repayments, up from 31% in 2003, the contribution of amortizing bank debt--traditionally favored by bank lenders--fell to 31% from 48% over the same period. Although these schedules are beneficial in the short term, as they reduce the amount of debt service required, the greater challenge of refinancing outstanding term debt will become an increasingly important rating factor in the next three or four years.
Default is somewhat difficult to measure objectively in the European market context. In the U.S., Chapter 11 filings provide the framework for orderly restructurings where viable businesses can be rehabilitated. This is not the case in Europe, however, where formal insolvency proceedings in many jurisdictions have in the past been protracted, to the detriment of recovery outcomes, or led to liquidation. Although this is changing (see "Jurisdiction Matters For Secured Creditors In Insolvency," published April 13, 2006, on RatingsDirect), the situation has encouraged creditors to avoid formal insolvency proceedings in less friendly jurisdictions in favor of more predictable options. These might be debt rescheduling, refinancing all outstanding debt, an equity injection from existing or new shareholders, and/or a debt-for-equity swap usually involving subordinated lenders. The practical implication of these moves is that restructurings (often involving a coercive exchange or a material economic loss for one or more classes of creditors and, therefore, a default under Standard & Poor's criteria) will happen, in many cases, well in advance of an insolvency filing or payment default.
No Two Secured Debt Instruments Have The Same Risk Profile
In Europe, 92 recovery ratings have been assigned to date. There has been little correlation between the credit rating on the company and the recovery ratings assigned so far (see table below). Over 2004-2005, 41% of the recovery ratings assigned in Europe have been '1', where we are confident of full recovery, or '2', where we expect substantial (80%-100%) recovery of principal (see chart 1). This is almost identical to the 42% in Standard & Poor's much larger global library of recovery ratings and reinforces the market's perception that a significant proportion of senior secured loans supporting European LBOs should hold up well in distress.
Distribution Of Corporate Credit And Recovery Ratings Assigned In Europe In 2004-2005
--Recovery rating--
Corporate credit rating
1
2
3
4
5
BB
1
1
2
0
1
BB-
3
5
6
0
3
B+
8
7
5
1
8
B
0
3
7
1
2
B-
0
0
3
1
1
The range of recovery estimates is wide, although a high proportion of '5' recovery ratings have second priority security (71% and 75% of all '5' recovery ratings in 2004 and 2005, respectively, for instance). This demonstrates our belief that no two secured debt instruments have the same risk characteristics and that it is imperative for lenders and investors to differentiate between individual transactions, taking account of both default risk and potential recoveries.
Lenders Seem Indifferent To Credit Risk
Two interesting observations can be made regarding the rating data for the first quarter of 2006, which are, however, based on a limited sample of 13 issues assigned recovery ratings. First there are no 'BB-' or 'BB' ratings, in stark contrast to earlier years (see chart 2). All rated transactions are in the 'B' category. Although this largely reflects the highly aggressive financial risk profile of these companies, it also takes into account the propensity for many private equity sponsors in the current inflated market to arrange recapitalizations to pay out dividends. This limits Standard & Poor's ability to give weight to the often-stated deleveraging objective embedded in the financial projections for a private equity-sponsored LBO transaction. The corporate credit rating is consequently negatively affected.
Second, in addition to the deterioration in corporate credit quality, recovery prospects for the 2006 cohort also appear relatively poor. One reason has been the relatively high proportion of second priority issuance (38%) but it also partly reflects the increase in high-yield corporate bond issuance structured as senior secured notes with only average recovery prospects. Several companies such as New Reclamation Group (Pty) Ltd. (B+/Stable/--) and SAVCIO Holdings (Proprietary) Ltd. (B+/Stable/--) offered senior secured notes that were assigned a '3' recovery rating to gain greater financial flexibility (requiring incurrence rather than maintenance covenants, for example) than would be possible with equivalent secured bank debt. At the same time, they avoided any issue of structural subordination and the risk that the notes could be rated below 'B-.'
Only a minority of LBOs in Europe are publicly rated. The overall volume of rated leveraged loan issuance has averaged 25% of primary market issuance over the last five years, according to Standard & Poor's LCD data. The requirement for public secured loan and recovery ratings in Europe is still case by case, usually where transactions are very large, have a high-yield component, are largely targeted at leveraged loan investors, or involve a transatlantic dual-currency loan syndication strategy. Nevertheless, CLO investors have shown some preference for publicly rated loans. Of the CLO portfolios included in Standard & Poor's European Leveraged Loan Index, 43% had public loan ratings in March 2006.
Although the European leveraged finance market has developed rapidly in recent years toward an equally bank- and investor-driven market, a systematic and transparent link to fundamental credit quality for LBOs and senior debt has not yet fully evolved. Nevertheless, the improvement in transparency and liquidity available in the secondary market is having a growing impact on the primary market. Arranging banks, for example, are responding to high secondary prices and excess demand by reducing spread margins for the various senior and subordinated loan tranches during syndication.
Most private equity sponsors fully accept that it is just a matter of time before the debt market starts to turn off the liquidity tap. As and when this happens, our expectation is that performing LBOs will migrate toward the 'BB' rating category. A real credit curve for the LBO senior debt market would encourage all market constituents to price credit risk in a more transparent and efficient manner rather than, as happens in Europe today, financing mandates being awarded via a blind auction where leverage, not cost of funds, is the main deciding factor. In the meantime, with the possibility of defaults picking up in Europe, lenders would be well advised to take full account of recovery prospects when committing to new leveraged loans.
(Leveraged Commentary & Data is a unit of Standard & Poor's, not affiliated with the Ratings Group.)
