Leveraged loan volumes for both first and second liens in the U.S. and Europe have continued to grow strongly in 2006 and look set to beat last year's €123.5 billion. The rise in volumes has been countered by even stronger growth in demand, which has unsurprisingly led to a drop in spreads across the board.
Market conditions have undoubtedly had an impact on credit dynamics. Average LBO purchase-price multiples have risen by about a turn of EBITDA over the past two years in Europe (to 8.4x from 7.4x, according to Standard & Poor's Leveraged Commentary & Data), leading to greater leverage ratios. This indicates that most of the higher purchase price paid is being financed by debt and not equity. Figures for some recent months, however, show that equity contributions are rising again. We'll be watching to see if this continues.
These factors have led to an overall decline in credit quality in Europe. In a portfolio of the total universe of 686 public ratings and private credit estimates, the most common rating has clearly moved from 'B+' in 2005 to 'B' in 2006, with this trend showing no sign of reversing (see chart 1).
Chart 1
Are More Defaults On The Way?
At this point, with default rates at cyclical lows, the importance of declining credit quality might be considered limited. However, we have seen defaults of rated debt picking up in Europe, with six in 2006, up from two in 2005, and we expect to see an increasing number of defaults over the next year or two as the cycle turns. And rising default rates will make the second element of credit analysis--recovery of principal in the event of a borrower's default--more important for investors.
Since we introduced recovery ratings three years ago, we have assigned 127 of them to secured loans and bonds in Europe (both publicly and confidentially). Of these, 65% of first-lien debt deals have ratings in category '2' or higher, meaning we expect recoveries above 80% of principal. In addition, a number of those with a recovery rating of '3' (50%-80% recovery) have covered above 80%, but are constrained by multi-jurisdictional issues. For second-lien loans, recovery ratings in category '5' (less than 25% recovery) dominate (see chart 2). Given the small universe of recovery ratings to date, however, it's too early to say if they're declining along with overall credit quality.
Chart 2
An interesting point to note is that while the U.S. has seen a strong shift toward separate loan agreements for second-lien loans, that's not yet the case in Europe. Of rated second-lien loans in Europe, only about half have separate loan agreements. Nevertheless, as many more companies in Europe than in the U.S. will try to do an out-of-court restructuring, we're conscious of the potential nuisance value to senior secured lenders of subordinated secured debt holders, who may be able to recover more than they should theoretically be able to when senior lenders want to restructure a company. If new data prove this to be the case, we may well adjust our second-lien recovery ratings.
Factors That Are Affecting Recovery Ratings
Looser deal structures
A key trend reflected in current recovery ratings is the impact of looser deal structures and documentation (see “Ratcheting Up The Risk: European LBO Documentation Gives Borrowers An Easy Ride,” published Sept. 27, 2006, on RatingsDirect). For example:
Scheduled amortization is minimal. Term loan A (TLA) tranches are much smaller, and we're now seeing European transactions with no TLA, which, while common in the U.S., was a new feature for Europe in 2006. At this stage, lack of TLA is generally limited to cross-border deals partly syndicated in the U.S.
Documentation is increasingly drawn up in favor of the borrower. We have now seen some transactions come in for recaps two or three times, and we're seeing looser documentation on each occasion. For instance, headroom for covenants is increasing to the point where lenders may not be able to step in before a payment default occurs. In addition, covenant cures through the injection of cash, or even equity, are becoming more common. The level of cash sweeps is falling, and they often have a number of exclusions allowing the company to make acquisitions or use their cash in other ways. And lender rights have weakened, with lower majorities required to pass resolutions.
Finally, we have seen several loans refinanced with bonds with inherently more aggressive structures and lacking maintenance covenants and amortization requirements.
Various insolvency regimes
The second key factor in recovery ratings is the importance of creditor rights in the various insolvency jurisdictions. While insolvency issues are especially critical for European investors because these debt issues tend to be multi-jurisdictional, there's a perception that they're less important for other investors. However, cross-border transactions, whether syndicated in the U.S. or Europe, are a very significant part of the market, worth nearly €50 billion between January and September 2006, versus new volume of €350 billion for the same period, according to Standard & Poor's LCD. While the proportion of cross-border transactions isn't surprising given the amount of M&A activity over the past couple of years, the size and importance of cross-border deals demonstrate that insolvency regime issues are vital for all market participants buying into such transactions.
We have published detailed reports about the insolvency regimes of the U.K., France, Germany, and Spain over the past couple of years, as well as an update of the main European jurisdictions earlier this year (see “Jurisdiction Matters For Secured Creditors In Insolvency,” published April 13, 2006, on RatingsDirect). By the end of 2006, we will have published reports on Sweden, Norway, and Denmark--all three of which look to be fairly friendly to secured creditors. In the first half of 2007, we're also aiming to publish reports on the main Eastern European countries that recently joined the EU. However, it's worth noting that several European insolvency regimes are largely untested because legislation has been amended fairly recently, and we have yet to see sufficient defaults go through the process to see how well it's working.
Conclusion
In conclusion, we see the European and U.S. markets converging in terms of liquidity issues, deal structures, and "price-flexing"--the repricing of deals, usually downwards, because of high demand. As a consequence, credit quality has clearly declined, with higher leverage and looser documentation resulting in a rise in defaults in 2006. For this reason, post-default recovery will become more important as we move into 2007.
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