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The U.S. market for leveraged finance is set to grow in 2007, even as some experts see signs of a peak in the current credit cycle, as new investors provide liquidity, according to speakers at Standard & Poor's Ratings Services' 2006 Bank Loan & Recovery Ratings conference.
Linda Pace, portfolio manager, at the Carlyle Group, is among those calling for the market to be "categorically up" in 2007. Continued growth would come on the heels of an unprecedented surge in leveraged loans in 2006, boosted by an influx of money from abroad and an increase in the number of domestic players, specifically institutional investors.
"We're not raising $15 billion-$20 billion funds to sit around and do nothing," Pace told attendees at the Dec. 7 conference.
Borrowing related to leveraged buyouts has boosted the market, and even as the size of LBOs looks at or near the top--"some limitation on the capacity" for a single transaction, according to Steve Miller, managing director at Standard & Poor's-–the market for leveraged finance will expand in 2007.
"Everyone was going into 2006 fearful that it would be the end of the credit cycle-–and that hasn't happened," Miller said. "The current read is that 2007 should be great-–unless it isn't."
Peter Nolan, managing director at J.P. Morgan Securities Inc., was less bullish, calling for "some moderate growth."
"It's hard to see how we can grow materially," Nolan said. "At the same time, "there's just a lot more liquidity out there to supply companies if and when they have a hiccup. What the long-term ramifications are, we'll see."
"Liquidity in the market is such that people don't hang around saying, 'I'm going to hold this until maturity,'" Nolan added. On top of that, the size of the market and the increased number of participants is unprecedented-–and a benefit. "There's a belief that bigger is better," which might help the leveraged finance market better withstand a downturn.
And there are signs that the credit cycle in the United States may be nearing its peak as leveraged loan originations are rising sharply, with the simultaneous narrowing of credit spreads, especially at the low end of the recovery rating spectrum. But differentiating the current market from past cycles is the perceived lack of an overextension in a particular industry.
"We don't have any obvious run-up in a specific industry sector," Miller said. "You don't see the extreme, aggressive credit profiles that you saw in the late 1980s."
In addition, the market breadth is "much larger" to buy companies and to invest in debt, Carlyle's Pace said, which leaves classic balance-sheet and liquidity issues as the ultimate drivers for a turn in the credit cycle. She added that the failure of a "megadeal" leveraged buyout with several equity sponsors "might hurt the availability of capital."
"I think it would take quite a large shock to turn the market around," she said, adding that such an event was unlikely.
At the same time, "that is to a certain extent what everyone in the market is waiting for," said J.P. Morgan's Nolan. He said such a shock, rather than come in the form of an LBO failure, could be a stalled loan syndication-–which could cause some timidity when the time comes to underwrite the next big deal.
Standard & Poor's Miller said another disruptive force for growth in the leveraged finance market could be "the drumbeat in the more broadline press about the credit bubble." This effect, he said, occurred to some extent with the bankruptcy of Adelphia Communications Corp. in 2002, when there was subsequent trepidation among investors in collateralized loan obligations (CLOs).
Still, a slight pullback might be just what the market needs to give lenders slightly higher returns, thus spurring the availability of yet more capital for borrowers.
"Ironically, one might say the best thing to happen on the upside would be a slight correction," which would offer investors a bit more spread as pricing is adjusted, said Carlyle's Pace. She also called loan credit default swaps (LCDSs) "one of the more exciting things to happen to our market in some time." But she expressed concern that these were effectively spawned--and surged--during a bull market, and haven't yet been tested as a risk management tool.
In any event, credit derivatives and other structured products–-such as collateralized debt obligations (CDOs) and so-called "CDO squareds," which are CDOs of CDOs--are helping some banks to hedge their portfolios and providing more risk-hungry hedge funds to make bets on the market outside of cash instruments. But such products won't likely be a strong force for growth in cash instruments.
"It's something that you see around the margins, but it's not driving the market," J.P. Morgan's Nolan said.
In fact, a disconnect between the maturities of contracts in the structured arena and the cash market may be a stumbling block. Because most CDSs are five-year contracts, while loans are often for shorter terms, their effectiveness as a straight hedging tool is diminished, which may limit their growth, Miller said.
Nonetheless, leveraged loans look set to grab an increasing share of the finance market from traditional corporate bonds. According to Miller, loans now represent 80% of all issuance, up from about half five years ago and just 30% a decade ago.
Carlyle's Pace agreed, saying that as private equity firms raise more and more money, we will see growth in loans outstrip that of bonds.
Writer: Joe Maguire
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