Even before all the numbers have been reported and added up, it's clear that 2006 will be another record year for the European leverage loan market. The second half alone, even with the two big holiday months of August and December, already hit €59.4 billion from 118 transactions through the end of November. That brings 2006 year-to-date total volume to a record-setting €128.6 billion from 266 deals, compared with €116.9 billion from 204 transactions in all of 2005.
The second-lien market in 2006 has been equally robust as both volume and number of deals through November have also topped their full-year 2005 figures. The first 11 months of 2006 have seen €7.5 billion of second-lien issuance from 90 deals, compared to €5.4 billion from 57 transactions for all of last year. The current period has also been dynamic for second-lien investors, as arrangers are learning to opportunistically tap this market for capital. In November, Nycomed created a new investment opportunity by adding a €425 million second lien and reducing the senior term loans on a pro rata basis. The credit originally consisted of a massive €5.7 billion all-senior structure. This is the first instance where a second-lien facility was created post-launch, though in other deals, such as Prysmian Cables in July 2005, a portion of first-lien facilities have been shifted into the second-lien tranche.
On the flip side, iglo Birds Eye, which drew extremely strong support from the market, took out a €72.5 million second-lien tranche while increasing term loan B/term loan C (TLB/TLC) by the same amount. This is the third time in 2006 that issuers chose to forgo higher priced second-lien paper for lower-priced senior debt. In April, MTU Friedrichschafen went to market to raise €1.1 billion of senior and a small €70 million second-lien facility, but later flipped the deal onto an all-senior structure worth €1.17 billion. And in August, Cineworld rolled its £23 million facility into first-lien institutional tranches.
Volume In 2007 Is Likely To Stay On A Record Pace
The deal pipeline for 2007 is already extremely crowded. Deals ready for early 2007 include the estimated €5 billion buyout of PagesJaunes by Kohlberg Kravis Roberts & Co. (KKR) and the €3.5 billion buyout of Kion by KKR and Goldman Sachs Capital Partners. Volume in Europe over the past few years has grown exponentially due to the tremendous growth in institutional capital, particularly from the influx of U.S. investors. And the current hyperliquid environment doesn't look ready to slow down in the near future. As long as there are deals to feed the fire, it appears that volume will continue to soar to record levels.
LBOs, which have increasingly fueled Europe's bull market of the past few years, will dominate the coming year as well. In 2006's second half, 96% of primary issuance, or €56.9 billion, were LBOs. For the first 11 months of 2006, 89%, or €114.1 billion, of the deals launched were LBO transactions, up from 84% in 2005 and 65% in 2004. The big change in LBOs through November 2006 is the decline of recapitalizations. Of the 239 LBO transactions launched so far this year, only 17.6% are from recapitalizations (10.0% from dividend recaps), down from 27.1% in 2005 (14.6% from dividend recaps). Pure buyouts represent 64.4% of volume thus far this year, up from 57% last year.
With dividend recaps on the decline, equity contributions have risen and leverage ratios have fallen steadily since September. For the three months ending November 2006, the average equity contribution rose to 36.0%, its highest level since December 2004. At the same time, leverage for LBOs has been trending down. For the three months ending November 2006, the total debt ratio for LBOs was 5.4x and the senior debt ratio was 4.3x, both representing three-month lows. In the grand scheme of things, however, this trend of declining leverage provides small comfort for the leveraged loan market. For the year to date through November, the average total debt ratio for LBO transactions is still 5.5x, more than a quarter turn up from 2005's 5.2x and nearly a full turn higher than 2004's 4.6x.
Why Is Covenant Headroom Holding Steady Recently?
With leverage remaining at record highs, arrangers are left to ponder how best to structure these increasingly aggressive deals, which over the past few years have been accompanied by rising covenant levels. Through the end of the third quarter 2006, the average initial level of the debt/EBITDA covenant was 6.3x. While that's the same level as in 2005, it's a full turn higher than 2004's 5.3x. How is it possible, then, that the average covenant headroom level has held at roughly 25% over the past few years?
Covenant headroom compares the credit statistics from the projected financials (one year out) with the first covenant compliance levels. For example, for a transaction that provides pro forma financials as of July 31, covenant headroom analysis is based upon the projected debt/EBITDA ratio from the financial model at Dec. 31 versus the maximum debt/EBITDA covenant level allowed on the same date. This focuses the analysis on the levels shortly after the dust settles on the deal.
Headroom provides breathing space for the borrower should the company's performance falter. If the covenants are very tight and the company underperforms the projected model, the borrower technically will be in default of its credit agreement. In these situations the lending syndicate may grant the issuer a covenant waiver or reset, as was the case with Focus DIY, where earlier this year senior lenders to the company waived technical default on senior debt through April 2007. However, the syndicate group's forbearance isn't guaranteed, and covenant waivers generally require amendment fees to the syndicate. To avoid the risks associated with technical defaults, borrowers prefer to have extra leeway on the covenants incorporated in the original credit agreement.
Through the end of 2006's third quarter, the average leverage ratio at the end of projected year one was 5.2x, based on the transactions for which Standard & Poor's Leveraged Commentary & Data (LCD) has both a financial model and covenant levels. The average maximum ratio allowed under the financial covenants for these transactions was 6.5x, providing an average headroom of 25%. This appears to be the maximum buffer zone that arrangers are comfortable providing. Although headroom has grown from the 1999 average of 18%, it has been steady over the past four years, despite rapidly escalating leverage. In 1999, the average projected year-one leverage ratio stood at 4.1x, against the maximum allowed ratio of 4.9x, resulting in the 18% headroom. This figure rose over the next few years, but since 2002 has remained in the 24%-26% range.
However, a significant rise in leverage occurred from 2004 to 2005. In 2004, the average headroom was 23%, but this was based upon an average projected leverage ratio of 4.3x and an average covenant level of 5.2x. In 2005, the average headroom was slightly wider, at 26%, but was based upon variables approximately a full turn higher, as the average projected leverage ratio was 5.1x and the average covenant level was 6.4x.
Current Deals Expect Less Deleveraging In Year One
Comparison of the pro forma leverage levels with the projected year-one levels provides further insight into how deals are riskier today than last year and the year before. The vast majority of deals have a lower leverage ratio in the projected year one than in the pro forma figures, since borrowers always expect to either record more EBITDA or pay down debt in the first year. While 86% of the transactions had decreases in leverage in the first year of financials in 2004, through the end of the third quarter this year that had decreased significantly, to 73%.
Furthermore, today's deals expect to see less deleveraging in the first year than did the transactions from prior years. Through the third quarter of 2006, the average projected year-one leverage ratio is 5.2x, just slightly below the average pro forma leverage ratio of 5.4x. This decrease is almost half the average decrease in both 2005 and 2004. Looking at covenants beyond total debt ratios, issuers today seem to obtain greater flexibility by reducing the number of financial covenants placed on them.
Most credit agreements include four standard tests: maximum debt to EBITDA, minimum interest coverage, minimum debt service coverage, and maximum capital expenditure. In addition to these four, lenders have a variety of other financial measures to impose, such as senior debt to EBITDA, senior interest coverage, or fixed-charge coverage. Transactions launched through Sept. 30, 2006, included 3.9 covenants on average (based on 126 deals), down from 4.1 in 2005 and 4.2 in 2004. The median stood at four covenants for all three years. However, the number of deals carrying five or more financial covenants has decreased significantly. In 2004, 35% of transactions included five or more covenants. In 2005, the share dropped to 22%, and by September 2006, it stood at only 17%.
Measures relating to senior debt are gradually becoming less frequent. Some 23% of deals launched in 2004 included a senior debt-to-EBITDA covenant. Through the end of the third quarter of 2006, this share dropped to 17%. The senior interest coverage covenant saw a similar fate. Two years ago 6% of transactions carried such a test, compared to only 3% now. Although these changes are neither drastic nor high-profile, they are slowly chipping away the measures put in place to protect lenders' investments.
(Leveraged Commentary & Data is a unit of Standard & Poor's, not affiliated with the Ratings Group.)
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