Ratings

The leveraged loan market has burst out of the gate this year, posting record volumes and Europe's largest-ever buyout to boot. First-quarter leveraged loan volume was $44.4 billion from 60 deals, 50 of which ($37.9 billion) were LBOs. The comparable figure for first-quarter 2005 was $25.5 billion, and first-quarter 2004 volume totaled $20.0 billion. The prior record for first-quarter volume was $24.2 billion in 2001. The institutional market continues to boom. Approximately $27 billion of institutional paper entered the fray in this year's first quarter, including $3 billion of second liens. This amount represents about 40% of all of 2005's institutional issuance of $69 billion, and nearly 100% of 2004's institutional issuance of $30 billion.

A closer look at first-quarter volume, however, adds some perspective. Without the period's two massive deals--Ineos ($5.9 billion of senior debt) and TDC A/S ($8.7 billion of senior debt)-–overall volumes are far less inflated, at $29.8 billion, and institutional volume is reduced by one-third, to $17.2 billion.

The bulk of the first quarter's leveraged loan volume was seen in January and February, with March much more spartan in terms of new launches--especially in the larger end of the market. The supply of deals thinned considerably, to just $6.6 billion in March, from the bumper $19.6 billion in January and $18.2 billion in February.

There is no denying that LBO activity is pushing up the average transaction size for loans. Fifteen percent of first-quarter transactions included $1 billion or more of senior debt, and nearly half of those deals were "mega-jumbo" transactions, at $2 billion or more. Looking ahead, other notable jumbo/mega-jumbo deals in the pipeline include three large public-to-private (P2P) LBOs: VNU N.V.'s possible $9.1 billion transaction, French caterer Elior's potential $1.9 billion transaction, and Swedish health care group Gambro's $4.9 billion transaction. All of these deals loom on the horizon and are still subject to shareholder approval.

A significant number of traditional-size transactions also remain in play: 15% of LBO transactions were less than $150 million in total debt, and 40% were less than $250 million, which is down from the 2003 and 2004 levels of 62% and 58%, respectively, but about even with 2005's 42%.

With all of this issuance, credit quality continues to decline in Europe, which is primarily a private rating market. Based on deal count, only 11% of the European leveraged loan transactions tracked by Standard & Poor's Leverage Commentary & Data (LCD) had public debt ratings in the first quarter of 2006, 43% had private ratings, and the rest (46%) were not rated. Of deals that were rated (54% of first-quarter transactions), 4% were in the 'BB' range (i.e., loans rated 'BB+', 'BB', or 'BB-') and 50% were in the 'B' range.

Also, leverage ratios continue to rise alongside the declining average rating. Pro forma average total debt to EBITDA for European leveraged loan borrowers was 5.9x in first-quarter 2006. The median was also 5.9x, but the third quartile threshold (25% of the population was greater than this level) was 6.7x. In 2005's first quarter, however, these figures were generally a full turn lower, at 4.8x for the average, 4.7x for the median, and 5.9x for the third quartile. Even the fourth-quarter 2005 numbers are a half turn lower, at 5.3x for the average, 5.1x for the median, and 6.1x for the third quartile.

Similarly, coverage ratios are on the decline. For this year's first quarter, senior coverage fell to 3.3x, down a half turn from the full 2005 average, which was 3.9x (already down versus the 2004 average of 4.5x).

These signs of increasing credit risk have not slowed the influx of investors, however. And despite the rising leverage ratios, the wealth of capital available for investment is driving down pricing. Though sparse by U.S. standards, reverse-flex activity in Europe--where pricing is adjusted down after the launch of syndication in response to market conditions--has been marked this quarter for a market where EURIBOR plus 275/325 basis points (E+275/325) has long been the pricing standard for term loan B/term loan C (TLB/TLC) tranches. Unlike U.S. spreads, which flex according to market liquidity, European spreads tend to stick to a standard grid of E+225/275/325 for 7/8/9-year tranche tenors.

Over the past nine years, the average quarterly average institutional spread in the U.S. was E+312.8 with a standard deviation of 40.7 basis points (bps). The maximum was E+420.5 (fourth-quarter 2002), 107.8 bps higher, and the minimum was E+250.3 (first-quarter 2005), 62.5 bps lower. In contrast, the average quarterly average institutional spread for that nine-year period in Europe was E+277.9, with a standard deviation of 18.2 bps. The maximum average quarterly spread was E+303.8 (fourth quarter 2003), 26 bps higher than the average, and the minimum was E+240.6 (third quarter 1998), 37 bps lower. Clearly, European spreads express less volatility than their American counterparts.

For first-quarter 2006, the average institutional spread in Europe is E+283.6, slightly lower than first-quarter 2005's comparable of E+284.3 and 14 bps lower than first-quarter 2004's 297.8. Reverse-flex activity has primarily driven this trend. In this year's first quarter, LCD tracked 26 reverse flexes, versus 48 for all of 2005 and 14 for all of 2004. Reverse-flex activity primarily reduces TLB/TLC pricing by 25 bps, getting market participants comfortable with a E+250/300 pricing on those tranches. There are instances, however, of large, oversubscribed deals, such as the recent TDC transaction, flexing by 37.5 bps.

Not unlike the senior leveraged market, the mezzanine market--with 32 transactions launched in the first quarter of the year--is well on its way to catching up with last year's record-breaking $10.7 billion of volume. The first three months of 2006 have netted $3.3 billion of volume--higher than any other first quarter on record and 74.2% more then the $2.0 billion seen in the first quarter of 2005. To better demonstrate how far mezzanine has come, volume stood at $4.2 billion for all of 2003 and at $3.0 billion for 2002.

Of course, the overall European leveraged market has changed dramatically over the last few years. One innovation is second-lien debt, which some investors argue cannibalizes mezzanine's share of the market. However, mezzanine has shown no slowdown in issuance, according to LCD's data. In the first quarter of 2006, the asset class represented 12.5% of total sources for all LBOs--the highest level to date, up from 9.4% last year. Second-lien represented 3.6% so far this year, up from 2% in 2005.

With both the mezzanine and second-lien markets growing rapidly, the trend seems to display peaceful coexistence rather than survival of the fittest. Of all mezzanine transactions this quarter, 56.3% also included a second-lien piece, up from 32.3% last year. The traditional structure of senior plus mezzanine decreased to 43.8% this year, from 66.7% in 2005. But the separation of mezzanine into two distinct breeds became more apparent this quarter, and the presence of second liens in the capital structure plays a big role in the market's bifurcation.

The first breed, traditional mezzanine (with no second lien in the structure), is considerably smaller and illiquid, averaging $72.4 million during the first quarter, 28.2% less than the overall average mezzanine facility of $100.8 million. The second breed, new mezzanine (with a second lien in the structure), is significantly larger and more liquid, at $123.0 million. Although warrants have become extremely rare in this market, with only 10.7% of deals carrying them, traditional mezzanine is more likely to be warranted, with 18.2% of this year's transactions including such an equity kicker. Only 5.9% of new mezzanine carried warrants.

Despite the lack of warrants and third-priority right to security, new mezzanine typically has a lower spread than its traditional counterpart, with respective first-quarter averages of E+951.6 and E+1005. Of 14 traditional mezzanine facilities, only two priced below E+1000, and none of these deals was reverse-flexed. In contrast, of 18 new mezzanine tranches, eight priced below E+1000, including Weetabix at E+775. Moreover, four of the 18 were reverse-flexed, including a 125-bp reduction on the £126 million of warrantless mezzanine for the Automobile Association (England), which left the spread at E+825.

Although mezzanine with a second lien in the structure had lower spreads in the first quarter, it had better prepayment protection, with 93.3% of deals carrying prepayment penalties, versus 57.1% for traditional mezzanine.

The first quarter's booming primary market has not been able to meet investor demand for paper. As a result, the secondary market continues to enjoy a record-setting bull run. The average bid of the S&P European Leveraged Loan Index (ELLI) rose nearly a quarter-point in the first quarter of 2005, to 100.38 for the week of March 30, 2006, from 100.13 at the close of 2005. The last big run-up in secondary pricing occurred during this same time last year, when the average bid in ELLI also rose about a quarter-point, to 100.22 for the week ending March 31, 2005 from 99.96 at the end of 2004. Last year, however, secondary pricing peaked a few weeks later at 100.29. For the remainder of 2005, the secondary market ebbed and flowed, declining to 100.01, but never falling below par, and rising into the teens, but never crossing back over the 100.20 mark. Thus far this year, the average bid for ELLI has been above last year's peak of 100.29 for the past three weeks.

All in all, on a market value basis alone, ELLI has had positive market value returns every week in 2006's first quarter, resulting in a quarterly market value return of 0.43%. This compares with 0.28% for the same period last year. Interest income return has provided a steady average of 0.11% per week for the 13 weeks of the first quarter, adding another 1.37% in returns. The U.S. dollar and Sterling have remained weak against the Euro for most of the first quarter (versus the Euro, the dollar lost 2.45% and the Sterling 1.32%). As a result, currency return was (0.23)% for the first quarter, resulting in a total return of 1.58% for the period. This is down versus the same period last year, which returned 2.16%. However, total returns (excluding currency) reflect the strength of this year's very bullish secondary market. Total return (excluding currency) for first-quarter 2006 is 1.81%, up versus 2005's comparable of 1.53%.

As investors pursuing paper have driven this bull market, they have bid up pricing on the higher spreading, lower rated 'B' credits to higher levels than their better rated 'BB' counterparts. The average spread for 'B' credits in ELLI is 2.91%, 24 bps higher than for 'BB' credits, which have an average spread of 2.67%. The average bid for 'B's in ELLI is 100.33, resulting in a 12-bp premium over the 'BB's, the average bid for which is 100.21. The 'B' credits, however, dominate the marketplace. Fifty percent of new issues in first-quarter 2006, and 75% of ELLI, were in the 'B' range, versus 4% for 'BB's in the primary and 20% in ELLI (the balance are primarily unrated).

As the primary market's volume and leverage levels appear to be handily beating the heady heights set in 2005 and pricing has steadily declined to new depths, 2006 seems well on track to outpace the highs and lows reached last year. New investment capital provided by the steady flow of new investor groups continues to pour in. Also fueling the market are the growing numbers of U.S. investors crossing over to Europe. Consequently, arrangers are able to structure larger and riskier deals. Thus, like a dog chasing its tail, the market continues to pursue its counterintuitive cycle of higher risk and lower pricing. This begs the overarching question: What credit event will trigger the market's almost inevitable stumble?