New Investor Influx Fuels European Leveraged Loan BoomBy and
Familiar CLOs and bank lenders left with smaller market share
Any downswing in credit cycle may shakeup investor base
Europe’s leverage loan market has expanded this year as new investors with varying appetites for risk join the fray. These incomers opened the way for a greater diversity of deals that should continue into 2018 if low interest rates and low defaults persist.
In the search for yield, money has poured in from fund managers’ hands from pension and insurance funds, sovereign wealth funds, private banks, family offices and others. This new demand has eroded the share of lending from the traditional collateralized loan obligations and banks that have underpinned the loan market since it recovered from the crisis.
“The CLO bid is not so important these days,” said Paul Tapper, the London-based managing director at Rothschild Credit Management. “CLOs do not necessarily drive a syndication strategy and some deals can get done without CLOs.”
As a result, borrowers have found appetite for bigger deals, longer tenors, lower pricing and more aggressive structures, taking the market beyond what could have been provided by the traditional investors.
Taking advantage of the diversification of the lender base, companies have raised more debt in 2017 than in any year since the financial crisis. At last count, institutional loan issuance was just over 78 billion euros ($92 billion), a 45 percent increase over 2016.
Fed by this deal flow, CLOs have flourished to 20 billion euros this year, the most in a decade -- yet their share of the market has fallen. Other fund investment formats, collectively described as “managed accounts”, have grown rapidly and now take an equal or greater share on some transactions.
“In a typical LBO loan the investor base comprises CLOs and managed accounts with about a 45 percent share each, while banks have typically made up about 10 percent,” said Dominic Ashcroft, co-head leveraged finance capital markets EMEA at Goldman Sachs.
The buyer base varies depending on whether the deal is rated at the upper or lower end of the sub-investment grade bracket, although there’s little transparency in how fund managers apportion deal between their vehicles.
Beyond the Matrix
CLOs jostle to buy leveraged loans with unlevered loan funds, segregated accounts, multistrategy vehicles, global loan funds, and direct lenders. But the lending criteria of each type of fund can differ.
CLO managers face many constraints. They can only lend to loans that fit into a matrix of tests, and may be unable to buy big volumes of low-margin double B paper, or long tenors, or floating rate notes.
“Managed account mandates can show more flexibility, and we expect that to continue to manifest itself in institutional loan appetite and also in demand for the FRN product,” said Mark Walsh, co-head EMEA leveraged finance capital markets at Credit Suisse.
But the broad church of loan investment vehicles includes those that want double B paper and are relatively indifferent to falling new-issue spreads.
During the second half of 2017, double-B rated borrowers raised loans that paid a margin of less than 300 basis points over Euribor. That’s way below the average all-in spread of 364 basis points for single-B and unrated deals seen at the end of November. Virgin Media and Telenet raised loans with a 10 year tenor. In both instances, CLOs were the marginal buyers.
Banks are also happier with the double B space, but tight pricing, aggressive terms, and the need for rapid responses means they struggle against the rest of the market.
Conversely, total return funds are chasing yield and aren’t constrained by ratings, so can lend to deals that fall outside the comfort zone of CLOs. They look for lower single B or triple C, and potentially second-lien, paper in pursuit of the returns they need, as long as they are confident in the credit and its recovery prospects, but only buy double B paper for trading gains.
Adding to the patchwork investor scene, direct lenders are in the mix: those that are unable to put enough money to work via unitranches or other bilateral facilities are looking for high risk-high return paper from the syndicated loan market.
Exposed to Risks
This more flexible and varied funding community opens the way for bigger and more varied lending in Europe, but it also brings uncertainties compared with the stable CLO investor base.
It’s unclear how dependable these new investors will be in the downswing of a credit cycle, although the presence of real money investors such as insurers and retirement funds in the mix provides some comfort.
Pension and insurance funds have taken their time to understand the loan asset class, and arrangers say they don’t see this liquidity rushing in and out of the market - as can be the case with retail loan funds in the U.S. - but this is yet to be put to the test.
Those with a total return investment strategy may well go elsewhere to chase yield if they see opportunities in other asset classes such as high-yield bonds.
Arrangers recognize that although CLOs’ share of the market has fallen, those funds constitute a stable, long-term, transparent buyer base with reliable demand for paper.
(Ruth McGavin and Sarah Husband are leveraged finance strategists who write for Bloomberg. The observations they make are their own and are not intended as investment advice.)