If 2017 was the year of refinancing, 2018 is turning out to be the year of M&A. But as lenders continue to search for new ways to get returns on their capital, observers are starting to worry about an external shock creating volatility through the markets. For pessimists, the dicey conditions could spell the worst downturn of the decade; however, most commentators can’t see a trigger on the horizon, only further opportunity.
Thanks to buoyant capital markets last year, European leveraged finance volumes totalled €214bn, exceeding even pre-financial crisis volumes (€189bn in 2007). Many businesses took the opportunity to refinance and benefit from lower rates. In Q4, 2017 62% of volumes were driven by refinancing reflecting the desire to lock in lower rates. In Q1, 2018 only 31% of volumes were refinance-linked with a marked switch to M&A financing activity (62%). This switch has been welcomed by lenders, providing new names to the market and consequently more choice as to where to deploy capital, as well as having a stabilising effect on yields.
In the European market, lenders are continuing to scramble to deploy capital, with banks and credit funds now often competing on both private equity and corporate lending opportunities. The issue for many lenders is that the majority of stronger-credit borrowers have already secured their refinancing deals, requiring lenders to hunt for opportunities that provide greater yield to meet their investor target returns. The result of this, with echoes of 2006/2007 lending behaviour, is that lenders are facing liquidity demand from borrowers with weaker credit profiles. In addition, due to the vast sums of liquidity chasing relatively few deals, terms are being eroded in a borrower-friendly environment, arguably removing essential lender protections. As an illustration of this, cov-lite volumes now account for 78% of outstanding leveraged loans in Europe according to S&P.
Given the greater proliferation of lending to riskier borrowers combined with the erosion of lender protections (e.g. aggressive pro forma adjustments to EBITDA, loss of financial covenant protection, ease of re-leveraging through incremental facilities), we are now in a period where credit market risk and volatility has undoubtedly increased.
Yet, for all the warning signs, no-one seems too concerned apart from the Brexit-focused and the stubborn cynic, at least not if loan volume issuance is an appropriate barometer. We expect borrower terms to stay favourable as long as the market brims with liquidity: the supply/demand mismatch between liquidity and borrower appetite and strength of negotiating position shows little sign of waning
As new entrants continue to add to market liquidity, or existing participants develop new lending strategies (e.g. the push of direct lenders into asset-based lending), there is debate as to whether the market will burst at the seams or grow to exciting new heights.
While we are currently seeing a number of stress cases in traditionally cyclical sectors, particularly in the UK (e.g. retail, consumer and construction), the lack of lender triggers in cov-lite loans being written today means that the translation of this heightened risk into higher default rates may not materialise for sometime, if at all. A significant geopolitical event or rapid increase in interest rates, which currently appear unlikely, might accelerate a widespread issue in the credit markets. However, in their absence, the more risk-averse look further down the line when the current vintage of cov-lite loans gets closer to its maturity wall.