Into the valley of debt
25 October 2010
Refinancing was a breeze in the good old days, but now it’s set to kick up a storm, say Christian Pilkington, Mark Glengarry and Patrick Schumann
In the halcyon years before the recession companies refinanced with impunity, and lenders were happy to fulfil their requests. But from 2011 those debts will become due, triggering a potentially catastrophic ’wall of debt’. By way of illustration, European debt refinancing was at a low of £5bn in 2009, while it is expected to explode to more than £60bn by 2014.
So who will finance this debt? How will companies refinance their loans? With talk of a double-dip recession increasing, could this be the trigger?
As financial markets react nervously to the ambiguous messages conveyed by economic indicators, it remains unclear whether we are finally on the path to economic recovery or heading for a double-dip recession. While we have certainly moved on from the crisis days following the collapse of Lehman Brothers, commentators agree that the refinancing profile of European companies presents a serious challenge to the embryonic economic recovery.
As borrowers took advantage of the benign credit environment in the pre-crunch years, European leveraged loan issuance grew from approximately e100bn (£87.45bn) in 2003 to well over e230bn in 2007. The majority of these loans were issued at the height of the credit boom in 2006 and 2007 to finance leveraged buyout transactions, with average tenures of seven to nine years.
With default rates at historic lows and robust profit margins driving aggressive company valuations, gearing increased steadily. These loans are now beginning to reach maturity. According to the Standard & Poor’s (S&P) European Leveraged Loan Index (ELLI), outstanding loan maturities will grow from less than e5bn in 2011 to e37bn in 2014, reaching a peak of e49bn in 2015.
Borrowers looking to refinance maturing debt in a post-credit crunch world face a multitude of challenges, including lower credit quality, anaemic economic growth, stricter underwriting standards, the disappearance of non-bank lenders, reduced collateral values and banks burdened by the impact of regulatory reforms.
In light of this, it is clear that borrowers will continue to face a severely restricted leveraged loan market and may need to look at alternatives when refinancing their existing loans, including paying down debt where possible.
However, while the equity and capital markets have witnessed a spectacular rebound following the Lehman crash, the real economy has been much slower to recover. With the prospect of high unemployment, inflation and fragile property values, European consumer-driven demand remains weak. As long as economic growth across Western economies struggles to gain momentum, leveraged companies will not be in a position to generate the EBITDA (earnings before interest, taxes, depreciation and amortisation) growth necessary to achieve any meaningful deleveraging on a cashflow basis.
For borrowers looking to obtain bank debt, problems are exacerbated by the dramatic impact of the financial crisis on the make-up of the lender market. In addition to many banks going out of business, non-bank lenders such as hedge funds and pension funds have all but retired from lending activity.
Most importantly, issuance of new collateralised loan obligation (CLO) vehicles, historically purchasers of 60 per cent of leveraged loans issued, has ground to a complete halt.
S&P notes that arbitrage CLO volume dropped to zero in the first quarter (Q1) of 2010, down from e400m in 2009, e11.2bn in 2008 and e32.3bn in 2007.
In addition, the regulatory changes affecting the financial industry will almost certainly alter lending volumes. Basel III and other capital adequacy rules in particular will determine the risk appetite and asset base of lenders.
If, as announced, countries such as Germany and the US impose stricter capital requirements than Basel III, many banks will need to increase substantially their capital bases to continue lending at the level they were doing prior to the implementation of the new rules.
What next for borrowers?
Highly rated companies will continue to be able to fund by capitalising on established lender relationships and strong balance sheets. Yet even the best performers cannot expect to refinance on the same favourable terms of days gone by. Stricter underwriting standards are the order of the day and borrowers will have to accept increased spreads, additional fees and improved security packages.
Weaker candidates and those with urgent refinancing needs have resorted to ’amend and extend’ existing terms. While permitting borrowers to extend their maturity profiles or obtain financial covenant relief, these amendments come at a cost, as lenders demand hefty fees and an increase in spreads.
More importantly, these techniques only serve to delay rather than solve the problem of excess leverage. Nevertheless, in the right circumstances such amendments can be a useful tool for borrowers. UK media and telecoms company Virgin Media, for example, completed a major amend and extend refinancing programme in 2010, improving its S&P corporate credit rating to BB- from B+.
Where bank debt proved inaccessible, issuers have opted for high-yield takeouts to tap new funds. According to Dealogic, European issuance reached a record e38bn in 2009 and e31.8bn so far in 2010. This represents a substantial shift away from a traditionally bank-dominated market.
Italian marketing agency SEAT PagineGialle took advantage of the buoyant high-yield bond market to issue senior secured bonds to repay senior secured bank facilities. Other companies, such as cable operator Ziggo Bond have used high yield issuances to pay down tranches even further down the capital structure. While often increasing the cost of funding, high-yield bonds can provide flexibility to issuers by replacing maintenance covenants in loan agreements with incurrence-based covenants.
Where bonds are part of the original capital structure, some borrowers have used distressed debt exchanges as a means to reduce leverage. In these instances existing debt is swapped for longer-dated bonds to avoid running out of cash.
Some issuers have also asked bondholders to forgive a portion of old debt, while offering incentives such as better security and higher interest on new debt. However, in a research paper Moody’s has noted that recovery prospects for bondholders of European companies involved in distressed exchanges are poor, as these companies often remain extremely challenged in eventually generating positive cashflow.
Alternatively, companies have bought their own debt on the secondary market where lenders were keen to shift loans off their books. Debt often trades at a substantial discount to its face value, permitting the purchaser to leave it outstanding or retire it. The practice is a source of controversy as loan documents such as the Loan Market Association’s templates generally restrict buybacks. Nevertheless, loan buybacks are frequently used to reduce interest payments and leverage, provided the acquisition is made out of distributable profits rather than new debt. Danish telecoms group TDC’s acquisition of e200m of its own debt is one example.
Borrowers in distress can also look for external help by seeking a white knight to acquire the business and inject fresh funds. The volume of distressed M&A is expected to rise considerably in the next few years and opportunistic investors will aim to profit from attractively priced opportunities. Those companies that manage to deliver successfully will find themselves best placed to use accumulated cash reserves for acquisitions.
In circumstances where a borrower is unable to refinance, it may have no choice but to enter into formal restructuring proceedings to stave off insolvency. Not surprisingly, the past two years have seen an upsurge in cases of debt for equity swaps, write-downs and equity injections being common features in major European restructurings. The restructuring of Wind Hellas, for example, was the UK’s biggest pre-pack administration ever and involved a cash injection of e50.2m, a release of e1.8bn senior debt and a write-down of more than e1bn worth of subordinated notes.
It appears that the maturity wall will continue to be a challenge to corporate solvency for years to come. While European corporate default rates are declining, S&P believes it to remain well above 4 per cent for 2010. Some argue that lack of decisive action will eventually lead to the onset of another crisis, with perilous consequences for economic growth and employment figures.
Notwithstanding this, there has been some activity in the loan market, which has helped to partially erode the wall. According to S&P’s ’Leveraged Commentary and Data’ (LCD), paper listed in the ELLI due to mature between now and 2014 has dropped from e77.3bn in 2008 to e62.5bn to date - a reduction of 19 per cent. The table on this page provides an overview of the measures that borrowers have been able to take to reduce leverage.
While the longer-term picture remains daunting, nearer-term maturities are slowly being reduced to manageable levels. As the table indicates, repayments and prepayments have increased, while defaults and restructurings have seen a marked drop.
However, in an environment where the financial system remains vulnerable to destabilising setbacks, much will depend on the performance of Western economies and the development of interest rates in particular. In the meantime, companies need to focus on driving business efficiency, pay down debt as much as they can and above all address maturing debt as early as possible. This story is not over.
Christian Pilkington and Mark Glengarry are partners and Patrick Schumann is an associate at White & Case