Stuck in the middle

The US sub-prime mortgage decline has had a knock-on effect in Europe. Thank heavens for the mid-market, says Stuart Brinkworth, which is keeping leveraged deals alive

Despite recent developments in the European leveraged loan market, the mid-market still has reason to be cheerful. Over the past two years the credit bubble has been personified by an abundance of demand for leveraged loan paper coupled with a short supply.

The result was a reduction in interest rates as well as sponsors benefiting from cheaper debt, which not only fuelled the buyout market, but led to frequent recapitalisations, refinancings and secondary buyouts. The high watermark of the credit bubble also saw a loosening of terms with the rise of the covenant-lite deal.

Hard times in the US

Over the summer, signs of difficulties began to appear in the US sub-prime mortgage business. Defaults on high-risk mortgage loans, including the now notorious Ninja loans (loans made to aspiring home-owners with ‘no income, no job or assets’) increased significantly, resulting in some specialist lenders, such as Countrywide Financial, getting into severe difficulties.

What made matters worse was that many subprime portfolios had been packaged into collateralised loan obligations (CLOs) and sold to investors worldwide, spreading exposure to institutional investors in the US and overseas. Many of these CLOs were subsequently downgraded as the value of their underlying collateral dramatically reduced which, against a backdrop of rising interest rates, led to a further drop in their value and a general depression in the credit markets as institutional investors suddenly became much more risk-averse.

The downgrading of mortgage CLOs has had a knock-on effect on leveraged loan CLOs which have, in the past two years, become substantial investors in European leveraged loans. This has resulted in the spreads on CLO liabilities increasing substantially and investors being reluctant to lend to leveraged CLOs.

This has forced many CLO warehouses to be liquidated and resulted in the market being awash with leveraged paper, causing a huge downturn in secondary market prices. Good credits that would otherwise sell at par are now trading at 95p and less, resulting in $400bn (£200.29bn) of primary loans (new deals underwritten but not yet sold) remaining unsold as they cannot compete with secondary market pricing.

Liquidity crisis, not credit crunch

To say that the events in the US sub-prime market have caused a credit crunch in the leveraged market is actually incorrect. Compared with sub-prime, the credit quality of the leveraged market remains very good. While credit spreads have certainly widened in recent months, corporate default rates still remain at their lowest for 15 years.

The problem that the leveraged market currently faces is one of liquidity not credit quality. The events in the US sub-prime market have caused investors to become much more risk-averse and switch investments to much safer havens, such as government-issued paper.

In addition, rather than participating in lossmaking new deals, many institutions are considering purchases in the secondary market once prices have bottomed out. This, combined with the huge amount of paper currently available in the market as a result of difficulties in the CLO market, has caused a liquidity crisis.

This has resulted in many institutions left holding loans that they simply cannot sell, even following the restructuring of deals or offering them at substantial discounts. The £9bn financing of Alliance Boots is perhaps the best example of this, where the second lien and mezzanine were relaunched at significant discounts, but the second lien was subsequently pulled due to lack of investor appetite. Loans sourced from new deals just cannot compete with secondary market pricing.

This has resulted in those institutions that have been the most active arrangers in the early part of this year, such as Lehman Brothers, JPMorgan, Goldman Sachs, RBS and Barclays Capital, holding many billions of pounds of relatively high-risk leveraged debt which they are unable to sell and which prevent them from investing in any significant way in new transactions.

Mid-market to the rescue?

This raises the question as to what is going to happen to the leveraged market in the foreseeable future. The answer depends on which part of the leveraged market we are talking about.

At the top end of the market, where deals are typically investment-bank led and predominantly sold down to institutional investors, the liquidity issues will be a huge barrier to new deals getting done in the short term. It will take some time for this overhang of primary loans in this part of the market to clear.

There is indeed a risk of this part of the market worsening as investment banks reach their financial year ends and are required to sell primary loans at almost any price to achieve a satisfactory year-end regulatory capital position.

This has prompted talk of an end-of-year firesale of assets and institutions building up cash piles to take advantage of cheap debt with good credit quality.

By comparison, participants in the midmarket are painting a more positive picture and are claiming, at least, that they are still open for business. There are a number of reasons for this:
– The mid-market is a clearing and not investment-bank led market where the participant banks are able to retain a larger portion of the debt they arrange on their own balance sheets.
– It is easier for mid-market deals to be achieved on a ‘club’ basis (where two or three banks share the underwriting risk), removing the need for syndication.
– Deal sizes are much smaller in the midmarket, making underwriting risk much more manageable in any case.
– Mid-market deals are usually less complicated and therefore can be adjusted relatively painlessly for them to be sold. Because of these factors, while some liquidity issues will remain in the mid-market, they should not be as pronounced as at the top end.

Back to the good old days?

While the liquidity crisis has caused uncertainty in the leveraged market, it has also provided the catalyst for a readjustment in pricing and terms to what bankers are traditionally more comfortable with. Banks, rather than sponsors, are now more likely to drive the terms of the deals, with a return to more traditional structures such as amortising A notes and mezzanine with warrants, rather than bullets and second liens or payment-in-kind notes.

Leverage is also beginning to come down a notch or two with pricing beginning to return to traditional levels. A significant reduction in the number of recapitalisations is also expected as cash out to equity will no longer be justifiable, and the secondary buyout market is also expected to slow as sponsors sit on their assets longer as leverage and valuations come down.

The mid-market, then, appears to be well placed to become the back-bone of the leveraged market, as this is where the real deal opportunities lie – a view backed up by one leading European clearing bank, which recently declared itself ready to invest a multibillion amount in mid-market arrangements. While the liquidity issues at the top end of the market will not last forever, if finance practices across the City wish to remain busy, they may well end up being indebted to the mid-market.

Stuart Brinkworth is a partner at SJ Berwin