Open for business?

It is no secret that in a downturn, debt will begin to trade at a substantial discount simply because of where the market is, having no bearing on the merits of the credit. There is huge incentive for banks to get in on this action: good credit at a 30-40% discount, no underwriting risks and even more promising returns. But is this all talk and no action?

"I'd suggest there isn't a large amount of liquidity in the secondary markets at the moment. The availability of secondary paper is limited as many sellers consider the prices available to be below the economic value of the asset," says Ian Sale, managing director at Lloyds TSB Corporate Markets Acquisition Finance. So there are limited sellers, but are there any potential buyers?

"The main focus of the UK high street banks is currently on primary debt where they can also win attractive ancillary business, rather than buying secondary debt," says Sale. Anecdotal evidence backs this up: chats with banks indicate that they are not looking to purchase secondary debt, especially since many of them no longer have trading desks. In other words, if banks were to take up second-hand debt, they would be forced to hold it, resulting in the implications of mark-to-market write-downs. The primary market, it seems, is the preferred route for banks.

Managing director of corporate & structured finance at RBS, Neil Rudge, is of the same mind: "We like the primary market in that it allows us to be strategic in the business that we write. Whilst secondary markets offer the ability to purchase debt at a discount, our strategic priorities are to write value-added business with our core client group and in situations that allow us to inform the structure, documentation and terms of the credit facilities."

Rudge further explains that currently, primary-originated transactions tend to be arranged on a club basis rather than underwritten. Therefore, RBS would rather arrange a new vintage deal that fits its strategic goals than buy an old vintage at a heavy discount.

Sale is optimistic and says that, in fact, a recovery of the primary market could actually be on the horizon. The £553m secondary buyout of Wood Mackenzie by Charterhouse from Candover was the first big deal completed at the larger end of the market this year, with Lloyds Banking Group and two other banks taking on some underwriting for it.

"In my view, there hasn't been a shortage of debt during 2009; only a shortage of deals," insists Sale. "But more potential transactions are beginning to come into the pipeline. One reason for this is that vendors still need to sell, and purchase prices have finally started to drop a bit."

Michael Berry, CEO of debt advisory company Versatus, believes that now is the best time to get into the primary market: "If you know your product, those that are in the market now are enjoying extremely high returns. The risk/reward profile is better than ever, with the lowest leverage levels in history and unprecedented high margins and fees."

Secondary value

But there is still value when it comes to assessing the benefits of the secondary debt market. Recently, senior debt in strong credits has traded just below 70, giving investors an annualised return approaching the mid-teens, which is equivalent to mezzanine returns on the primary market. And purchasing secondary debt means taking on none of the risks involved with underwriting. Sale says that the interest for this type of debt is mainly from institutional investors. Yet there are banks that are taking advantage of the heavy discounts and buying back more of the debt they already have to improve their capital cushion.

Last month for example, Bank of Ireland repurchased debt worth $600m at 40% of face value as part of its debt buy-back programme. The total nominal value of its purchases reached a whopping EUR1.7bn. The combined equity accretion arising from the tender offers was expected to be around EUR1bn. Separately, Allied Irish Bank offered a 12.5% annual coupon on up to EUR2.7bn worth of bonds it intends to issue in a bond-exchange programme.

Mezzanine debt provider ICG is also playing the secondary game. The lender just recently announced a 7-for-2 rights issue that will see the company raise £351m to take advantage of new opportunities in the market. Specifically, the capital will be used to buy second-hand senior debt in the form of individual senior debt assets or in portfolios. Lenders like ICG are able to pick up senior debt in companies they know well at a significant discount, yielding returns of 20% or more.

"The secondary market can present some very interesting opportunities for purchasers, more so when the buyer is familiar with the credit and may indeed already hold some exposure on its books," says Gordon Watters, managing director of Ares Capital Europe. He continues: "In situations where the underlying credit is strong, the fact that some of these companies remain relatively highly levered and may have looser covenant controls and loan documents should not be a deterrent, as in part this is reflected in the potential discounts being offered."

If investors are comfortable with the credit risk involved in secondary debt, they can earn significantly higher returns than those on offer from the primary market. Yet some, like Berry, remain unconvinced of the rewards secondary debt provides. "I think that those that expect returns of 25% are being slightly naive. Firstly, it is not very easy to buy secondary debt in any decent quantity. Secondly, due diligence is skimpier, management is often tired and discouraged, while leverage is extremely high and documentation weak. The chances of winning are lower than when issuing a new deal."

There is also the added factor that pricing in the secondary market is on its way up again, which will mean that discounts for second-hand debt will not be as persuasive as they were before. Though it seems like secondary debt is a hot asset right now, it is not without its problems. Many remain sceptical of the secondary market and the uncertainty that comes with it.

But are primary issuances the way forward? Watters believes that the primary market will be slow to recover and remains dependent on banks' credit risk departments being willing to take on underwriting risks. Though the biggest deal in Europe this year, debt was a modest part of the Wood Mackenzie SBO, as most of it was made up of equity. According to reports prior to the deal closing, the breakdown of the debt was said to comprise of £230m in senior and £40m in mezzanine. The fact remains that if a deal that size had been completed two years ago, more leverage would have been used. If that sale is a sign of anything, it is a sign of how drastically the market has changed and how long it will be before the primary market can actually return to its days of prime.

Trading down

Many if not most of the deals done in the heady days of 2005-2007 in Europe have seen the senior debt slices trade at deep discounts to par value. In December, when the rhetoric of secondary trading took off, the senior debt of NXP, the Dutch semi-conductor business that underwent a EUR8.5bn buyout in 2005, was trading at just 24% its par value. Alliance Boots, Europe's largest-ever LBO which saw KKR lead the £12bn buyout in the summer of 2007, was at 67%. Gala, the UK bingo business which has seen a plethora of private equity backers, saw its debt sink to 51% of par value.

Of course much of this was pricing - and at prices like those, not all were willing to sell.

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• UK / Ireland