High yield to revive Europe's loan market

High yield has had a rocky start in Europe. Its investor base means bonds are subject to wider market fluctuations, meaning the recovery of both came to a halt last summer, when the previous six months' record €32bn+ issuance all but dried up as global investors feared the worst. The effects were felt more strongly in Europe, where less liquid market meant that a handful of deals were quite literally left hanging.

The team at Marlborough Partners know this all very well. They started out together in 2003 when they set up debt advisory business Blenheim. Then the market was in its seemingly endless ascendancy and leverage markets were frothy. High yield was nascent and mostly a subordinated instrument which competed with mezzanine. The team - as Blenheim, then Houlihan Lokey (via an acquisition) and ultimately Marlborough have truly seen it all, having advised on €13bn of primary deals and €14bn of amends and restructurings since then.

'When we started in 2003, deals were almost entirely underwritten and held by banks and mezz providers," recalls William Allen, managing partner at Marlborough. "We then witnessed the institutional market, through CLO / CDO issuance, bring in huge liquidity which fuelled the 2006-7 underwriting boom where the bulk of risk was still underwritten by banks but sold down into the CLO / CDO universe." This was during the industry's ascent - but it wasn't to last. "The credit crunch killed off new CLO / CDO issuance in Europe and heralded a sustained "risk-off" and "capital conservation" approach by the banks. Whilst bank liquidity has gradually returned , albeit it on a greatly reduced scale, and credit funds have brought in a modest amount of new capital, we have seen mezz-return expectations effectively pushing that lender base out of the market as the gap they once filled is occupied by sponsor equity.

With H2 2011's slump seemingly over - Q1 of this year saw a remarkable recovery - the market is not just back, but is top of the totem pole: previously high yield was subordinate to senior but sits comfortably alongside it, pari passu. Additionally, it is shorter term: nowadays seven-year maturity with a non-call of three years is standard, down from five years ago, when a nascent European high yield market consisted of 10 year maturities and five year non-call provisions.

These changes are significant. While high-yield remains expensive (coupons are more expensive, plus the ratings incur costs) it is at least cheaper - from a ‘getting out' point-of-view - than it was during its last ascent. To boot, high yield's presence is more welcomed as bank and CLO liquidity diminishes; years ago, it was deemed mispriced mezzanine owing to its ranking.

High-yield began its 12-month growth spurt in the middle of 2010. In 2010 and the first half of 2011, around half of large European LBOs (volume) contained high yield; the figure is substantially higher for refinancings, according to S&P CIQ LCD. In fact this period saw value increases driven by primary deals, indicating sponsors were accepting the tool even outside restructurings.

CLO exodus ushers in HY
The reliance on this relative newcomer to European deals should continue its colonisation of the capital structure as borrowers face maturity peaks from next year through 2015: Most deals structured in 2006-2007 had CLOs as the majority of their investor base. These loans are coming due (a record €94bn is due in 2015) which is why refinancing activity is upping its pace. "A huge number of deals are getting closer to their maturities and a lot of the debt is held by CLOs nearing the end of their re-investment periods. Some can extend via cashless deals but others are being more conservative and may not give their consent," explains Jonathan Guise, managing partner at Marlborough, warning "This is the last year we will see a meaningful number of amend-and-extend deals for businesses with CLOs in their investor base".

This inability - or unwillingness - of CLOs to re-issue may make high-yield a necessary player in the refinancing arena. "As a rule of thumb 10-15% of CLOs are not able to extend at the moment. Once it hits 25-33%+ - which we believe it will do around the end of this year or beginning of next - you are going to have too much of a short term refinancing problem to amend and extend," says David Parker, managing partner at Marlborough. It is believed that UK cereal brand Weetabix, which Lion Capital just sold to Chinese trade buyer Bright Food, required 80% acceptance to extend its loans but managed to get nearer 90% as a result of paying down some debt with cash and sweetening the deal with margin uplift.

"If practically the amend and extend game is over next year, then you have to refinance through alternative sources," Guise explains. This means that PE firms are dependent upon the continuing development of the high yield market for large deals and the recovery of bank balance sheets, as well as the growth of the embryonic alternative capital providers for mid-market deals."

A tall order. So it is handy that insurance companies are redirecting their investments away from equities in favour of bonds as a result of Solvency II. Thus the regulation - though mostly deemed a headache for the industry - may inadvertently help fill the gap being left by banks, which are shying away from lending at the levels seen between 2005 and 2008.

And credit funds, currently the preserve of the US, are increasingly springing up in Europe. Most recently, a new fund created by ex KKR, Apollo and Ontario Teachers' execs Searchlight Capital raised $860m for its debut debt and equity fund. In December, Scottish Widows Investment Partnership (SWIP) launched a European high-yield bond fund. Summit, a Boston-based GP, launched a credit fund last March and expects to close on $300m imminently. It will invest in bank loans and high-yield bonds. Ares, which impressed markets almost immediately upon launching in 2008, its raising its latest fund and partnering with GE to tackle larger deals.

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Marlborough Partners suggests high yield will help revive Europe's leveraged loan market

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