Liquidity imbalance is the new normal in Europe’s loan market, with surging demand – attributable in large part to the European Central Bank’s relaxed monetary stance – facing restricted supply in both primary and secondary markets.
The reality is that banks in Europe are desperate to put balance sheet to work amid a chronic shortage of supply.
Meanwhile the loan market is experiencing toppy conditions amid looser – or no – financial covenants, lower margins, Ebitda cures and tighter transferability restrictions, which favours sponsors.
“Covenant-lite” volume surged to over 50% of total secondary European loan trading in 2016, from 30% the previous year, according to data from LCD.
This has come amid a surge in demand, together with the emergence of discrete phenomena such as non-bank lending, most frequently involving large multi-strategy funds that offer direct senior lending or circumvent bank participation by offering “unitranche” lending across the entire debt structure.
Another element in what might be described as a “vicious cycle of liquidity” has been the increased activity of European CLO managers who have been snapping up assets in the face of reduced CLO funding costs. The data give a clear picture of the imbalance in the secondary European loan market.
According to Thomson Reuters, secondary loan volume fell to a 12-year low of US$59.4bn in 2016, with volumes down 14% year-on-year.
Investment-grade volume was dwarfed by leveraged loan activity, with the latter accounting for 67% of total volume in the fourth quarter of 2016.
Alongside this, distressed trading in Western Europe has severely contracted, with a collapse in volumes to US$8.7bn last year from US$21bn in 2014, according to Thomson Reuters.
Nevertheless the demand is certainly there, and might well be matched with supply as government directives force the sale of NPLs at banks in countries such as Italy and Germany; the market is laser-focused on that process and whether the banks will sell at market-clearing prices.
Creditor influence has steadily dwindled in the face of documentation flexibility with a lack of triggers for lenders to force a solution.
And increasingly bond facilities are being refinanced by covenant-lite loans with their perceived advantage for borrowers, reversing the trend from a few years ago when bonds were considered more competitive and were used to refinance loans.
POSTPONING THE INEVITABLE
When a refinancing at maturity is not possible, borrowers are often able to postpone what appears to be an inevitable balance-sheet restructuring by an extension to the existing facilities.
This can be via full lender agreement or forcing through a “cramdown” on non-consenting lenders through legal mechanisms such as a UK scheme of arrangement. Primary lenders are frequently agreeable to that strategy due to their own pressures against writing down assets.
At the same time there is a frustration from buyside funds with the reduced liquidity from the broker-dealers. Increasingly, they are steering clear of event-driven situations, reducing their teams and shying away from the use of balance sheet in secondary trading, which is a critical component to liquidity in the market.
Inevitably this leaves the door open for alternative liquidity providers, particularly those with balance sheet at their disposal.
Still, it is not all doom-and-gloom in secondary loan trading. There have been notable pockets of activity involving large secondary loan transactions across Europe in event-driven situations.
For example: complex restructurings such as in Spanish toll roads; political instability impacting credits in Eastern Europe (such as those from Ukraine and Turkey); underlying price volatility in commodities and energy; and major structural declines, such as for directory businesses, or some segments of shipping.
At some point the macro backdrop will change, not least the monetary stance of the ECB, and the secondary volume cycle will turn. This will happen in the context of heightened political uncertainty due to Brexit, and other areas of risk such as France and Turkey.
In the face of a changing business model for secondary market players, it behoves those with an eye on the long term to build up research capacity, relationships and reputation in terms of consistency and discretion if they are to prepare for the next stage of the cycle.
David Beckett has over 15 years’ experience within the restructuring and corporate finance markets, both as an adviser and investment professional. He has led SC Lowy’s sourcing capabilities since inception in 2009.