In this article:
The annual outlook can be a tricky undertaking. At this point last year, few could have predicted the volatility that resulted from Russia’s invasion of Ukraine, or the market turmoil prompted by the UK’s mini-budget in September. But while crystal ball gazing is unlikely to yield results, there are certain dynamics underway in the European leveraged loan market that might reveal what sort of activity we can expect in 2023.
The key hangover the market is facing this New Year is from soaring funding costs. Conditions in 2022 were among the worst in years. The average margin on deals in the primary market rose to a high of 516 basis points over Euribor with yields climbing to around 8 per cent in December.
Against this backdrop, issuance plummeted to one of the lowest levels in almost a decade:
This is particularly noticeable when looking at refinancing. Only €21.48 billion of refinancing deals were completed in 2022, down from €28.48 billion in 2021 as borrowers opted not to replace existing loans with new ones at higher terms.
This in itself has not been a problem. The maturity wall in the European leveraged loan market is not huge, with many companies having already refinanced their debt since the start of pandemic. Loans totalling around €88 billion that were outstanding before 2020 have been refinanced over the past few years, with maturities extended to 2027-2029, as chart 3 shows:
But while the maturity wall has mostly been dealt with, a handful of 2024 deals still need to be replaced and issuers are beginning to look cautiously at their loans due in 2025. However, given the treacherous issuance conditions and spiralling costs in the primary markets, borrowers are instead looking to refinance this maturing debt privately, arranging amendments and extensions of their outstanding loans with existing lenders.
This way companies can negotiate directly with their investors and avoid the vagaries of the primary markets. The deals frequently come with an attractive fee for investors, while terms are updated to reflect market conditions more accurately.
In the loan market late last year for example, Sebia, a clinical equipment manufacturer, completed a €900 million deal to extend the maturity of its financing to December 2027 from September 2024. One of the company’s previous euro-denominated loans had been priced at 300 basis points over Euribor, while the new deal offered investors an additional 175 basis points of margin with an original issue discount on top. The resulting yield was 7.25 per cent despite no significant change in credit quality. Lenders were also offered two basis points in upfront fees for committing to the new deal.
In the high yield bond market a similar trend is underway, and single-B rated German pharmaceutical firm Stada recently completed a liability management exercise that saw it replace its 3.5 per cent secured bonds with a 2024 maturity for new bonds due in 2026 priced with a 7.5 per cent coupon. Holders were paid another eight basis points fee to agree to the exchange.
Although stronger companies will be able to swallow these higher spreads and fees, more marginal companies may struggle – particularly as the larger maturity wall in 2025 begins to creep closer. The ability to differentiate between these two categories of borrowers will be key in the coming year: although most amendments are potentially lucrative exercises for investors, others could offer little more than the rearrangement of deckchairs on a ship bound for default.
Rethinking the relationship
The upcoming wave of amend-to-extend (A&E) transactions does not just present investors with an opportunity to pick up a substantial chunk of yield or a few basis points on a fee. After a long period of cheap capital in which borrowers held the upper hand, these new deals provide investors with a fresh look at all terms – including the language in the documentation and even covenants. Sponsors are also getting creative to entice lenders to extend existing deals, for example by putting in additional preference shares to make leverage ratios more attractive.
This is a crucial development after several years of investors having to take what they can. In 2022, around 97 per cent of the deals that were newly priced in the European market were done on a covenant-lite basis with little to no maintenance protections available to lenders. Elsewhere, terms that favour issuers such as ticking fees, margin ratchets, and dividend buckets have in recent years made deals riskier for lenders and chipped away at the strength of the product.
Although more and more borrowers are likely to approach their existing lenders to update outstanding loans this year, even a tsunami of A&E deals over the next few months would not be enough to fix the terms on every deal in the leveraged loan market. But the renegotiations offer an exciting opportunity to rethink the borrower-lender relationship, and – at the risk of crystal ball gazing - a shift in that dynamic could offer investors a brighter future in 2023.