By David Oakley and Paul J Davies
FT.com
September 27 2006
SourceInvestment banks and specialist funds are taking bigger risks when funding leveraged buy-outs in Europe and show an increasing willingness to gamble on high returns, according to Standard & Poor’s.
Lenders have come to accept ever-looser loan agreements over recent years, with less protection against defaults and early repayments, the ratings agency said, which could come back to haunt them if the credit cycle turns.
The European leveraged loan market has evolved rapidly in the past five years from one dominated by commercial banks that held loans until maturity to one where about half of all loans are traded among institutional investors, such as hedge funds and managers of structured investments called collateralised loan obligations.
David Gillmor, co-author of a report published on Thursday, said a big attraction was the high yield on loans.
“These loans typically offer interest of more than 200 basis points above Libor [the London inter-bank offered rate] and for the past few years default rates have been pretty low. This has attracted US lenders, who are now willing to dip their toes into the European market.”
Marc Lewis, who also compiled the report, said: “The problem for these lenders is that if the credit cycle turns, then these loans could come back to bite them.”
The study found a broad deterioration in credit quality among loans owing to a number of factors.
The amount private equity firms can borrow to fund buy-out deals compared with the size of the target company has been increasing, while the use of riskier structures such as interest-only loans or loans where interest payments can be deferred have also been on the rise.
The study also found companies had fewer restrictions on having to use strong cash flows to pay off debt.
S&P said the high-yield demands of hedge funds and collateralised loan obligations, which pool groups of loans and sell credit notes with varying risk profiles, had been instrumental in driving the widespread reduction in credit quality.
“As the institutions’ market power has increased, LBO deals have been increasingly structured to accommodate the needs and demands of this large segment of the market at the expense of credit quality,” the report said.
Established CLO managers say it is indisputable that protections have been pushed back in favour of borrowers but that those with good credit analysis and the ability to be selective can protect themselves.
“One thing that is clearly worrying is that there are a number of new entrants that do not have the resources or expertise to do full credit analysis,” said John Foy head of leveraged finance at Prudential M&G.
He added that those at the top of the pecking order, who have long-held relationships with banks and private equity sponsors, get the first look at loan deals. “There is almost a waterfall effect, where deals we reject are passed to those lower down who have liabilities in the structures they have sold and need to buy product even without any credit analysis,” Mr Foy added.
Another CLO manager said the process was cyclical and that documentation would tighten again once markets began to change direction and more companies faced difficulties.
Copyright The Financial Times Limited 2006