As traditional providers of debt financing are still struggling from the aftermath of the financial crisis, structural shifts in the composition of global debt markets are opening up appealing opportunities. With collateralized loan obligations acting as the other “traditional” source of capital for leveraged buyouts in recent years, the current low issuance of new CLOs as well as the looming expiration periods of existing CLOs leave a gap, thus creating opportunities for credit funds and other providers of private debt.
At the same time as funding from CLO vehicles is becoming scarcer, banks are in the midst of the deleveraging process, especially in Europe where banks face huge refinancing requirements for an estimated €1.7 trillion of maturing debt over the next three years. Morgan Stanley expects European banks to shrink their balance sheets by $1.5 trillion to $2.5 trillion over the next 18 months, of which a large proportion is likely to come from restricted lending activity.
In the midst of this situation, we expect to see continued investment activity and sustained demand for LBO debt. The current “dry powder” of roughly $400 billion in private equity funds is expected to lead to potential demand for debt financing of nearly $500 billion, assuming a market standard equity contribution of approximately 45%. As another prominent driver for strong loan demand, European corporates will be forced to find refinancing solutions for €63.4 billion of loans due to mature between 2012 and 2015.
In the first half of 2011, there were signs in the leveraged finance market that the European high-yield market would “ride in and come to the rescue” with the second half of the year subsequently demonstrating how notoriously sensitive the high-yield market is to the macro environment as new-issue high-yield volumes nearly disappeared in Europe. Although the high-yield market is expected to play a prominent role in the LBO financing over the coming years, the volatility and availability of high yield will create challenges for many companies in need of capital. With this evidenced clearly in recent transactions, the high-yield market has been seen to have its limitations in funding this upcoming financing gap.
With the available data indicating that loss rates are higher and recovery rates lower in the high-yield market compared to leveraged loans, the current market environment offers the investor with capital and sourcing capabilities significant opportunities and attractive returns. Newly issued senior secured debt in Europe (typically with opening senior leverage at or below ~4x and total leverage at or below ~4.4x) will offer current yields of EURIBOR/LIBOR +4.5%-6%. Senior loans in the U.S. middle market typically contain LIBOR floors and spreads over LIBOR of 5%-6.5%. In short, despite lower leverage levels, lenders today benefit from higher spreads.
We conclude that the private debt market, specifically the senior secured loan and mezzanine market, will exhibit a supply/demand imbalance over the coming years. This dynamic will offer well-capitalized investors opportunities for achieving attractive risk-adjusted returns.
Scott Essex is a managing director at Partners Group.
