Uncertainty in the European Loan Market
In mid-2005, the European loan market has reached an uncertain point. Lending volumes reached an all-time high during 2004 as strong competition between banks, and a trend for relatively low-risk refinancing, saw continued downward pressure on benchmark pricing (see figure 1 below). The graph also registers a convergence in pricing between the main European markets, as top-tier banks increasingly shop for mandates in each other’s home markets.
Concerns over credit quality and a renewed focus on risk-adjusted return also started to impact the European market during the first half of 2005. Although it is too early to say for certain that the market has bottomed out, few expect this year to end on the same combination of high volumes and low pricing that marked the end of 2004.
Some 18 months ago, in early 2004, ‘A’ and ‘BBB’ rated corporates were being funded at around 40-50 basis points (bps). This is now down to around 20-30bps in the UK and 10-20bps on the continent – a substantial reduction in pricing across the corporate spectrum (see figure 2 below). When combined with a substantial drop in fees, this decline in margins has narrowed the field of banks able to compete in the investment grade market. In the UK, the top 12 banks now provide as much as 55 per cent of overall liquidity – with the top 20 European banks contributing up to 80 per cent of liquidity in the wider European market.
This competition has also impacted the way banks originate new business, increasing the focus on mid-cap and regionally-based companies to maintain market share. Inevitably, this has driven a compression in pricing between stronger and weaker credits in the market. While headline pricing for ‘AA’ rated corporates in Europe dropped by 26 per cent, pricing for ‘A’ rated borrowers has fallen by 32 per cent. The salient feature of the market is therefore remaining liquidity among top-tier banks, with strong international competition between these banks driving both an overall reduction in pricing and a narrowing of risk premiums for weaker credits and acquisition facilities.
One area that may generate a liquidity constraint in Europe is big-ticket corporate M&A. Q4 2004 witnessed the beginnings of just such a resurgence in the US, which has largely been sustained in the first half of 2005. Some saw K-mart’s $11bn acquisition of Sears in late 2004 as the start of this, and it has continued to include the announced $57bn merger of Procter & Gamble and Gillette, which is now expected to close in autumn 2005.
Although such bumper deals can skew the figures and misrepresent activity in the broader M&A market – as was the case in Europe last year, where debt for corporate M&A was concentrated around a few large deals – the figures show a deeper confidence for corporate M&A in the US during Q1 2005. Debt issuance for this purpose has increased to $17.4bn across 33 deals in Q1 2005 from $6.1bn across 28 deals in Q1 2004.
This confidence, however, has yet to communicate itself fully across the Atlantic. The European corporate M&A market recorded a decline from $33bn, backing 23 deals in Q1 2004, to $8.3bn, supporting only 10 deals in the same period this year. The 2004 figure is, however, inflated by the presence of a single deal – the €16bn facility provided for the Sanofi-Aventis merger. Yet this year has also produced eye-catching M&A deals early on, including a €12bn loan to allow the completion of Telecom Italia’s partial buyout of Telecom Italia Mobile.
The wider corporate sector seems to be showing a degree of ambivalence towards such transactions, with a tendency for deals to stall even after debt mandates have been awarded. This has taken place with the Swiss company Xstrata’s proposed $8.4bn bid for WMC in the mining sector – now on hold – as well as the expected €3.3bn deal to support the telecoms buyout between Spanish group Auna and rival Ono. In some senses, this is to be expected after a prolonged lull, with much of the final upswing in US M&A preceded by similar delays – including the Sears deal. There may yet be a high-profile deal in the pipeline to set an example to the European market. Pernod’s proposed bid for Allied Domencq would, for instance, clearly impact the market with its €8bn debt package.
Such caution remains in place despite the sharp falls in risk premiums that have taken place for investment-grade acquisition facilities. Boards and shareholders have remained nervous of mergers as a result of some lessons learned from the M&A boom in the late 1990s. During that period, a lot of liquidity was used up on a lot of deals – not all of which proved to add value to the companies concerned. When combined with the generally conservative attitude displayed by corporates towards their balance sheets for the last four years, this seems to have been sufficient to dampen enthusiasm for high-end M&A.
The general preference for balance-sheet management rather than debt-driven expansion has created a sustained demand for refinancing facilities, which became correspondingly more attractive as pricing declined during 2004 – finally accounting for 60 per cent of all lending in the UK, and up to 80 per cent in the other main European markets. Such was the attractiveness of refinancing that many new facilities were nonetheless refinanced within a year of their initial close. These borrowers were able to take advantage of both falling margins and longer tenors, which crept back to the seven-year terms last seen in the late 1990s. This initially came in the use of extension options, with Suez group’s €4bn refinancing, which set an example for the use of a ‘5+1+1’ structure in mid-2004. A further 25 European borrowers followed suit with the same maturity profile during the rest of 2004 – totaling $52bn of debt – although Philips also unveiled a straight seven-year tenor on its $4bn refinancing. These terms were also replicated when Sanofi-Aventis refinanced its one-year tranche in January 2005, at a margin slashed from 40bps to just 10bps.
Although liquidity has yet to be exhausted – as signaled by continued over-subscription to new deals – the substantial exposure that refinancings have transferred to bank syndicates during 2004 has undoubtedly affected lenders’ balance-sheets. How far this core demand can continue to drive the growth in the market is therefore uncertain.
This same conservative impetus among corporates has also led to the sale of non-core subsidiaries, creating another important market driver in the recent cycle – a target-rich environment for the private-equity market, which has in turn created an aggressive demand for leveraged debt. As a result, sponsor-driven buyout lending has increased to around a fifth of the UK market and slightly less for the European market as a whole. But even this sector seems to be registering a slow-down in Europe, with Q1 deal flow falling from 76 deals in 2004 to 72 in 2005.
This slow-down partly reflects the credit concerns that have surfaced in the sector. Many market participants think heavy competition among both private equity funds and banks has led to undue aggression on pricing structures and leverage ratios. This has inevitably led to questions being raised over credit quality on some transactions. These concerns have been exacerbated by other signs of weakening credit strength in various markets – a consumer spending slowdown in the UK, widening bond spreads in Europe, as well as the downgrades of Ford and General Motors in the US. The latter event came earlier than expected and triggered automatic selling of the paper by investment-grade buyers – also causing a corresponding brake on liquidity among high-yield investors. Yet given continued liquidity among the top banks, there should remain a healthy – if slightly tempered – appetite to support leveraged buyouts in the mid-market, where the majority of recent activity has been focused in Europe.
The more general medium-term outlook for the syndicated loans market should be one of ongoing liquidity and strong competition for mandates, as borrowers benefit from greater international transparency in loan pricing. Indeed, the attendant pricing convergence has led some to reconsider what had been thought of as an essentially closed series of national inter-bank markets. Yet this has also made the pricing outlook harder to call. On the one hand, a bigger, more unified market makes it harder to argue with market pricing if it continues to decline. But on the other hand, the impact of a credit event in one European market may have a more immediate impact on neighbouring markets – including the borrowers those markets serve.