US Private Placements: Investors Turn to Better Credits
Following a boom year in issuance in the US debt private placement (PP) market in 2003, when volumes hit US$46bn, activity has slowed but remains at historically buoyant levels. While a key driver for the peak in 2003 was the high level of European originated transactions, this market segment slowed noticeably in 2005. Total US PP volumes to end-August 2005 were US$21.3bn, a 2 per cent increase on the same period in 2004. However, the non-US share of volumes had reduced significantly (see chart below).
* 2005 Data as of 1 Aug 2005The drop-off in European issuance is in line with the trend in the public eurobond market, where volumes fell by nearly one fifth to €111.7bn in the first three quarters of 2005. Following a bumper year for bond issuance in 2003, when new volumes of €245bn included large amounts of early refinancing, new funding needs have been limited. Renewed merger and acquisition (M&A) activity in several sectors in 2005 provided some boost to this demand. However, banks have been keen to lend long-term money directly, with many companies opting for syndicated bank loans instead of bonds or US PPs.
Investor interest in PPs remains strong in the US, where the instrument is an established asset class. In Europe, investors have yet to catch on, with at most a handful of investors taking an interest in the market. The arranger landscape, where European banks have ramped up their US PP marketing as a good way of leveraging off large lending portfolios, is more balanced.
US investors moved to raise the credit profile of their PP portfolios in 2005. While the 2003 boom was mainly underpinned by a keen search for yield, and a resultant high proportion of National Association of Insurance Commissioners (NAIC)-2 versus NAIC-1 credits, Q205 saw more prudent behaviour. This move coincides with a turning of the credit cycle in the very same quarter, when downgrades outnumbered upgrades for the first time in seven quarters according to Fitch data (see chart below). In EMEA, the positive credit cycle had already been less pronounced and shorter than elsewhere. During the first half of 2005, downgrades strongly exceeded upgrades in Western Europe.
MetLife, a major PP investor, has reported that the average rating of its portfolio moved from a stable BBB+ during 2000-2003 to A- in 2004.
In January 2004, the NAIC introduced its Filing Exempt (FE) process. Under FE, a nationally recognized statistical ratings organisation (NRSRO) rating (public or private) is fully recognised by the NAIC, whose securities valuation office (SVO) credit unit will no longer perform its own analysis. The procedure, with a rating assigned ahead of investor placement, removes NAIC rating risk. This arises when arrangers market an unrated transaction as ‘investment grade’ (NAIC-1 or -2) and the NAIC rating, which is not assigned until post-financial year end (FYE) of the investor, may differ from this opinion, potentially leaving investors with a higher than expected capital weighting. As the credit cycle turns, Fitch believes investors will increase their focus on credit transparency going forward.
A standard feature of US PPs is the inclusion of financial covenants in documentation. These are typically identical to the issuer’s banking covenants to ensure practical pari passu creditor status. In this way, the PP market, which is almost exclusively investment grade focused, differs from the public bond market, where investment grade issues rarely include such investor protection. While covenants do not give creditors preferred status, they confer the important benefit of ‘bringing them to the table’ in case of financial difficulties for the issuer. In some cases of strong NAIC-1 credits, covenants may be replaced with a most favoured nations (MFN) clause, providing investors with the assurance that should any creditor be granted financial covenants in the future, they will also be given this benefit. The presence of covenants (or MFNs), which reflects the historic long-term relationship nature of the US PP market, aims for considered re-setting of covenants to allow the issuer to work through its challenges.
However, as hedge funds have become active buyers of troubled PPs, an issuer may find this relatively relaxed climate, with a limited number of buy-and-hold investors, has changed into a more short-term focused and unwieldy group. A case in point is Rhodia, the troubled French chemicals group, where traditional PP investors have found themselves mired in a complex workout alongside short-term value focused hedge funds, less willing to negotiate covenant waivers and eager to trigger make-whole payments.
Furthermore, the increasing capacity and activity of private equity (PE) funds on the M&A scene have caused concern among fixed income investors. A high profile case in the public bond market was the investment grade-rated Danish service company ISS, whose new PE owners took a hard line with incumbent bond holders, declining to repay notes on grounds of a lack of such covenants in the documentation. Investors are learning the hard way that unless they actively analyse and demand improved protective language in bond documentation, a strong investment grade credit holding may turn into a leveraged buy-out (LBO) overnight. PP investors would typically have greater protection than public bondholders in such cases.
The Rhodia and ISS examples illustrate how borrowers and investors are sensitive to the granting and negotiation of covenants. As Fitch has argued repeatedly in recent years, European borrowers will need US-style Chapter 11 legal protections from opportunistic short-term investors if covenants in bond documentation are to be negotiated in good faith. Even strong credit PP issuer Porsche may find its plans to increase its stake in fellow German car manufacturer Volkswagen affect its financial covenants, requiring detailed explanation to US investors.
In the first nine months of 2005, some 22 European corporates issued US PPs (see appendix at end) totalling US$6.6bn. The single largest transaction, and possibly the largest US PP ever, was UK building materials wholesaler Wolseley’s US$1.2bn deal. The building materials sector in general has remained popular with investors, accounting for nearly one third of all European issuance with four sizeable deals, including Grafton and Kinsgpan (both Ireland) and Cemex Espana in addition to Wolseley (see chart below).
The food and beverage segment volume was accounted for by five geographically diverse issuers, with Royal Numico’s US$425m deal being the largest. In the energy industry, Red Electrica de Espana’s total US$800m issuance dwarfed the only other transaction, TXU Europe’s US$52m. The automotive sector was solely represented by Porsche Holding’s US$480m issue.
The geographic diversification of European issuance was high, with the UK accounting for only just over one quarter of volume and a total of 10 other countries represented (see chart below). In fact, lower UK volume was a major reason for the overall decline in European issuance. France remains absent from this market, with issuers unwilling to risk Rhodia-style developments. No issues were recorded either from Italy. German activity was moderately high, although not as strong as in the previous year, when a number of large automotive manufacturers (BMW, VW and Porsche) took advantage of attractive pricing to issue large PPs.
