Trends in the European Loan Market
As evidenced by another period of record lending – first quarter volumes for 2006 were US$239.7bn – the European loan market is a more important source of funding for the corporate sector than ever. And an increasing percentage of this volume comes from borrowers building sustained, reciprocal relationship with core banks.
These borrowers know that if pricing increases following the current credit cycle – as many predict it will – they will gain competitive advantage from the strength of their banking partnerships. And this relationship focus will be reciprocated on the lending side. Banks have broadened their view of borrowers – seeking to combine ancillary business and core lending into mutual, long-term relationships.
This attitude to lending has been formed in a loan market characterised by dwindling margins. At the beginning of 2004, there was a 20 per cent increase in surplus cash on UK company balance sheets, while on the continent the EU money-supply peaked 8 per cent higher than the previous year. These factors reduced demand for loans, which created downward pressure on pricing. This in turn forced lenders to look for alternative means to sustain income streams from borrowers.
The drop in pricing also encouraged widespread re-financing, accounting for 72 per cent of total volume in 2004. Loans with longer tenors became more readily available, with the number of seven year loans – often structured as 5+1+1 deals in order to allow for more flexibility – increasing by 20 per cent as a percentage of total volumes between 2004 and 2005.
Although re-financing levels slowed to 61 per cent of total volume last year, loan volumes were boosted by an increasing use of debt in the mergers and acquisitions (M&A) market. Indeed, the percentage of European loan volume used for M&A deals increased from 7 per cent in 2004 to 15 per cent in 2005. And the surge in the overall M&A market – 51 per cent compound growth between 2003 and 2005 – has started to provide the market with enough demand to begin to counterbalance the liquidity that has until now seen rock bottom margins.
Certainly, M&A activity has been the main driver of volumes in the loan market since the beginning of 2006, providing a respite that has allowed banks to employ more discriminatory pricing policies. A parallel development is that sub-20 bps pricing is now strictly reserved for top-tier relationship credits.
Activity in the leveraged market also reached new highs in 2005, accounting for 23 per cent of loan market volumes last year as opposed to only 12 per cent in 2000, a near-doubling. This surge was driven mainly by the well-documented abundance of liquidity in private-equity funds. Debt usage in buyouts has increased sharply because banks became more willing to increase leverage ratios, while a more liquid market also developed for the higher-yielding junior tranches. This included increased appetite from CDO-type structured finance vehicles, which make up about two-thirds of US leveraged finance provision but still only a third in Europe.
This growth saw average leveraged buyout (LBO) deal size reach US$664m in 2005 – just US$100m short of the average investment-grade transaction size. Bumper deals on the continent last year factored heavily in both the LBO and M&A market, and overshadowed the usually well-placed UK market – registering a modest 17 per cent increase in total loan volumes. Spain was the European star last year, registering a staggering increase of 179 per cent in total loan volumes since 2004. It comes as no surprise then that two of the largest deals last year – Telefonica’s US$40bn takeover of O2, and Gas Natural’s US$10bn takeover of Endesa – originated in Spain.
But concern also mounted regarding the back-end loading of some repayment profiles, with some commentators suggesting we may see distress appearing in some cases. However, the good credit profile of the biggest deals should exempt these.
Lenders will continue to balance big-ticket lending with smaller facilities to weaker credits, while ensuring that relationship building remains an ambition across the credit spectrum. Lenders are also willing to participate in low-margin deals in order to become the preferred financial suppliers of individual companies – to the extent of viewing some lending activities as a loss leader in developing long-term corporate relationships.
Indeed, such policies have changed how banks measure their return on capital. Risk adjusted rate of return on capital (RAROC), which was traditionally used by lenders to measure the return from a single exposure – for example, a bond exposure – is now being used to measure the total income stream from a given client across the entire bank’s product range. Whereas this approach was once the preserve of the most advanced banks, it is now being used more widely, certainly by all banks seeking advanced compliance to the incoming Basel II capital adequacy framework. Given that the majority of European liquidity is now provided by a dwindling number of large banks – all of which belong to the advanced-Basel II group – a relationship-wide approach to return on capital will become the norm.
But it is not just lenders that see the value of relationships. It has become common parlance among borrowers that rewarding banks with ancillary business is a good way to keep down the cost of capital. This became the publicly-stated policy of two UK PLCs last year – Carphone Warehouse and Tesco.
This strategy dictates that borrowers should offer business to those institutions with the capability and desire to supply a range of financial solutions in line with company business objectives. Relationships of this kind create their own economies of scale, as borrowers benefit from a more consolidated and focused bundle of bank products and banks shift their activities towards that of long-term advisers interested in maximising the internal financial efficiencies of borrowing companies.
Such relationship-based funding is gathering momentum just as the downward trend in European loan pricing appears to be flattening off. Although banks will still compete heavily for mandates, they are also looking more closely at loan covenants and at the overall economics of each corporate relationship.
Historical plateaus in the loan market have lasted, on average, for six to 10 months. If this is again the case, it means that the current period represents the best opportunity for borrowers to take a strategic look at their financing options. They would be well advised to take a holistic view of bank services – including lending – with a view to consolidating their relationships before the next credit cycle.
There is as yet no sign of demand for loans waning. M&A activity continues to prosper, driven on by uneven share prices and an abundance of liquidity in the private equity market. The European loan market this year has already beaten first-quarter volumes for 2005 and the large deals continue to happen, such as Mittal Steel’s US$29.6bn bid for Arcelor that has been accepted by the Arcelor board.
With this increasing demand comes more selectiveness by banks – again shifting the focus onto core relationships. For the moment, however, more transactionally-orientated borrowers are also able to access cheap one-off lending facilities, particularly top-tier credits. However, as the credit cycle begins to turn, transactional borrowers may struggle to obtain the same pricing, particularly in the event of macroeconomic adversity.
As it stands, the macroeconomic outlook for 2006 is stable to positive, barring any geopolitical catastrophes or major credit events such as a big-ticket default. However, the current market may not be as resistant to macroeconomic volatility as it has been in the past year. A repeat of geopolitical events, such as the London bombings, or sustained interest rate hikes by the European Central Bank (ECB), are likely to intensify the price discrimination policies of lenders.
In the absence of a shock, any upturn in pricing will be more gradual than those we have seen in the past. This is in large part down to the stability that long-term bank-borrower relationships bring to the loan market. And it is good news for those already involved in focused banking relationships as it will support their access to continued cheaper borrowing.
Some borrowers will, on account of the nature of their business or loan purpose, continue to access bank liquidity on a transactional basis. But for borrowers seeking to optimise yield from longer-term bank debt, strong and broadly based relationships are imperative.