The European leveraged loan market has been open to non-bank participants for less than four years. During this period the market in terms of outstandings has grown dramatically as yield-hungry investors are attracted by assets that rate at the top of a company’s capital structure. Demand has been so great that much of the corporate borrowing that would have taken place over this period in the High Yield market has been executed in the loan market.

This strong demand has been matched by increasing supply in the form of borrowing by private equity sponsors to finance the recent LBO boom. Against the backdrop of this strong growth a number of recent developments have been the cause of increasing concern for the market:

1. Leverage (net debt/ebitda) in Primary deals has been steadily on the rise since the credit cycle bottomed-out in 2002.
2. Spreads have continuously tightened (reverse flex) over the same period. As a consequence, spread per unit of leverage (SPL) has declined from 73bps in Q3 2002 to 45bps in Q1 2007.
3. Lending standards have been loosened to a point where many of the recent deals have been executed in covenant-lite form (where most of the lenders rights have been removed).
4. CLOs have become the dominant buyers of loans on both sides of the Atlantic. Over the past year 62% of the primary issuance in the US and 70% in Europe have been bought by CLOs. With the current problems related to structured credit’s exposure to the sub-prime sector in the US, concern has emerged that contagion may spill over into the CLO market.
5. Investors have been swamped with ever more complex (and often considerably more risky) instruments such as 2nd Lien, mezzanine, PIK loans and toggles. When the credit cycle turns it is likely that investors will be disappointed by the recovery rates available in these junior structures.

Weakness has emerged over the past few weeks in the US loan market. At the time of writing the key loan index in the US has seen an implied spread widening from 105bps to 295bps. Also a number of high profile deals have been postponed due to ‘market volatility’. Are we about to see an implosion in the loan markets driven by these concerns or is this move part of a much needed correction?

Fundamentals

Whilst certain metrics (net leverage, LBO equity contributions) have deteriorated recently, the fundamental backdrop is still very strong for European corporates. They have record amounts of cash on their balance sheets, Q1 earnings were 20% ahead of the same quarter in 2006 and interest cover has grown from 2.3x in 2002 to 3.3x in H1 2007.

The macro picture is bright: the largest and most important economy – Germany – is growing strongly as reflected in the outperformance of the DAX this year (+22% YTD). Inflation remains muted and interest rates low. All sectors (perhaps with the exception of Spanish property) are experiencing solid growth and the outlook appears to be for more of the same over the next 1-2 years.

The situation in the US is different. Critically the US economy is at a more advanced stage of the economic cycle and beginning to show signs of stress. First it was the auto and airline sectors, now it is housing market and sub-prime debt. Remember that this is all set against a backdrop of the Fed attempting to slow the economy with the blunt tool of monetary policy.

US companies have seen leverage multiples rise. The M&A boom has been more pronounced and in particular there has been considerably more LBO action than on this side of the Atlantic. US corporations have been lowering guidance with the proportion of positive v negative falling from -5% to -25% ahead of the Q2 2007 reporting season.

Thus it is hardly surprising that the credit markets in the US have started to re-price. The bulk of the LBO funding is being executed in the loan markets and this can only continue whilst the technical side of the equation remains strong. As we shall now see, the recent weakening of the market technicals has been a key factor in the loan market sell-off.

Technicals

Supply of loans has risen dramatically over the last 3-4 years but it now seems that the market only woke up to the fact that supply had significantly increased in mid-June.

Primary issuance in Europe hit a record high in May 2007 (€37bn) bringing the YTD volume to €103bn. According to LoanConnector the current European pipeline stands at €91bn up 81% from the same point in 2006. The equivalent US pipeline is $225 to 250bn driven by the relentless pace of private equity-led deals.

At a time of deteriorating fundamentals, record tight spreads, sub-prime woes and rising interest rates this appears to have been a bridge too far. Since mid- June the main loan index in the US has fallen seven points which had the effect of trebling the implied spread. In other words, US loan investors now expect three times the excess return from loans that they were happy with in mid-June. In Europe LBO deals are typically more difficult to execute (especially very large ones) and consequently the pipeline is less than half that seen in the US. European loan spreads have widened in sympathy (Senior Index Implied Spread 170 to 325). On both sides of the Atlantic demand has weakened. Nervousness exists over the full extent of the fall-out from the sub-prime/CDO situation and investors have no appetite for the weaker structures and credits. We believe it will take 3-4 months to clear the existing pipeline.

Covenant-lite issuance that was non-existent in Europe a year ago reached over €2.5bn in May 2007. These loans have significantly reduced (and sometimes non-existent) legal clauses which enable a lender to keep abreast of a company’s performance and declare it in default if certain financial criteria are breached. As the demand for loans has been outstripping supply, borrowers have been able to dictate terms to investors who have in turn been prepared to waive maintenance and incurrence covenants. These loans have conspicuously underperformed the broader market and investors are likely to shun them going forward.

In the aftermath of the recent Prosieben deal ($6bn) in which the senior loans fell two points on the first day of trading, borrowers are experiencing a significant degree of “push-back” from investors who only recently would have bought the loans regardless.

At the time of writing, the European loan market remains fixated on the outcome of the Boots/KKR deal. It has been the intention of the sponsors from the outset to raise the £9 billion in cov-lite loans with the senior tranche paying a spread of 275 bps. The latest public infomrationis that the senior tranche is likely to be priced at a level around 325 bps with 2nd Lien at 425 bps. It remains unclear as to whether there is sufficient appetite for all of this deal under current credit market conditions.

Relative value

An indirect effect of the recent strong demand for loans (and the subsequent spread tightening) has been a re-pricing of High Yield markets. Supply that would have been destined for high yield has come to the loan market which has the affect of strengthening the technical picture. At the same time, narrowing senior and junior loan spreads has pushed senior and subordinated debt levels higher as investors revalue the whole universe of debt assets across company capital structures. It was this effect that was partly responsible for the ever-tightening credit spreads (and out-performance of high yield) in H2 2006 and early 2007. This process also works in reverse. The recent weakness in the loan markets has had a visible and corresponding knock-on effect in high yield.

The European High Yield market has fought back against the loss of so much primary business to the loan market and consequently H1 2007 saw a large increase in the supply of senior secured floating rate notes (FRNs) which generally rank pari passu with senior loans or sit in the same part of the capital structure that senior debt would occupy.

The key point here is that loan markets are now an integral part of the publicly traded credit markets and as the credit cycle matures it is inevitable that investors will naturally be drawn towards the safest assets. This can take the form of moving up the credit curve (in extreme conditions into government bonds or cash) or higher up a company’s capital structure towards secured loans or FRNs. During the last credit crunch in Europe (1998 – 2003) recovery rates for defaulted senior loans averaged 78 cents on the dollar whilst in junior subordinated notes the recovery rate was closer to 20.

Investors now have a number of options when planning to invest in the debt assets of a particular company. Hedge funds and prop desks can construct complex capital structure arbitrages to benefit from the improving or deteriorating credit conditions of a particular company. The development of the LCDS market (single name credit derivatives on loans) as well as LevX (indices on senior and junior loans) gives investors added flexibility.

For the first time investors can hedge loan portfolios efficiently as well as take outright negative positions against single credits or the loan market as a whole. The Lev-X indices (especially the seniors) have experienced good two-way flows during the recent spread widening. The introduction of new non-cancellable indices which we expect to start trading in September, should further boost market liquidity and transparency.

Summary

The European leveraged loan market in mid-2007 bears no resemblance to the market four years ago. In all respects the market has grown, broadened and matured. The speed of the growth, the complexity of the instruments and the recent tightness of pricing undoubtedly poses questions for the market going forward. Coupled with credit related concerns in the US, the market is likely to experience bouts of pressure and volatility in H2 2007.

We believe that barring a credit-related ‘black swan’ situation, strong fundamentals, good demand, steady supply and the recent re-pricing will provide a solid backdrop for the European loan market. We do not believe that the credit cycle has turned in Europe and that recent spread widening is part of a much-needed return towards fair value.

Credit investors should ask themselves a simple question. As the credit cycle matures, what offers better value: senior secured loans at spreads of 300+ bps with recovery values around 80% or junior subordinated debt at the bottom of the capital structure at spreads of 450bps with recovery value between 20% and 30%?

Historically loans have provided investors with exceptional risk-adjusted returns. It is this factor more than any other which has attracted so many new investors to this market and in our view will continue to do so in the future.