Maximum leverage, maximum flex

Blenheim Advisors’ latest research advises clients to ensure they get the most leverage for the best terms, before default rates cause the European debt markets to tighten. By Nicholas Lockley.

The latest research by independent debt advisory specialists Blenheim Advisors highlights the importance of maximising both leverage and equity protection in deals.

William Allen, founding partner, Blenheim Advisors

In a report to clients William Allen and David Parker of Blenheim pick out four future trends that may come to define Europe’s leverage finance market and which may end in problems for borrowers.

First they cite a Moody’s report forecasting default rates reaching 3% by the end of 2007. 

Data for 2005 covenant breaches support this forecast; of the 19 breaches witnessed in 2005, about 40 percent occurred within 12 months of the date of the initial financing. Furthermore, 10 of the 19 breaches occurred where the affected transaction average leverage multiple was 10-30 percent greater than the S&P 2002-2005 average leverage multiple for the same sectors, according to Blenheim. 

The say there is clearly a correlation between rising leverage and increasing covenant breaches – and ultimately default.

The two co-authors say the predicted increase in default rates will potentially reduce demand for leveraged loan products.

They say collateralised debt obligation fund managers are particularly sensitive to increasing default and this is the second trend: it will lead to CDO managers looking to increase their margins, making debt more expensive for borrowers.

Thirdly, they say Basel II, in effect from the start of 2007, will mean institutions become more risk averse and move away from non-investment grade paper. Blenheim say this will further drive up the importance of institutional credit funds.

Finally, the private equity market itself is highly competitive and highly liquid where purchase price and leverage multiples are “close to, if not at, all time highs”.

This they say will put pressure on returns and place a greater emphasis on debt capital to enhance the equity investment.

The two authors are confident of a robust European leveraged finance market in the near term, but they warn private equity managers to keep a close watch on default rates and the impact they may have on credit funds.

Blenheim says managers should use the high level of competition between underwriters now to “extract considerable structural and documentary flexibility”. To ignore this advice in the light of the market’s trends would seem to be a high risk approach.