Leveraged finance Priced to perfection

It’s been a while since Chuck Prince slipped into his dancing shoes. Back in 2007, Citi’s then chief executive notoriously claimed: “When the music stops, in terms of liqui-dity, things will get complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Of course the music did stop, to devastating effect. But seven years on from that unfortunate soundbite, rising leverage levels in large buyouts in particular have caused some observers to question whether lessons have really been learned.

At the peak of the economic cycle in 2007, average equity contributions in leveraged buyouts had decreased to just a third of enterprise value, only one third of deals featured an all-senior structure, and more than half of large buyouts had leverage of more than 6x EBITDA, according to data from Standard & Poor’s.

After the global financial crisis, the banks’ risk appetite changed dramatically: as regulators sought to keep the industry on a shorter leash, lending criteria tightened and liquidity dried up. Private equity firms were forced to use more equity in their deals and operate with less risky structures, which resulted in more all-senior deals.

This trend reached its peak in 2009, when average equity contributions hit 53 percent, and 83 percent of deals featured all-senior debt packages.

But the market is unquestionably hot again – to the extent that there are signs of overheating.

A SUPPLY/DEMAND PROBLEM 

“Leverage is certainly rising for LBOs,” says S&P Capital IQ LCD’s Ruth McGavin. “The first quarter multiples look pretty aggressive relative to last year. And [anecdotally] there is concern from institutional investors around the market that leverage is rising quickly. We are not very far away from the record-high leverage multiples seen in the boom years.”

In a recent report, S&P warned that a low-interest rate environment, coupled with a continued supply/demand imbalance for paper, could lead to excessively borrower-friendly terms and features on new issuance, leading to increased use of leverage, and a rapid re-pricing of existing loans.

That imbalance has arisen due to increased demand for speculative-grade paper from both bond and loan fund managers, as well as the returning CLO market. Before some unexpected outflows at the end of April, there had been a record 95 consecutive weeks of inflows into leveraged loan funds.

However, with LBO and M&A volumes still relatively low, the supply of paper has not increased at the same rate.

“As long as demand for senior secured floating rate debt continues, loans will be increasingly aggressively structured from the investors’ perspective. We expect leverage will rise and spreads will compress,” adds McGavin.

So far, credit quality has generally been holding firm amid the broadly stable macro conditions in Europe. But if this imbalance continues, it “could prove highly destabili-sing for credit quality,” the ratings agency said.

Not surprisingly, some people are starting to get nervous about the current environment.

“Given recent geopolitical and macro-economic events, we are surprised at how ebullient credit markets have been in 2014,” Bill Conway, co-chief executive officer at The Carlyle Group, said during a recent earnings call. “The world continues to be awash in liquidity and investors are chasing yield seemingly regardless of credit quality and risk. We continuously ask ourselves whether the fundamentals in the global credit markets are healthy and sustainable. Frankly, we don’t think so.”

So are people right to be worried?