So what exactly are leveraged loans? Leveraged loans are floating rate instruments that are issued by companies to finance corporate restructuring, such as leveraged buyouts (LBOs). After an LBO, private equity companies have to issue a large amount of debt to fund the transaction, and this is then placed on the target’s balance sheet. A relatively recent example was Malcolm Glazer’s takeover of Manchester United in 2005. Following the takeover, Manchester United approached a number of institutions in the City asking if they were interested in buying the loans. As it happened, we decided not to (and that’s not just because I’m a Leeds United fan). Other companies to have issued loans include Gala, the AA, Lego and United Biscuits.
Senior leveraged loans occupy the most senior position in the company’s capital structure, which means that if the company fails and defaults on its debts, then leveraged loan holders are first in the queue to recover their money. The average recovery rate for a senior loan holder has historically been around 80%, significantly higher than the 40% recovery rates that are typical for the average high yield corporate bond holder in event of default. Even though senior leveraged loans occupy the highest position in a company’s capital structure, though, they typically have a credit rating of double-B or single-B, which reflects the sub-investment grade equivalent rating that would apply to the borrowing companies. Typically a European loan might pay investors money market rates plus 2.25% (currently 7.85%) compared with around 7.50% for a high yield bond, so given the lower risk profile for loans, they currently look good value.
Another advantage of leveraged loans is that they are floating rate assets rather than fixed assets. In other words, the income paid from leveraged loans is a fixed basis point payment over a reference interest rate, and so the total income paid duly rises and falls in line with interest rates. Leveraged loans therefore have no duration (or interest rate risk) and are therefore particularly attractive in a rising rate environment.
The surge in LBO issuance over the past few years has inevitably resulted in the rapid growth of the European leveraged loan market. In addition, institutional investors have increasingly been able to gain access to the primary market for loans, and now represent 49% of the market, up from 40% in 2005 and 25% in 2004. Interestingly, we have seen US retail loan funds (known as ‘Prime Rate’ funds) enter the European market, as the US managers have increasingly recognised the relative value offered by European leveraged loans. Hedge funds have also become major players, attracted by the high yields, the floating rate feature and the exceptional risk/return characteristics the asset class has demonstrated.
One market development that we’re watching closely is the potential for rising risk within new leveraged loan deals, which has been possible due to the soaring demand for the asset class. Although encouragingly, while average debt/earnings was higher at the end of 2006 than a year earlier (with debt standing at 4.25 times earnings, compared with 4.01x in 2005), there was a gradual fall in leverage within transactions as the year progressed (4.23x at the end of Q4, down from 4.43x in the third quarter). Our analytical vigilance is as important now as it has ever been – but this is a very interesting asset class right now.