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Jennifer Bollen finds booming leverage markets bringing second-lien debt back into vogue in private equity deals – and in Europe, that can mean mezzanine-like risk 

The European leveraged loans market has returned to boom-era activity, thanks to high levels of liquidity and pressure to allocate capital. Lending has reached pre-crisis levels, debt packages are bigger and issuance of a sliver of debt known as second-lien has reached its highest level since 2008.

The total value of European leveraged syndicated loans reached $172.4bn in the first half of 2014 – the highest half-year level since 2007 when issuance stood at $368bn, according to data provider Dealogic. In the first half of last year the total stood at $134.5bn.

Average senior and total leveraged loan gearing levels in European private equity buyouts rose between January and the end of June 2014 to 4.8 times and five times EBITDA, respectively, according to a report on loan trends published by debt advisory firm Marlborough Partners. The figures compare with average senior levels of 4.4 times and average total leverage loan levels of 4.7 times in 2013. Meanwhile, average equity cheques remained low at 43.6% – the lowest level since 2007, according to Marlborough. 

Confidence
“There are two big factors,” says Paul Shea, co-founder of UK direct lender Beechbrook Capital. “The banks are very happy to lend to larger companies. They are willing to provide higher leverage, have got lots of liquidity and they are willing to take on risk, in our view. The second thing is there are a large number of private credit funds which have raised significant amounts of capital and this needs to be deployed over the next few years.”

Ciara O’Neill, a managing director at corporate finance firm DC Advisory, says the market-wide liquidity “has given syndicate desks high levels of confidence to underwrite these things”.

However, the pressure to put capital to work has led to fears of an overheating market. 

“There is not an abundant supply of new transactions, so there is a little bit of a supply-and-demand imbalance in the amount of capital looking for exposure in leveraged credit and the amount of leverage opportunities,” says Jonathan Rowland, a founding partner of debt advisory firm Tomorrow Partners. “There is a risk of a bubble if people get ill disciplined and if people start to extend more racy multiples.”

Another sign of confidence in the loan markets is the rise of senior second-lien debt – a portion of debt that sits just below the most senior layer of a company’s overall capital structure and pays a higher rate of interest.

The issuance of European second-lien has surged across the market during 2014, according to Marlborough’s report – €800m of second-lien was issued between January and the end of June, representing the highest level since €900m was issued in the whole of 2008. In the past decade, second-lien issuance peaked at €13.2bn in 2007.

“[Second-lien debt] has certainly seen a resurgence and debt levels and structures in the past 12-18 months have started to look like those in 2007 and 2008,” says Neil Harper, chief investment officer of the private equity fund of funds group at Morgan Stanley Alternative Investment Partners.

Second-lien remains a small proportion of the typical capital structure but its popularity has soared. 

“Any large market deal will have a bank proposing second-lien at the moment,” says Jonathan Guise, a managing partner at Marlborough. “You will not see it in the data yet but if you were to look at deals in the last two months and deals above €350m, you would see a fairly big proportion of second-lien.”

Marlborough counted six issuances of second-lien among European private equity-backed companies in July alone, including a €350m tranche in CVC Capital Partners’ merger of Spanish health services company IDCSalud with hospitals operator Quirón, and €155m issued as part of BC Partners’ refinancing of its German pharmaceutical company Aenova Group.

Other high-profile examples include retailer Matalan’s £150m of second-lien, issued in May which, alongside £342m of first-lien secured notes, refinanced Matalan’s senior secured notes and senior notes.

The rebirth of the European collateralised loan obligations (CLO) market has further fuelled demand for second-lien, according to O’Neill, who says managers of post-crisis CLOs have structured many of the vehicles to target a greater proportion of second-lien than CLOs issued several years ago. 

By August 2014, 19 European CLOs worth a combined €8.01bn had been issued since the start of the year, compared with 21 CLOs worth a combined €7.9bn in the whole of last year, according to rating agency Standard & Poor’s.  

Wiped out
Second-lien debt originated in the US where borrowers used it to stretch the proportion of senior debt on top of a bond, says Shea. 

“There was demand for a second-lien tranche, which began in the US but moved into Europe, despite not having such a large high-yield bond market,” he says. “So, effectively, the market started turning a lot of mezzanine into what is called second-lien – and it became cheap mezzanine.”

This time round, second-lien is certainly being structured as “cheap mezzanine” as opposed to “stretched senior”, says Guise, with separate documents, separate voting rights and certain provisions typical of mezzanine.

Figures from a European second-lien debt report published by S&P in June reflect the perception that second-lien is more akin to mezzanine than first-lien senior secured. A sample of 72 second-lien and 123 mezzanine instruments shows that mean recoveries for the two types of debt are the same at 36%. S&P says the data shows how these facilities are treated equally in a default situation.

“Mean recoveries for second-lien instruments continue to mirror those of mezzanine debt instruments, despite the general market perception that mezzanine instruments are subordinate to second-lien instruments,” says the report. “In our view, this perception arises because second-lien facilities are typically secured by assets that are also pledged to higher-priority lenders. In contrast, mezzanine instruments may be unsecured and generally have more prior-ranking debt, and are therefore priced higher to account for this risk. The expectation is, therefore, that mezzanine instruments would receive lower recoveries than second-lien instruments.”

But debt advisers are not anxious about the risks associated with second-lien. 

“They are only really taking a sliver of incremental debt,” says Rowland. “I have not seen a second-lien structure where the second-lien is saddling more than a turn of leverage. You might find one and a half but we are not seeing second-lien taking a significant proportion of the overall capital structure.”

Shea says that the amount of leverage at inception is the most important thing to keep an eye on. 

“If senior leverage is two to three turns of EBITDA, which is common in the lower mid-market, you have a better chance of getting 100% recovery,” he says, “but if you put second-lien debt behind five or six turns of senior, the chances of a good recovery are much lower.”

Meanwhile, Guise is confident the underlying businesses are more robust post-crisis. “They have been through difficult times and the outlook is stronger,” he says. “For those who say it is ‘cheap mezz’, take more of a cyclical view and say at the moment it is appropriate.”

However, Shea highlights the importance of ensuring lenders secure the strongest rights they can to protect themselves in the event of a restructuring. In the wake of the credit crisis, as companies’ worth plummeted, investors exposed to the junior portions were wiped out. 

“What became clear during the crisis was some of the inter-creditor rights of subordinated debt holders were not very effective compared with senior debt,” he says. 

“That has been improved since the downturn but if you do not have the strong documentary rights, you cannot slow down a restructuring process. If you want a decent recovery, you need as long as possible to organise a good auction and achieve a fair market price. If the second-lien debt has few rights, then you can get cut out very quickly.” 

Whether second-lien behaves more like stretched senior or cheap mezzanine varies from deal to deal, depending on the overall capital structure. Nonetheless, some remain concerned that investors are not being paid sufficiently for risk. 

“We are in an unusual situation with an elongated period of incredibly low interest rates, so there is a real search for yield wherever you can find it,” says Morgan Stanley’s Harper. “People are willing to accept modest spreads on all forms of corporate credit.”

“In the upper mid-market and large-cap markets, there is a huge supply of finance and a limited demand from borrowers, so the price just gets driven down,” says Shea. “How is that priced? The pricing is driven by the huge liquidity rather than the risk. It is driven by the need for people to deploy capital. I am sure everyone has very strict underwriting standards. But that is what they said in 2005 and 2006.”

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