David Gillmor and Taron Wade find Europe's senior loan market delivering a strong recovery over its first cycle

The upsurge and subsequent slump in financial markets over the past decade has seen an expanded European leveraged loan market run its first economic cycle. This cycle has also provided a wealth of data from which to measure recovery performance.
Although the data include a high volume of so-called interim recoveries, Standard & Poor's Ratings Services believes the results provide a realistic measure of the recovery experience of European leveraged loan investors and show that senior loans have delivered strong recoveries. What's more, their experience is similar to that of investors in US loans.

From 2002 to 2008, the European leveraged loan market experienced phenomenal growth, with issuance almost doubling between 2005 and 2006 to €119bn, before peaking at €165bn in 2007, according to S&P Capital IQ LCD. However, after the global financial crisis in late 2008, the market suffered a severe dislocation: the trailing 12-month default rate for leveraged loans in the region hit 14.7% in the third quarter of 2009, up from a pre-crisis rate of less than 2% per year.

Unlike in the US, this series of events represents the first real cycle for an expanded European leveraged finance market and therefore data on actual recovery rates post-default has been limited. This preliminary study, in which we have evaluated 101 known defaults, has found that, thus far, recovery rates on European first-lien debt have remained strong throughout the cycle at a mean of 76% by value between 2003 and 2010. This mirrors recoveries on similar debt facilities from US companies.

Interim recovery rates higher than ultimate recoveries
However, at the moment, we view the nominal European recovery rate with caution since it includes a high volume (65%) of interim recoveries, generally debt exchanges. If only ultimate recoveries are included, the recovery rates are materially lower, with a mean of 63%.

Ultimate recovery - the value of the settlement a lender receives by holding an instrument throughout its emergence from default - represents the current estimate of a defaulted instrument's value, based on the best information available.

When we isolate the 144 ultimate recoveries from the 261 interim ones, an interesting picture emerges. Specifically, the ultimate recoveries achieved are materially lower than the interim recoveries. We believe this is due to the high percentage of interim recoveries in which debt has been rolled over or extended.

As we track these new instruments to ultimate recovery, the recovered value for original
investors in the facilities or notes may look different. In fact, there is a real possibility that ultimate recoveries will be lower than the interim figures calculated.

Despite the apparent turn in the default cycle after the third quarter of 2009, it has always been our view that the default rate over the past two years was artificially depressed by the accommodating behaviour of senior lenders. To us, these lenders were likely more interested in minimising book losses while at the same time capitalising on amendment fees and higher spreads.

However, as banks comply with increased regulation and the need to reduce their risk-weighted assets, we believe senior bank lenders are increasingly likely to adopt a more robust stance to disposing of non-core assets. We also believe they would take appropriate remedial action to address loan exposures where underperforming businesses with overleveraged balance sheets have approaching maturities.

Our European study reveals other similarities with US first-lien debt, which saw a mean nominal recovery rate of 83.7% between 1987 and 2011. Senior unsecured debt, primarily speculative-grade bonds (rated BB+ and below), achieved recoveries of 48% between 2003 and 2010. This compares well with the US long-term empirical average of 51.8% for senior unsecured bonds or 45.9% for all bonds.

But there are also marked differences with the more seasoned and developed US leveraged loan market and its historic recovery experience. First, the nominal European recovery rate includes a high volume (65%) of interim recoveries, generally debt exchanges, and must therefore be viewed with caution.

Second, mezzanine and second-lien debt in the European context are different from such products in a US context and are therefore not comparable.

Third, using trading prices as part of the actual recovery calculation is not yet viable in Europe because we view the secondary market for distressed debt as illiquid overall and there is some scepticism over whether or not debt is being written down to a sustainable level during restructurings.

Outliers drag down recovery rates for publicly rated companies
Comparing recoveries on first-lien debt for publicly rated companies against our portfolio of credit estimates, we see a markedly different outcome. A credit estimate is a confidential abbreviated analysis and, generally, does not include all of the aspects of a standard ratings analysis. For these reasons, a credit estimate is not intended to be a substitute for a credit rating. Recoveries for publicly rated companies have a mean of 62% and a median of 66%, while those for credit estimates have a mean of 79% and a median of 91%. The lower recoveries for publicly rated companies can be partly explained by a single large default - Lyondell Basell, the majority of whose tranches had recoveries in the 60-70% range; and by Wind Hellas the majority of whose tranches had a recovery in the 0-10% range. Without these two companies, the mean for the publicly rated companies would have been slightly higher at 65%.

Insolvency regimes have little bearing on first-lien recoveries
When reviewing the recoveries by country, it is important to note that the sample size is comparatively small. The 31 instruments in the Spanish jurisdiction, for example, represent just seven companies. Nevertheless, the data indicate that recoveries for France and Spain are as good as, or better than, recoveries for the UK, despite the latter having what we consider more secured creditor-friendly legislation.

Although our findings from this study are preliminary (an evaluation of 101 of 237 known defaults thus far), we believe they accurately model investors' experience over the first real cycle of an expanded European leveraged finance market. Although there are limits to the existing data - including the high percentage of companies that we consider to have only interim recoveries - it does indicate that recovery rates on European first-lien debt have remained strong throughout the cycle. This experience mirrors recoveries on similar debt facilities from US companies. We will continue to collect and analyse this data to obtain a fuller picture of the recent cycle for the European leveraged finance market, about which data on actual recovery rates post-default has so far been limited.

David Gillmor is a senior director and Taron Wade a senior research analyst at Standard & Poor's Ratings Services