In recent years the European Leveraged Loan market has grown from bit-part player to becoming a central actor in the raising of funds to buy, develop and sell private companies. The market is currently experiencing interesting times, in the traditional Chinese sense of the phrase: a time of disruption and upheaval. After brisk activity in 2021, the converging headwinds of war in Ukraine, supply chain bottlenecks, rising inflation and rising interest rates have driven increasingly pessimistic economic outlooks. This in turn has led to diminished risk appetite amongst leveraged loan lending banks which has caused a rapid upward repricing, creating large, stuck underwriting positions and strain in the underwriting and distribution model.
We have been here before. The leveraged loan market has not infrequently witnessed periods of stagnation with underwriting banks suffering extended symptoms of indigestion. Each time has had different characteristics. The two obvious new differentiators this time round are the increased deal sizes involved and the emergence of new, aggressive market participants, which drive uncertain outcomes.
Where do we go from here, even if here is not the place you would want to start from? The competition amongst leveraged loan market participants to secure mandates for arranging and underwriting private equity deals is intense. As well as deriving fees for underwriting, lead banks are also in prime position for ancillary business such as FX, interest rate management, treasury cash services and future advisory business around exit strategies, all of which greatly improve the deal economics and justify the initial balance sheet commitment. Achieving prominent market share is essential, as the financial sponsors gravitate towards the market leaders with the strongest underwriting and distribution power. Given the cyclical nature of the market, all banks are aware that, from time to time, the market seizes up, and underwriting banks will be stuck with large underwriting positions. In such instances, the banks are faced with unpalatable choices.
Those choices boil down to a question of tactics: essentially, whether to bid aggressively on all available deals and take a tracker approach to market and credit conditions, or, in stock-picker mode, to be more selective on deal engagement. Either approach has challenges, but the latter is more sustainable.
Under the tracker tactic, they accept that at times when the music stops, they will bear large concentration risk. Until it does, in the immortal words of ex Citibank CEO Chuck Prince, ‘we are still dancing.’ When it stops, they face the next awkward choice. They can hold the position until such time as market sentiment improves and they are able to distribute, while, in the meantime, the position uses up Risk Weighted Asset (RWA) allocation, effectively shutting them out of new business. (RWA being the key metric, under the banking regulatory framework, for assessing the level of capital required to be held by banks.) Alternatively, they accept the new market pricing and sell at a large discount to clear the position; when the market does eventually reopen, driven by renewed appetite, there is a distinct first mover advantage for those banks with RWA capacity. Given the potential rewards, some gravitate towards this tactic, enjoying the benefits of market leader status and accepting the occasional losses as part of the cost of doing business in the sector. But this approach is hazardous. Leaving aside the career risk of those responsible for stuck underwriting positions, the cost of clearing repriced assets can be immense, more than many years’ profits in good market conditions. This will inevitably jeopardize senior management’s appetite to continue active engagement in the market. Those recently contemplating their position in the Twitter deal will empathize.
The alternative selective approach is no less challenging, but it is more generally advisable. The more discerning bank will attempt to mitigate stuck position risk in two ways.
First, they will dial down their appetite ahead of the market if they perceive market conditions are weakening, the idea being to increase market penetration during lean times, when pricing more accurately reflects risk, and easing off when the market gets overheated. This contrarian approach is difficult to execute. No bank has a fool proof crystal ball and many Cassandra calls prove to be false alarms.
Secondly, they will heighten their risk due diligence and lower their tolerance to marginal credit quality, via preserving standards in documentary terms and conditions, credit risk metrics and risk/reward-driven pricing. This requires significant investment in constructing an effective internal risk management process to provide the requisite analytical firepower. It will not eliminate, but will considerably mitigate, the financial losses in the future - the logic being that when large, concentrated positions occur, better that it is a robust credit proposition. In the meantime, these more discerning banks are in the uncomfortable position of reduced market share, witnessing less risk-stringent competitors enjoying the spoils of market leadership.
Hence the banks’ dilemma: whether to participate aggressively in the market or not, with tactical and strategic implications. Whilst the banks grapple with this Gordian Knot, another complicating factor is the emergence of private lenders, funds that have greatly expanded their footprint in the leveraged market in recent times. Precise figures are elusive, but it is estimated that 30-40% of all transactions are now funded by this unregulated source. Not constrained by RWA considerations or other regulatory impediments, the private lenders have increasingly encroached on the banks’ traditional space, starting as participants in bank-led syndicates, but now more aggressively funding complete deals, excluding banks from the process.
It remains to be seen how the private lenders will react when more repricing events hit the markets and impact their profitability. They will not face immediate RWA-driven capacity constraints on new business, but losses inevitably will take their toll on shareholder appetite for continuing to participate. Given their heightened market position this time around, I suspect we will not have long to wait to learn the answers.
January 2023