The Rise of Corporate Debt, Leveraged Loans and Smaller LBOs
The article below is from our BRIEFINGS newsletter of 13 May 2019
Demand for leveraged loans — a form of capital issuance to companies with sub-investment-grade credit ratings — is continuing to march higher even as some regulators raise concerns about rising debt levels. We sat down with Goldman Sachs’ Christina Minnis and Vivek Bantwal, who run the firm’s leveraged loans business, to discuss their perspectives on the market.
You just hosted Goldman Sachs’ Fourth Annual Leveraged Finance Conference. What was the tone among investors -- especially in light of the Federal Reserve’s recent comments that the rise in leveraged loans could be a potential risk to the financial system?
Christina Minnis: Overall, the tone was constructive among the nearly 800 issuers and investors who attended this year’s conference. To be sure, there was chatter about unchecked risks. But while borrowing is up, leveraged loans are in the most secure part of a company’s capital structure – meaning that in a bankruptcy, loan holders would be the first to get all their money back. For credit investors, that’s where you would want to be -- in the senior secured part of the capital structure.
Vivek Bantwal: The market has also evolved over the past decade. It’s true that debt levels have crept up over the last 10 years and that “covenant lite” loans – or loans that offer limited protection for debt investors if a borrower runs into problems -- have become the market standard. But at the same time, companies’ earnings, cash flow generation and coverage ratios are more robust. In our view, that means the leveraged loan and high yield markets are safer than they were in the last downturn.
What’s more, the equity checks as a percentage of a leveraged buyout’s enterprise value are more robust, at around 40%. In other words, the amount of equity that private equity firms are contributing to buyouts is, on average, higher than levels we saw during the financial crisis. One area, however, that we’re watching closely is a recent loosening of loan documentation, which gives borrowers more flexibility but weakens lender protections.
In December, leveraged loans posted steep losses. How would you describe the market conditions today?
CM: The US leveraged loan market has rebounded in recent months amid stronger demand, tighter supply and improving technical conditions. One catalyst was the Federal Reserve’s more dovish tilt to keep interest rates low for longer. That essentially tempered the earlier-in-the-year phenomenon where investors were favoring fixed-rate bonds to floating-rate loans.
How has regulation affected the development of the market?
VB: The leveraged lending guidelines, which were implemented in 2013, essentially pushed the most levered deals out of the regulated banking market into the direct lending market where asset managers, private equity and hedge funds deploy loans directly to investors. The growth there has been significant and now represents about 20% of the leveraged loan market by volume. It’s an area that we’re watching closely.
Leveraged loans are often used to fund leveraged buyouts. What’s the outlook for transactions that are being financed by leveraged loans?
VB: We have seen a slowdown in the mega deals from last year because of the market downturn at the end of 2018. Those might take some time to return. We are, however, seeing a return to small deals, or transactions of $1 billion or less, with activity exceeding year-ago levels. We’re also seeing a pickup in deal activity in the $1 billion to $5 billion range.
CM: We would expect to see large deals to return to market. The private equity industry, for example, raised more than $800 billion in 2018 so there’s a lot of cash that could be deployed for big transactions, especially since the cost of capital is so low.