One aspect of financial markets confirming the optimistic tone of M&A markets is the upturn in leveraged finance volumes in 2017. Figures from Moody’s show that leveraged finance volumes for the first half of 2017 were US$143bn. This is 8.7% higher than the figure for the whole of 2016, and 143% up on the same period last year.
The usual definition of leveraged finance is that the company receiving the funding has debt levels of more than four times EBITDA; and while M&A is only one of many reasons for such companies expanding their balance sheets, the report shows that M&A was a significant reason for the finance raised, with April and June being especially busy for the issuance of loans.
Acquisitions Daily spoke to Bernd Bohr, partner at the global law firm Mayer Brown, to get an explanation of exactly what is happening in the market, and why.
Bohr emphasised that the while the numbers do show an upturn, they are in no sense a record. Bohr said that the numbers “are not even close to peak” He added that much of the activity in any case relates to the refinancing of loans at lower rates, although there has also been some increase in leveraged buyouts (LBOs) over the last two to three years.
Something else the numbers do show clearly is that there has been a strong upturn in the number of loans issued compared to bonds of late. Almost twice the volume of loans have been issued compared to the amount of bonds, with refinancing accounting for a substantial part of the volume.
Bohr makes a number of points in this regard. The leveraged loan market in Europe has only really developed in Europe in the last ten years, and this upsurge partly reflects the maturity and improved liquidity in the European market. But it also says much about the relative attractions of loans against bonds at this point in the cycle. Also loans have historically been paying a floating rate, based LIBOR, but the fixed rate loan market has also expanded in recent years.
Moreover, loans have tended historically to come with a maintenance covenant, which requires financial tests such as a debt to cash flow ratio to be met in every reporting period. This can create problems for cyclical industries, but Bohr says that there has been a: “dramatic erosion in covenant terms” in recent years. He even talks of the “death of the maintenance covenant,” in the face of a highly competitive market, in which the relationship between borrower and lender has shifted in favour of the borrower. At the same time transaction costs in issuing bonds has also risen sharply.
All these dynamics, in addition to enduring low interest rates, work in favour of companies seeking to take on more borrowing to finance capital expenditure. Especially for those aiming to finance long-term projects or thinking that bond yields may be about to rise, this seems a good time to raise capital or refinance. Indeed the relationship between borrower and lender seems unlikely to change in the near future in the absence of an unforeseen event. This is directly supportive of more acquisition activity at a time when low economic growth and low inflation make organic growth difficult.
Bohr says that that companies and countries that might until recently have been regarded as too risky are now coming to the market and able to access finance. He underlines that many debt funds need to deploy their capital. For instance there has been a resurgence in lending to metals and mining companies as confidence has grown that the bottom of the cycle has been reached.
The clear message seems to be that the rise in leveraged finance is not a short term aberration but a consequence of structural changes in markets, allied to the economic condistions which are set to endure. This suggests that many companies for whom acquisitions were an unlikely aspiration a few years ago are now likely to be looking to do deals for the first time.