Hedge funds set to become dominant lender class

4 September 2006, London – Close Brothers, Europe’s leading independent corporate finance house, has carried out research that shows the phenomenal growth of the European leveraged loan market and that traditional banks now hold only a small proportion of the leveraged loans they arrange. 

The banks, who traditionally represented a relationship and point of stability for corporate borrowers throughout the business cycle, now typically hold relatively little economic interest in the loan following syndication, compared to historic levels, with economic influence passing to non-bank institutional lenders.

Growth in European leveraged loan issuance

Close Brothers research shows that the size of the European leveraged loan and secondary debt markets has increased dramatically in recent years.  The European leveraged loan market has grown from c. €30–35 billion in 1998, through €150–185 billion in 2001, to €400–500 billion in 2005, depending on the source data and definitions used.  In terms of geographic spread, from 2001 to 2005, the size of the UK leveraged loan market grew by 2.0x, Germany 6.5x, Spain 4.0x, France 3.5x and Italy 2.5x.

Commenting on this research, Andrew Merrett, a Director in the European Special Situations Group at Close Brothers, said:

“This is a huge escalation in the amount of debt companies are carrying.  Many of these loans are equity by another name, and have been made to borrowers of poorer credit quality.  This in itself will cause default rates to rise whatever happens in the wider economy.  But, with the upward pressure on interest rates, these structures will be severely tested.  And there’s going to be fall out.”

Growth in non-bank lenders

Market practice today is that the proportion of interest-only tranches of leveraged loans being allocated to non-banks is reaching 75%.

The non-bank lenders taking up the syndication are mainly CLO funds (collateralised loan obligation) and hedge funds.  The traditional banks’ role is now, increasingly, to arrange and distribute these loans, retaining a much lower direct economic interest.  The presence of these new players, and the increased liquidity they bring, is driving three effects in the loans market: (i) higher leverage in corporates, (ii) better terms for corporates; and (iii) lending to lower credit quality corporates.

CLOs are unable to hold distressed debt for regulatory reasons, so where there is a risk of default they are forced to sell debt into the secondary market, where it is typically bought by distressed debt traders and hedge funds.  This is in addition to traditional relationship banks tending to now sell problem loans into the secondary market rather than work them out.  It is estimated that the European secondary loan market grew to approximately €40-45bn in 2005.

Commenting on these findings, Andrew Merrett said:

“People are just waking up to the fact that hedge funds are here to stay.  This shows they are going to be the dominant force in restructuring.  Now, in leveraged or distressed situations, it's hedge funds calling the shots from the creditors’ camp.”

The prevalence of non-bank lenders has led to an erosion of the established rules and frameworks for the work out of distressed situations.  They will no longer be relevant in an environment where relationship banks have a small economic interest.  The new techniques and approaches adopted by hedge funds will be increasingly common for the distressed corporate and private equity sponsors.

The trading mechanism for bank debt does not necessarily allow the corporate borrower or sponsor to know when a trade occurs, or to whom the economic interest has been sold.  Companies and sponsors could be blind as to who the underlying economic investors in their loans are.

Andrew Merrett comments:

“It’s a whole different ball-game in stressed and distressed situations, and the signals are that default rates are set to rise.  Companies and private equity sponsors need to be prepared for this.”

Enquiries:
Justin Clark

Close Brothers Corporate Finance

+44 (0)20 7655 3784