Standard and Poor’s Ratings Services today published a study of recovery rates for the European leveraged loan market, which shows strong recoveries for senior debt that are akin to those seen in the U.S. market.
The full report is titled “Europe’s Senior Loan Market Delivers A Strong Recovery Performance Over Its First Cycle”. Subscribers to RatingsDirect can access the research piece at www.globalcreditportal.com. Alternatively, to purchase/access the report, please contact Client Support Europe: +44 20 7176 7176 or [email protected].
The report describes the years between 2002 and 2008 as the first real cycle for Europe’s expanded leveraged finance market. Following rapid growth in the European market – to a €165 billion peak of new issuance in 2007 – the market hit severe turbulence, and the trailing default rate for leveraged companies reached 14.7% in the third quarter of 2009.
In its preliminary study, published today, S&P focuses on 101 known defaults. It reports that recovery rates so far on European first-lien debt have remained strong throughout the cycle, with a mean nominal recovery rate of 76% by value between 2003 and 2010. This is comparable with the U.S. experience between 1987 and 2011, where the mean nominal recovery rate is 83.7%.
However, this European recovery rate must be treated with care, S&P writes, since it includes a high volume (65%) of interim recoveries, mainly debt exchanges. Focusing on ultimate recoveries only the recovery rate is lower, with a mean of 63%.
This difference is attributed to the high percentage of interim recoveries in which debt has been rolled over or extended. As these interim situations are tracked over time, they may eventually recover less when ultimate recoveries are calculated.
The report shows that between 2003 and 2010, more than 120 first-lien debt instruments have an interim recovery rate of 90-100%, but looking at final recoveries, fewer than 20 fall into this category.
S&P holds the view that “the default rate over the past two years was artificially depressed by the accommodating behavior of senior lenders”, who were keen to minimise book losses while capitalising on amendment fees and higher spreads. This could change, however, as regulation and pressure to reduce risk-weighted assets cause banks to take a tougher line on non-core assets and on dealing with loan exposures to over-levered businesses.
Comparing first-lien recovery rates for publicly rated companies and those with credit estimates shows better results for the latter. “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%,” S&P says, although it notes that certain large defaults drag down the recoveries for publicly rated companies.
The report also looks into recovery rates in different European countries, and in a point that might surprise market participants, finds that recoveries for jurisdictions that are considered less friendly to secured creditors – namely France and Spain – are as good as, or better than the U.K.
The U.K. shows an average recovery rate of 71.4%, versus 75.8% in France and 89.2% in Spain. The sample size for some countries is relatively small, however, S&P warns.
The sub-debt experience
S&P’s study records very similar recoveries for second-lien and mezzanine debt – mean recoveries for the former are 31%, versus 30% for the latter.
In light of this, S&P suggests that the description of second-lien as “underpriced mezzanine” is more accurate for its sample than describing it as “stretched senior”.
S&P traces 30 second-lien defaults, and based on value, more than 83% of these have a recovery of less than 10%.
The report proposes that one reason second-lien has such low recoveries is because the small size of the tranche means it typically has a binary result: zero or full recovery in case of default. “A small incremental difference in the enterprise value of a company at default can result in a large shift in the value available for a lower-lien debt holder,” the report says.
The mezzanine story is similar – 81% of the 54 tranches captured by S&P’s study recovered less than 10%. A higher proportion of mezzanine tranches enjoyed recoveries in the 90-100% bracket, compared to second-lien, thanks to instruments that had their interest converted to PIK, which the agency counts as a default but an interim full recovery.
However, ultimate recoveries will only become evident over time, in part because of the value of equity given to subordinated lenders. Unless there is evidence to the contrary, S&P initially assigns the equity a zero recovery.
Equity was handed over in 63% of second-lien cases, although almost 70% of these received less than 5% of the total equity in the restructured entity. But in 7% of cases, the second-lien lenders took a much more substantial chunk of equity – more than 40% – and for these lenders there is material upside that will eventually feed into the ultimate recovery.
S&P adds the caveat that its study to date of second-lien may not be representative of the experience of the overall asset class in Europe, since these are the early defaulters.
Lastly, turning to the small number of senior-unsecured instruments within the study – mainly speculative-grade bonds – S&P notes that the mean recovery values are close in line with S&P’s U.S. data. This debt shows a mean recovery of 48% in Europe between 2003 and 2010, compared with 51.8% for the U.S. long-term empirical average.
For more on the U.S. experience, see “Default, Transition, and Recovery: Recovery Study (U.S.): Piecing Together The Performance Of Defaulted Instruments After The Recent Credit Cycle,” published Dec 1, 2011. – Ruth McGavin