After one of the most volatile years for the European leveraged loan market since the global financial crisis, the asset class is ending 2020 with a sense that conditions have, for the most part, returned to normal. This is not to downplay the difficulties faced over the past year, but rather the strong year-end for loans speaks to the resilience of the bid in the European leveraged finance markets.

Given the COVID-19 induced shutdown in March and April, it is unsurprising that year-on-year volume has fallen, with total issuance for the European loan market standing at €65.52 billion in the first 11 months of 2020, according to LCD, down from €80.33 billion in the same period in 2019.

Participants, however, have remarked how well their market has returned to health since the summer. Although volume has not returned to the record-breaking levels seen at the very start of the year — €17.22 billion of leveraged loan issuance was recorded in January alone — activity has restarted strongly in the second half of 2020.

LBO activity falls
The greatest blow to overall leveraged loan volume was dealt by the fall in LBO activity over the year. Auction processes stalled in March and April, and amid the global volatility, buyout volume plummeted. In the year to Dec. 4, just €20.75 billion of loan supply has been recorded for buyouts — the lowest such figure for that period since 2014.

But this is not to say credit markets weren't still ready and able to support large-scale buyouts, when they have come. For example, the jumbo debt package financing the €16.14 billion acquisition of thyssenkrupp Elevator AG by Advent International in the summer, which was the fifth-largest cross-border LBO financing completed since 2009, proved that funding capacity was still available.

As issuance returned in the second half of the year and investors' appetite grew alongside their confidence, pricing began to grind tighter.

This increase in appetite for paper was seen in the secondary market too, with the average weighted bid in the S&P European Leveraged Loan Index, or ELLI, rising to 97.3 by the end of November, having fallen to a low of 78.9 in March.

This return to competitive form is not necessarily good news for all, however, with bankers and investors bemoaning the almost overwhelmingly strong technical bid, with demand outstripping supply to drive loan terms ever tighter, and restoring a competitive edge to the market going into 2021. But after such a tumultuous year, when at times it seemed the market could be facing a long-term crisis, such worries for 2021 reflect a welcome return to normality.

Drivers to the upside:
Return to normality. The prospect of a COVID-19 vaccine and an end to lockdowns has boosted confidence globally, and in the European leveraged loan market, participants are welcoming a return to normal issuance conditions. Demand is rampant going into the new year, providing a supportive backdrop for new-money and opportunistic issuance, while volume looks set to return to pre-pandemic levels. “Defaults have not been as bad as people feared, CLOs are still ramping, and the secondary market is pretty much back to where it was,” said one market participant. “It's almost like we're back to normal, like the March sell-off never happened.”

M&A on the way. This renewed confidence will also prompt a wave of new M&A activity, especially buyouts. Already, large transactions such as the financing backing the buyout of U.K. supermarket chain ASDA and the funding for INEOS Styrolution Group GmbH's takeover of BP's petrochemical business are penciled in for launch in 2021, but more acquisitions are expected. Appetite is high among private equity sponsor firms, with some sources suggesting there is between $1.5 trillion and $1.7 trillion of dry powder available globally. On the selling side of the equation, those sponsors that have been left holding assets for longer than expected will be looking to strip out the dead wood from their portfolios, and corporates coming through the worst of the crisis will be looking to carve out non-central business departments to refocus on core activities.

Refinancings resurge. With demand surging, borrower-friendly issuance conditions are likely to continue, which will encourage many firms to opportunistically refinance, recapitalize, or even reprice existing transactions. Refinancings may also come from issuers looking to repay borrowings made on their revolving credit facilities during the crisis, or to refinance government loans made in 2020.

Drivers to the downside:
Ongoing volatility. While the COVID-19 vaccines announced late in 2020 have offered light at the end of the tunnel for market participants amid the pandemic, this development has not yet brought the crisis to a close. More lockdowns and further macro-economic instability could be on the way, while political events including Brexit, and the German federal elections in September could further weaken confidence.

Delayed reaction. Once the government-backed loans that have supported many firms throughout the worst of the pandemic — many of which have 12-month maturities — roll off, some companies may begin to struggle and the wave of defaults, waivers, and amendments that failed to emerge in 2020 could then hit. “Some firms have been trying to replace cash with debt,” said one senior market participant. “Once the tide goes out next year, we shall see who's been swimming naked.”

Higher leverage, lower pricing, and weaker docs. From an investor and bank point of view, terms look set to weaken in 2021. While borrowers are more levered than at the beginning of the year, having taken on extra debt to ride through the crisis, demand is high and still growing, with new collateralized loan obligation (CLO) warehouses heading back to levels seen before the pandemic, thereby pushing pricing tighter and eroding documentation (the European CLO market is the predominant investor segment in leveraged loans). In the three months to the end of November, average European term loan B yields returned to 4.59%, according to LCD, down from 4.93% in the three months to June. Of course, such tight pricing is regarded as an upside to issuance for borrowers and sponsors, and the last two months of 2020 have hosted a flurry of opportunistic add-ons, refinancings, and repricings as issuers look to take advantage of the strengthening market backdrop from their perspective.

The bond market. While loans will largely continue to be the asset class of choice for private equity sponsors, the red hot conditions in the bond market cannot be ignored. For top credits, a clear pricing benefit has opened up in issuing a bond over a loan, while risk appetite is higher in the bond space. Large LBO financings will also likely see high-yield take some of the market share, as underwrites try to drive pricing tension through the financing structure for deals.

Structural changes:
So long LIBOR. The Loan Market Association is already counting down to the end of 2021, when the sterling London Interbank Offered Rate (LIBOR) will stop being published. The rate will be replaced by the Sterling Overnight Index Average (SONIA), an unsecured rate that will be administered by the Bank of England. In the meantime there are a number of milestones to be hit, with the target for the final sterling LIBOR-linked loans set for the end of the first quarter next year. While there have been a number of SONIA-linked transactions completed in the high-grade loan market and documentation is available for all facilities under the new reference rates, there has been no such leveraged loan issuance yet, and some market participants remain unsure about the impact of the change. The step away from sterling-LIBOR will be the first of a chain of reference-rate changes globally, with the U.S. LIBOR set to be replaced by the Secured Overnight Financing Rate (SOFR), and the Euro Short-Term Rate (€STR) replacing EURIBOR.

Emergence of ESG. This year has seen Environmental, Social and Governance (ESG) criteria come to the fore of leveraged loan market participants' minds, and institutional funds note that this factor is of increasing importance to their own investors. While lenders are pushing for increasing transparency over issuers' ESG credentials — helped by initiatives encouraging more standardized disclosure from the likes of the European Leveraged Finance Association (ELFA) — more transactions with explicit sustainability-linked pricing ratchets are expected in 2021.

Earlier this year, for example, packaging firm Logoplaste Consultores Técnicos SA amended its outstanding term loan to include a pricing ratchet linked to ESG factors. This was the first sponsored institutional transaction to include sustainability language, but it has since been followed by Kersia and MásMóvil Ibercom SA, while the financing package backing Barings' takeover of Utac Ceram included the first ESG-linked unitranche financing seen in the market (a single facility that combines different types of secured and unsecured debt in a single loan with a blended interest rate). While ESG margin ratchets have now been seen on a number of deals, market participants note that other structures for ESG-linked lending could yet emerge, and become more standardized in the sector. “In reality, we're still in the very early days of focusing on ESG in the leveraged space,” said one senior banker. “There are lots of decisions still to be made, and we're yet to settle on the right method that will work across the market.”

Supply forecasts:
Banks have been broadly optimistic for European leveraged loan market supply in 2021, anticipating an increase in primary market volume. Barclays has forecast that issuance will return to levels seen in 2018-2019, with gross supply of roughly €75 million and net supply of roughly €23 billion in the coming year. The bank anticipates that this year-on-year rise will stem primarily from a recovery in M&A and LBO activity, with a greater proportion of this debt coming to the leveraged loan market over high-yield bonds. A strong issuance backdrop may also encourage more opportunistic refinancings, although the maturity wall for the ELLI for 2021-22 is low, with only roughly €10 billion due by the end of 2022.

J.P. Morgan reports that alongside increased M&A and buyout volume, more activity could come from European banks seeking to reduce exposure to corporate lending after their loan books expanded rapidly in the first half of 2020. The bank is anticipating a 2021 run-rate for European leveraged loans in line with 2019 figures, with €65 billion gross issuance, and roughly €30 billion net issuance. Moody's, meanwhile, has predicted that demand will continue to exceed supply in 2021, and that M&A activity will boost loan issuance volume above 2020 levels.