OREANDA-NEWS. Fitch Ratings says that single 'B' category European borrowers continued to favour leveraged loans over high-yield bonds for sponsor-backed leveraged buy-outs (LBOs) in 1Q16. Private equity firms have been taking advantage of high senior leverage and borrower-friendly terms available in all-loan structures as the median senior debt to EBITDA multiple reached 5.1x in 1Q16 and covenant-lite and loose documentation prevailed in new issuance.

In its latest 'European Leveraged Loan Chart Book', Fitch highlights that loan issuance proved resilient in 1Q16 because financial sponsors eventually increased their equity or quasi-equity contributions to finance European LBOs. Higher shareholder injections have been a response to sustained high enterprise valuation (EV) multiples around 9.5x EBITDA and a decline in total gross leverage to 5.2x in 1Q16 from 5.6x in 1Q15 due to the lack of attractively-priced junior debt available in today's market.

Junior debt has become increasingly rare in new European LBOs. Fitch observed only three transactions out of 14 featuring second-lien debt and none with mezzanine in 1Q16. Fitch expects credit investors to remain selective on subordinated debt issues and focus on higher quality credit profiles as subdued economic conditions prevent most companies with junior debt from growing into their capital structure and deleveraging.

As financial sponsors remain the main source of supply in Europe's leveraged loan market, their ability to beat trade buyers in auctions for European assets is critical to maintain leveraged loan volumes. Competition from trade buyers on larger assets with debt above EUR500m has been fierce.

The recent vendor auctions of Philips Lighting business, which opted for an IPO, and the disposal of global assets from the Ball/Rexam packaging combination going to Ireland-based Ardagh Group represent the latest examples where sponsors have failed to compete. Financial sponsors are effectively forced to target smaller companies with total debt below EUR500m as well as niche sectors where competition is more limited.

In 1Q16, sponsors continued the 2015 trend towards smaller primary market borrowers. These are often less competitive with IPO and trade buyers and typically promise top line and operating profit growth or the scope for synergies in combination with existing sponsor-owned assets. As a consequence, the overall credit quality of Fitch's leveraged credit universe is likely to remain weak. Around 50% of the 406 European leveraged credits as of March 2016 carried an Issuer Default Credit Opinion (IDCO) of 'b-*' or below and small issuers tend to cluster around the 'b-*' level as well, because their business models are often vulnerable and execution risks exist over their deleveraging plans.

However, Fitch expects European leveraged loan defaults to remain low in 2016. Long-dated debt maturities beyond 2020, satisfactory liquidity position and debt service capacity for most European issuers support a benign default outlook. The 'at-risk' portfolio, comprised of b-* with negative outlook or below credit opinions, has declined as of March 2016 compared with March 2015. Notable exceptions to the generally stable performance trend are the non-food retail, lodging and restaurant sectors which stand out as the most stressed. For future distressed credits, Fitch expects that senior debt recoveries will remain under pressure given the persisting high senior leverage in primary market transactions and the reduced role of loss-absorbing junior capital since 2014.

Fitch's latest "European Leveraged Loan Chart Book", is available on www.fitchratings.com or by clicking the link above. It includes updated data on primary market trends, loan performance, median credit statistics for different cohorts of issuers as well as recent trends in default and recovery rates. In this edition, the agency has segmented its statistics on issuance, covenant structures and median financial metrics by borrowers' debt size (below EUR200m; between EUR200m and EUR500m; above EUR500m). The data and analysis is based on Fitch's portfolio of private credit opinions, private ratings and public ratings on about 400 European leveraged credits (as of 31 March 2016), primarily LBOs, representing about EUR345bn of committed senior and junior debt.