43
Fitch’s View on the European Leveraged Credit Market: Present and Future Marco Cecchi de’Rossi Managing Director University of Castellanza Castellanza (VA) 8 November, 2006
Fitch’s View on the European Leveraged
Credit Market: Present and Future
Marco Cecchi de’Rossi
Managing Director
University of Castellanza
Castellanza (VA)
8 November, 2006
Agenda
An Introduction to Fitch
Fitch’s View of the Leveraged Credit Market
Ratings Migration and Recovery Prospects
2
An Introduction to Fitch
> Fitch is an international ratings agency, dual-headquartered in
the US and Europe
> Fitch rates
– Over 1,300 Corporates
– 99 Sovereigns and 132 Sub-sovereigns
– 81,000 Municipal transactions
– 5,600 Financial Institutions
– 1,400 European, 6,500 US and 300 Asian Structured Finance
transactions
> Fitch employs almost 2,000 people in 50 offices worldwide
3
Global Presence (August 2006)
Mexico City
San Francisco
San Jose
San Salvador
Lima
Santiago
Bogota
ChicagoToronto
Paris
Colombo
Mumbai
Johannesburg
Tokyo
Beijing
Hong Kong
Seoul
Bangkok
Singapore
SydneyBrisbane
Taipei
New York
McLean
AustinTampa
Powell
La Paz
Quito
São Paulo
Rio de JaneiroBuenos Aires
Montevideo
Caracas
Frankfurt
Milan
BarcelonaTunis
Warsaw
Istanbul
Moscow
London
KolkataChennai
New
Delhi
Kuala Lumpur
Jakarta
Monterrey
Dubai
Madrid
Tunbridge Wells
4
Fitch in Leveraged Finance
> Fitch currently rates approx. 400 European Leveraged Credits,
both public and private
– 10 dedicated Leveraged Credit analysts
– 50 Sector specialised Corporate analysts
> Wide market acceptance for bespoke research such as:
– Debt market trends: Second Lien, Mezzanine, HY
– Structures and new instruments: Rating Holdco PIK Notes
– Market-specific trends and developments: 2nd Lien, Mezz, HY,
Recaps
> Fitch’s private rating clients are leading European asset
managers, including
– Harbourmaster, ECM, ICG, Mezzvest, Highland, Invesco, Cheyne,
Alcentra, Lehman Bros., Goldman Sachs, Avoca, Mizuho
5
Fitch’s Public Market Coverage
> Fitch’s public HY rating effort was launched in 2003
> Fitch’s coverage extends to 45% of the Merrill Lynch HY Index
(by market index weight), or 49% pro forma for recent / imminent
coverage infill
– Mandated ratings
– Fitch Initiated ratings
> Fitch targets 70% coverage by YE07
> Fitch rates 13 (or 65%) of the Top 20 Leveraged European HY
Issuers (by index weight)
> Fitch aims to increase coverage to at least 80% of the top 20
by Q107
6
Yes14. SEAT PGNo4. Ineos
Yes13. FreseniusYes3. TDC
Yes12. NTLYes2. Ahold
No15. DegussaYes5. Rhodia
No18. VimpelcomNo8. VNU
Yes17. BasellNo7. ISS
20. TUI
19. Corus
16. Ladbroke
11. SKG
Issuer
No
Yes
Yes
Yes
Fitch Rated?
Yes10. Alcatel
Yes
No
Yes
Fitch Rated?
9. WIND
Issuer
6. Allied Domecq
1. FIAT
Fitch’s Public Market Coverage
Source: Merrill Lynch, Fitch
Merrill Lynch Index: Top 20 European Leveraged Corporate Issuers
7
Fitch’s Market Relevance
> Fitch offers more detailed research products
> Analysts average less than 10 public credits each
> Ratings actions and analysis are timely, relevant and accurate
> Recent examples include:
– Affirmation of Brake Bros at B+ on PIK Notes issue in September
2006
– Downgrade of Focus DIY to CCC from B- in September 2006
– Upgrade of Telenet to BB- from B+ in August 2006
– Affirmation of Vendex at BB- on PIK Notes issue in May 2006
– Downgrade of NTL to B+ from BB- in March 2006
8
Fitch’s Market Impact: Focus DIY
Fitch downgrades Focus
DIY to B- (Negative) and
Mezz Notes to CCC+
Fitch downgrades
Mezz Notes to CCC
Moody’s downgrade
Focus to B3
Fitch downgrades
Focus to CCC
(negative) and Mezz
Notes to CC
9
Fitch’s Market Impact: Vendex (Maxeda)
Fitch upgrades
Vendex Notes to B+
Fitch affirms Vendex
on PIK issuance;
S&P downgrades
Bonds recover to
pre-PIK levels
10
Fitch’s Market Impact: Telenet
Fitch upgrades Telenet to
B+; Senior Notes to BB;
Senior Discount Notes to B+
Fitch upgrades
Telenet to BB-to B+
11
Fitch upgrades to BBB-
Feb 21, 2005
S&P upgrade to
BBB- Feb 28, 2005
S&P upgrade to
BB+ Nov 10, 2004
Fitch upgrade to BB+
Sep 6, 2004
Source: Bloomberg Fitch
Spread to mid asset swaps – Bloomberg
Fitch’s Market Impact: Ericsson
An Introduction to Fitch
Fitch’s View of the Leveraged Credit Market
Ratings Migration and Recovery Prospects
Sector Specifics: Retail, Autos, Chemicals, Cable
Recovery Ratings Case Studies
13
Leveraged Credit Market Trends: Growth
0
20
40
60
80
100
120
140
160
180
2002 2003 2004 2005 H105 H106
(EURbn)
0
20
40
60
80
100
120
140
160
180
200
Western European Leveraged Transaction Volumes (LHS)
Western European LBO Transaction Volumes (LHS)
No. of LBO Transactions (RHS) (No.)
European Leveraged/LBO Issuance
Source: LPC
14
Leveraged Credit Market Trends: Liquidity
> Unprecedented levels of depth and diversity in the market
– Any cash-generating company
– Any size
– Any industry
> Combination of leveraged products
– More flexibility for arrangers
> Stable markets and strong returns for financial sponsors and CDOs fuel new fund-raising and excess liquidity
> Supply-demand imbalance leads to rising tolerance for
– aggressive structures
– higher financial risk
15
Leveraged Credit Market Trends: Leverage and
Credit Quality
> Leverage continues to rise, though weighted average pricing
remains static
– Weighting towards more expensive, albeit longer-dated senior
B/C tranches
– Downward price flexing
> Deteriorating average credit quality
– Increasing number of covenant waiver requests
– High refinancing risk from back-ended debt structures
– Looser covenants
– Complex capital structures
16
Leveraged Credit Market Trends: Leverage
3
4
5
6
7
8
9
10
2001 2002 2003 2004 2005 YTD Q306
Average EV Multiple Average Total Leverage Average Senior Leverage
Average EV and Leverage multiples have reached a new record high
Evolution of Multiples in Fitch-Rated Leveraged Transactions
Source: Fitch
17
Leveraged Credit Market Trends: Leverage
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
2000 2001 2002 2003 2004 2005 Q106 Q206 Q306
To
tal
De
bt/
EB
ITD
A
RLCP TMT Industrials Energy Total Market
Source: Fitch
Average Total Leverage by Sector keeps Rising…
18
Leveraged Credit Market Trends: Credit Quality
2000 2001 2002 2003 2004 2005 Q106 Q206 Q306
RLCP TMT Industrials Energy Total MarketBB
BB-
B+
B
B-
Source: Fitch
Average IDR for New Fitch-Rated Leveraged Deals
(including Recycled Transactions)
…Leading to a Deterioration in Credit Quality
19
Leveraged Credit Market Trends: Junior Debt
0
10
20
30
40
50
60
Q403 Q104 Q204 Q304 Q404 Q105 Q205 Q305 Q405 Q106 Q206 Q306
(EURbn)
0
10
20
30
40
50
60
70
80
90
100
LTM HYB Issuance (LHS)LTM Second Lien Issuance (LHS)LTM Mezzanine Issuance (LHS)Sec Lien+Mezzanine (% of Total Junior Debt Issuance) (RHS) (%)
Source: Fitch
20
Leveraged Credit Market Trends: High Yield
> HY issuance slowed in 2005, but has bounced back in 2006
– 2006 already a record year with over EUR30bn issuance
> Competition from second lien and mezzanine tends to leave HY only for
the largest deals…
– NXP EUR4.5bn equivalent
– Ineos EUR2.4bn equivalent
– TDC EUR2bn equivalent
> Evolving market standards
– Substitution threat drives capitulation on call protection
– Marked increase in FRNs
> Better mix of LBO, Cable and Corporate issuance
> Stronger credit profile than the private market
21
Cable
7.9%
LBO
27.6%
Corp.
64.4%
B
45%
BB
45%
CCC-C
10%
HY Business Mix and Ratings Profile
New Issues: Diversification YTD 2006
Ratings Distribution(European HY Market Q306)
Source: Fitch, Bloomberg Source: Fitch, Bloomberg
22
Leveraged Credit Market Trends: Mezzanine and
Second Lien
> Mezzanine and Second Lien volumes continue to rise
– Constitute approx. 40% of junior debt issuance
– 2006 – a record year for both mezzanine and second lien
> Substitution threat to HY due largely to greater prepayment
flexibility
> Latest example threatens even jumbo HY
– EUR1bn Mezzanine tranche for Casema/Multikabel/Kabelcom
> More aggressive capital structures than most HY
– Higher leverage
> Average Leverage for B+ and below IDRs: 6.5x for mezz, 5.3x for HY
– Recaps funded by cash-pay secured debt
– Mezzanine further subordinated
> Low expected recoveries for private junior instruments
23
Leveraged Credit Market Trends: Default Rates
> Low default rates until now:
– 0.3% in the HY Market; 2.4% in Mezzanine
> Fuelled by
– Steady economic growth and corporate profitability
– Extended period of low interest rates; flat curve
– High levels of liquidity; covenant resets and waivers are commonplace
– New structures require little or no debt amortisation
> But clouds are gathering
– Short Term interest rate rises
– Raw material price increases / volatility
– Exposure to global trends (US homebuilding; China demand)
> And credit risk is increasing
– WATCH Fixed Charge Cover levels
– Need for new money given back-ended debt structure = distress
24
Leveraged Credit Market Trends: Default Rates
* Adjusted for “distressed” mezzanine deals (rated “CC” or below at time of last update)
Source: Fitch
0
100
200
300
400
500
600
Q4
01
Q1
02
Q2
02
Q3
02
Q4
02
Q1
03
Q2
03
Q3
03
Q4
03
Q1
04
Q2
04
Q3
04
Q4
04
Q1
05
Q2
05
Q3
05
Q4
05
Q1
06
Q2
06
Q3
06
(EURm)
0
1
2
3
4
5
6
7
Mezzanine Adjusted "Defaulted" Volume (LHS)*Mezzanine Defaulted Volume (LHS)EHY Default Rate (RHS)Annual Default Rate (Adjusted) (RHS) *Annual Default Rate (RHS)
(%)
25
Leveraged Credit Market Trends: Default Rates
> Defaults in the short term likely to be seen in some legacy
(2003/4) deals which have not already been refinanced…
> …But in the longer term, refinancing risk has increased
significantly for many recycled deals
– Refinancing alone will be unable to provide a solution
> Fitch does not expect a significant increase in default rates
before late 2007/8
– Default rates are obscured by “refinancings”
> Certain troubled sectors will continue to experience difficulty, as
opposed to defaults across the board
– Auto supply
– Retail and consumer products
26
Leveraged Credit Market: Fitch’s Take
> Arrival of non-bank credit investors has eroded many of the premises of European leveraged credit
– Senior and total debt levels rise to historic highs
– Pricing declines
– Credit monitoring deteriorates through weaker covenants
– More complex capital structures = more complicated intercreditorarrangements
– Interests of sponsors and subordinated creditors increasingly misaligned
> Warrants and call protection have largely disappeared
– Sponsor community de-emphasises deleveraging in favour of
> Back-ended amortisation profiles
> Dividend recaps driven by expanding multiples
> Buy-and-build strategy – add-on acquisitions funded by debt
> Excess liquidity masks the risks of the market
27
Leveraged Credit Market Trends: Outlook
> Current aggressive market conditions are unlikely to be
dampened until default rates start to rise
> Recoveries will be compressed when the market turns, due to
– Current record high levels of leverage
– Lack of amortising senior debt structures
– Multi-layered debt structures
> Fitch’s new Recovery Ratings Methodology is designed to
assess this risk
> The results are compelling…
An Introduction to Fitch
Fitch’s View of the Leveraged Credit Market
Ratings Migration and Recovery Prospects
Sector Specifics: Retail, Autos, Chemicals, Cable
Recovery Ratings Case Studies
Ratings Migration and Recovery Prospects:
High Yield compared to the rest of the
Leveraged Credit Market
30
Recovery Ratings
> A major innovation by Fitch
> Splits Probability of Default and Loss Given Default
> USD1,400 billion of debt and other obligations affected
> Only published at ‘B+’ and below (over 300 entities), but affects
all rated entities
– All countries
– All types of debt obligation, not just bank loans or high yield
– All international scale ratings
– All corporate sectors, including banks, insurance and finance
companies
> Supported by detailed recovery analysis
31
Fitch’s Rating Methodology: B+ Issuers and Below
> Step 1: Assign an Issuer Default Rating (“IDR”)
– A rating addressing purely the probability of default as opposed to expected loss
– Derived through traditional credit analysis
> Step 2: Assign Recovery Ratings to every instrument in the capital structure
– Derive a distressed EV
– Allocate distressed value to investors (strict waterfall)
– Jurisdictional Issue (capping senior secured ratings)
> Step 3: Notch the Debt Instrument Rating Up or Down from the IDR to reflect Expected Recoveries
> More detailed examples in the Case Studies to follow
32
Typical Cash Flow ‘Haircuts’ used in Analysis
Range of percentage discount applied to cash flow
10 20 30 40 50 60 70 80 90 100
Aerospace/Diversified
Airlines and Gaming
Auto Parts
Chemicals/Health Care
Consumer
Energy/Commodities
Food and Beverage
Homebuilders
Retail
Technology, Media
Telecom/Cable
33
Typical Cash Flow Multiples used in Analysis
1x 2x 3x 4x 5x 6x 7x 8x 9x 10x
Aerospace/Diversified
Airlines and Gaming
Auto Parts
Building Products
Chemicals/Health Care
Consumer
Energy/Commodities
Food and Beverage
Retail
Technology, Media
Telecom/Cable
34
Likely Recoveries and R Ratings
RR351-70
RR271-90
RR191-100
Corresponding R RatingLikely Recoveries (%)
RR4*31-50
RR511-30
RR60-10
* Typically, this is the Implied Recovery Rate Carried by the IDR
Considered to be “Average” Recovery Prospects
35
Weighted Average Recovery Rating by Sector
68%
40%
44%
68%
59%
37%
51%
0%
20%
40%
60%
80%
100%
Aero. & Def. Auto. &
Related
Basic Matls. Consumer
Prods.
Food, Bev.,
Tob.
Power & Gas Health &
Pharma
RR4 range WARR
Global corporates, senior unsecured debt, by par value USD
Source: Fitch
RR1
RR2
RR3
RR4
RR5
RR6
36
Weighted Average Recovery Rating by Sector
60%
42%
5%
54%
34%
24%
43%
45%
0%
20%
40%
60%
80%
100%
Home-
building
Ind Prod
/Svcs
Media Retailing Tech-
nology
Telecom Transport Total
RR4 range WARR
Global corporates, senior unsecured debt, by par value USD
Source: Fitch
RR1
RR2
RR3
RR4
RR5
RR6
37
Fitch’s European Speculative Grade Ratings
B-
32%
B
37%
B+
15%
CCC and below
7%
BB- and above
6%
IDRs
(328 ratings)
2nd Lien RR
Source: Fitch
RR5
0%
RR4
2%
RR1
20%
RR3
27%
RR2
51%
RR6
83%
RR4
4%
RR3
1%
RR1
1%
RR5
9%
RR2
2%
RR6
87%
RR3
2%
RR4
2%
RR5
6%
RR1
1%
RR2
2%
Speculative Grade shadow ratings portfolio under new Methodology (Sep 06)
Bank Loan RR Mezzanine RR
38
Fitch’s Recovery Ratings Results are Compelling
> 71% of senior bank debt rated by Fitch achieves RR1/RR2
recovery ratings….
> …. Compared to only 3% of second lien and mezzanine
instruments…
> …And over 80% of these junior instruments achieve only an
RR6, as a result of
– Increasing EV multiples at the peak of the cycle
– Increasing Leverage multiples likewise
– Back-ended first priority debt amortisation profiles
– Lower equity contributions
– Mezzanine in particular further subordinated and taking “equity” risk
39
European Mezzanine Increasingly Out of the Money
0
2
4
6
8
10
H103 H203 H104 H204 H105 H205 H106
(EBITDA x)
Total LeverageEV/EBITDAMinimum Typical Distressed EV/EBITDA RangeMaximum Typical Distressed EV/EBITDA Range
Mezzanine Increasingly Out-of-the-Money
Source: Fitch
40
Fitch’s High Yield Recovery Ratings Portfolio
> Recent recapitalisation activity has left traditional HY largely
unaffected
– Holdco PIK Notes rank behind HY – deeply subordinated
> In contrast to mezzanine, which has been further subordinated
– Higher cash-pay debt levels in most private dividend recaps
– Introduction of second lien into “second-secured” position
> HY capital structures often carry less leverage, despite weaker
covenant protection (incurrence vs. maintenance)
> Therefore, Fitch’s bespoke recovery ratings indicate better
recovery prospects on average for high yield issues
41
HY Recovery Ratings Higher than in Mezzanine
Source: Fitch
RR6
87%
RR2
2%
RR1
1%
RR5
6%
RR4
2%
RR3
2%
Distribution of Recovery Ratings (by no. of Issues)
Issuers with an IDR of ‘B+’ or below
Mezzanine RR HY RRRR6
42%
RR4
29%
RR5
29%
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