Hedge Funds Pile Into European Loans, Cut Costs as Rates Rise

Date: Tuesday, July 18, 2006
Author: Cecile Gutscher, Bloomberg.net

July 18 (Bloomberg) -- At a time when interest rates and defaults are rising, Europe's lowest-rated companies are having no trouble getting loans.

More than 100 European borrowers that can't get investment- grade credit ratings, from Yellow Pages publisher Yell Group Plc to Paris-based buyout firm Wendel Investissement SA, have raised a record $110 billion in 2006, just above last year's total and almost double the amount in 2004.

Companies have saved at least $275 million in interest costs this year because new lenders are piling into Europe, according to data compiled by Standard & Poor's and Bloomberg. Hedge funds and money managers, including Silver Point Finance LLC and Black Diamond Capital Management LLC, are providing most of the money because loans offer them more protection from defaults and the ability to profit from rising interest rates.

``The debt markets have become cheaper to access,'' said John Davis, Yell's chief financial officer, in an interview from his office in Reading, England. ``There are more providers of debt, and that has made the cost of financing more attractive.''

Yell would have struggled to raise the 4.6 billion pounds ($8.5 billion) it needed to buy Spain's Telefonica Publicidad e Informacion SA without the new fund managers, Davis said. Demand from hedge funds may help Yell cut its borrowing costs by a quarter percentage point to 200 basis points over the benchmark London interbank offered rate, reducing its annual interest expense by at least 3 million pounds, he said.

TDC Buyout

Danish phone company TDC A/S received offers for more than twice the 12.2 billion euros ($15.3 billion) it needed for a leveraged buyout in March, according to Royal Bank of Scotland Plc, one of the arrangers of the financing. The bank is the biggest organizer of high-yield loans in Europe, according to data compiled by Bloomberg.

TDC paid 237.5 basis points over benchmark borrowing rates on an eight-year loan. The company originally expected paying a premium, or spread, of 275 basis points. A basis point is 0.01 percentage point.

``These large deals wouldn't have been possible without the participation of funds,'' David Bassett, global head of loan markets at Royal Bank of Scotland in London, said. ``There's not enough liquidity at banks for such large transactions.''

More than 200 institutions buy leveraged loans in Europe, up from 50 two years ago, said Bassett. So many investors want to lend to companies rated BB+ or lower that the portion of new loans held by banks may fall below 50 percent by year-end, from 57 percent now, according to S&P. Two years ago, banks accounted for 75 percent, S&P data show.

Lower Borrowing Costs

So far this year, 119 companies have raised $110 billion, according to data collected by Bloomberg. In the U.S., 961 companies have raised $321 billion.

Hedge funds, known for wagers such as George Soros's bet against the pound in 1992, are increasingly looking to the loan market for safer investments, says hedge fund manager Simon Richards, who buys high-yield loans for RAB Capital in London. The firm manages $4 billion of assets.

``Institutions are looking at deals that had previously gone entirely to banks,'' Richards said. ``The expected losses associated with senior secured loans are relatively low.''

Loans are attractive to hedge funds now in part because default rates are forecast by Moody's Investors Service to double this year. Lenders typically recover twice as much as bondholders and wield greater control over management in a bankruptcy, according to Moody's.

Beating Bonds

Investors have profited from lending to junk-grade companies, as the average interest spread over interbank rates narrowed. Loans from junk-rated companies in the U.S. returned 1.12 percent in the second quarter, according to Lehman Brothers Holdings Inc. By contrast, bonds sold by U.S. high-yield companies returned 0.25 percent during the same period.

German plumbing supplier Grohe Holding GmbH's term loans due in 2012 that pay 250 basis points over the euro interbank offered rate are trading at 100.375 percent of face value, according to Bank of America Corp. The loans are mainly held by funds. By contrast, the Hemer, Germany-based company's 8.625 percent bonds trade at 96 cents on the euro, less than their issue price.

The European Central Bank probably will lift its target rate for overnight loans between banks to at least 3.25 percent by February from 2.75 percent currently, according to all of 21 economists surveyed by Bloomberg.

Floating Rates

The likelihood that rates will continue to rise makes lending more attractive than buying fixed-rate bonds, said Zak Summerscale, who oversees 4.25 billion euros of high-yield loans at Babson Capital Europe Ltd. in London.

``Loan demand is absolutely huge these days,'' Summerscale said. Babson buys loans and then packages them into bonds for sale to investors such as insurance companies and pension funds as collateralized loan obligations.

European fund managers have raised 12.4 billion euros of CLOs this year, surpassing the 11.7 billion euros raised during all of 2005, according to Deutsche Bank AG research. In the U.S., CLOs totaling $31 billion were created this year, compared with $41.6 billion during all of 2005.

The abundance of credit is allowing companies to make bigger acquisitions and use less of their money. Buyout firms borrowed the equivalent of six times the annual cash generated by the companies they acquired in April, the highest level since the late 1990s, according to S&P data.

Orangina, the French soft-drinks maker bought by New York- based Blackstone Group LP and Lion Capital for 1.85 billion euros last year, borrowed seven times cash flow, or earnings minus tax and interest payments.

Regulator Warnings

Regulators are warning about the dangers of rising corporate debt. The Bank of England last week said a ``relatively low cost of capital'' may encourage companies to borrow too much, making them vulnerable in a recession.

Hedge funds magnify risks for companies, according to Max Roemer, managing partner of Frankfurt-based buyout firm Quadriga Capital. He tells bankers he doesn't want hedge funds to participate in his loans because they are less likely to keep lending if business sours.

``If corporate profits fall, a lot of companies will be under pressure,'' said Edward Eyerman, who assigns credit rankings to high-yield loans for Fitch Ratings in London. Hedge funds may ``threaten a company with bankruptcy if they don't get the deal they want in a restructuring.''

Staying Solvent

Banks have an interest in keeping companies solvent to get other fee-paying business, such as bond underwriting and merger advice. When chemicals maker Rhodia SA overstepped borrowing limits in 2004, hedge fund managers including Soros demanded immediate payment on $290 million. Rhodia's bankers, including BNP Paribas SA and Royal Bank of Scotland, lent Paris-based Rhodia the money to stay in business.

Black Diamond, an $8 billion hedge fund manager based in Lake Forest, Illinois, last month opened a London office. Europe's loan market holds ``excellent growth prospects,'' said Senior Managing Director Bill Bokos in a statement when the London office opening was announced in April.

Greenwich, Connecticut-based hedge fund Silver Point, with $5.5 billion in assets, has lent money to companies such as KarstadtQuelle AG, Germany's largest department-store owner, and Italian Internet provider Tiscali SpA since opening a London office last year. Jim Karp, whom Silver Point hired from Goldman Sachs Group Inc. to run its European business, declined to comment.

Developers to Doughnuts

Hedge funds and money managers in the U.S. account for three-quarters of lending to junk-rated companies, S&P data show. Silver Point provided credit to Salton Inc., the Lake Forest, Illinois-based maker of George Foreman indoor grills, and Krispy Kreme Doughnuts Inc., based in Winston-Salem, North Carolina, as both struggled to avert bankruptcy last year.

Wendel Investissement cut its loan cost by 12.5 basis points to 2.125 percentage points over benchmark rates after 31 investors offered to join the 1.9 billion credit. Lenders outside banks will provide Wendel with half of the loan to buy building materials supplier Materis.

``The appetite is so great at the moment,'' said Wendel Managing Director Yves Moutran in an interview from his office in Paris. ``For the risk they took, they were reasonably well paid.''

BNP Paribas arranged the loan. Citigroup Inc., Deutsche Bank, Goldman Sachs and HSBC Holdings Plc are organizing Yell's deal.

``Obviously we'd like to think our loans will end up with long-term investors,'' Yell CFO Davis said. ``But if it ends up with hedge funds, c'est la vie.''