The expected future recovery rates on Europe’s first-lien secured debt are well below the historical average. Higher leverage, a lack of covenants and debt secured by share pledges rather than actual assets are underpinning this trend.
Recovery rates – broadly speaking, the amount that will be repaid to lenders in the event that the borrower defaults – are gaining increasing importance in the mind of market participants as the ratings composition of Europe’s sub-investment-grade universe shifts towards the lower end of the spectrum.
“In the old days, things were triple-B, and you didn’t care if recovery was 10% or 90% because the chance of default was tiny,” said David Gillmor, sector lead for European leveraged finance at S&P Global.
“Now, so much is in the single-B universe the risk of default is much higher, and if your portfolio is almost entirely single-B, chances are that one or two might default, and then your return is going to be heavily eroded if you get low recoveries.”
The average expected recovery for all European rated first-lien secured debt is around 58%, based on S&P’s calculations, which looks at EUR 650bn of senior secured speculative grade debt. This is a full 14.5 percentage points below the 2003-2021 historical average of 72.5%.
Breaking down the data by rating and instrument type, the average recovery expected on BB rated bonds and loans is 63% on both. For B instruments, the recovery on loans is estimated to be 58% and for bonds 55%, and in CCC+ and below tranches, recoveries of 51% and 49% are predicted for loans and bonds, respectively.
The sheer amount of leverage taken on by borrowers is one of the key causes of the divergence between expected and historic recoveries.
“One of the unintended consequences of having the US and European leverage guideline limits is that almost everyone then goes up to the guidelines rather than having leverage appropriate to the company or sector,” said Gillmor.
The average leverage of a sponsor-backed issuer raising financing in Europe’s high-yield or leveraged loan markets was 5.3x in 2022, according to Debtwire data.
The issue of leverage is also clouded by the use of EBITDA adjustments, making recoveries harder to predict. “There is a risk from inflated EBITDA,” said one buysider. “The risk is that you thought you were lending at 5x EBITDA and actually in reality you are lending at 7x.”
Although the EBITDA numbers that most loans and bonds are marketed off feature some adjustments, some issuers utilise the tool more than others, and while many are seen as entirely legitimate by potential investors, worsening economic conditions may make these adjustments harder for a firm to realise.
One example of a more heavily adjusted figure came in mid-2022, when the Italian contract development and manufacturing organisation Biofarma was marketing a EUR 345m Euribor+ 575bps May 2029 senior secured floating-rate note (FRN). Structuring EBITDA was more than 60% above the reported figure, as reported.
The structuring EBITDA behind Biofarma’s deal included some straightforward adjustments, such as EUR 9m in pro forma earnings for a recent acquisition, but also incorporated EUR 6.7m in "synergies" that the company expected to generate in areas like procurement, footprint optimisation and manufacturing efficiency.
When the Italy-based packaging company Reno de Medici was looking to place EUR 445m E+ 525bps December 2026 senior secured FRN during the final months of 2021, investors flagged the highly adjusted EUR 119m EBITDA, which included a EUR 43.5m "raw materials normalisation" adjustment.
Cov-lite and share pledges
Meanwhile, covenants included in the existing universe of debt are either non-existent or minimal. Whereas lenders used to have the ability to constrain and influence the behaviour of management teams and owners through financial maintenance covenants, this has now all but disappeared. A clear line can be drawn between this and lower expected recovery rates.
With no covenants, it can take longer for a company to default, causing more value to be eroded, said Gillmor.
Security is also not what it used to be, with lenders in many instances no longer having a claim over specific assets, but rather share pledges, potentially reducing their ability to enforce security and seize assets. “Typically, we don’t have asset security these days which means that lenders are relying on the sale of the business as a going concern,” said the buysider.
Weaker documentation and security also open the door to lenders being primed, through the shifting of collateral into unrestricted subsidiaries or the layering in of more senior debt.