The Evolution of The European HY Market

The shifting European high yield and leveraged loan market is creating new funding opportunities.

Written by Eliza Holladay , Chief Strategy Officer at Arini .

The European High Yield and Leveraged Loan market is undergoing a significant transition. Substantial amounts of debt incurred during periods of low interest rates and tight credit spreads are coming due, while several traditional sources of financing are retreating from the European markets. This shift opens a funding gap that could see many European borrowers becoming price takers, despite having high quality assets and strong financial profiles, due to a lack of access to funding options. We believe this environment creates significant opportunities for the players that can offer new sources of funding to meet the growing demand. Robust sector and company knowledge, and the ability to efficiently assess credit risk across Europe, will be critical for maximizing this opportunity set.

Structural challenges and partial orphaning of the high yield market

Over the past year, we’ve heard a lot about the looming maturity wall and the difficulty that many companies will face in refinancing debt. The reality is that many of the European companies that raised High Yield debt during the period of low interest rates have not yet had to manage this change in market structure. However, the sheer quantum of debt coming due over the next two to three years will reveal the full scale of this funding crisis. In addition, rating agencies will closely monitor the increase in interest costs, with potentially negative rating decisions further alienating rule-based investors.

Despite the challenging outlook, not every business will face the same refinancing risks. Growing companies with strong cash flow generation will benefit from a nascent European CLO market that is continuing to rise in importance as a reliable funding source in the Leveraged Loan/High Yield market.

Simultaneously, many traditional private credit funds are sitting on record amounts of dry powder . This is a refinancing option for high-quality companies with balance sheets that are just outside of the typical risk profile for CLO managers. The challenge is for the remaining companies that are more difficult to underwrite or have raised an amount of debt that may appear unsustainable in a higher-rate environment. These companies have substantially less access to both private and public markets to refinance their upcoming maturities. We believe this presents an opportunity for players that have an appetite for this risk profile and a robust understanding of the environment.

Europe: a continent of challenges and opportunities

US credit markets are highly developed and efficient, with a large investor base and an abundance of available capital. Consequently, it is often the case that excess returns in credit can only be generated by taking close to equity-like risk.

In contrast to the US, European credit markets can be characterised as heterogeneous and inefficient, with many companies operating locally and subject to country-specific legal codes and political decisions. This means that with sufficient experience in and knowledge of local European jurisdictions, we believe attractive excess returns can be generated without the increased risk often associated with US investments.

There are several reasons for this. For one, compared to strong growth in the US, the economic outlook in Europe is less favourable. The European Commission currently estimates that GDP will increase by only 0.9% in the EU in 2024, with Germany trailing towards the bottom of that range at 0.3% . This is partially due to weakening manufacturing activity in a country that was once the backbone of European growth. Perceived lack of growth generally deters non-fundamental investors who are unwilling to look past macro challenges to opportunities created by micro or idiosyncratic challenges. Moreover, the tide (or lack thereof) does not lift all boats in Europe, but rewards nuanced investors focused on company-specific fundamentals.

The lack of integration across the European market compared to the US means that many companies operate locally and so have difficulty accessing critical raw materials and energy sources that have become in short supply in Europe, even more so since the start of the Russo-Ukrainian war. As a result, in certain sectors, investors can no longer rely on historical comparisons to evaluate a company’s prospects. Instead, investors need to evaluate step-function structural changes that require new underwriting of entire sectors.

The availability of lower interest rate debt in recent years also led to a significant rise in the number of capital structures that should have been smaller (initially) and/or more flexible. This applies especially to some parts of the technology sector and specialty finance, for example. The hunt for yield by investors also supported the increasing prevalence of these complex capital structures.

Smaller European issuers with business models that are difficult for traditional investors to analyse are at risk of being orphaned in the current credit landscape. During the QE era, excess yield justified effort and attention. Now, the complexity of current business models combined with small capital structures simply does not justify the required return on effort for many large traditional investors. The fragmented nature of European markets also means that the average company size and capital structure is smaller compared to the US. As larger, rule-based investors retreat from parts of the European High Yield market, continuing coverage of these often complex and small structures becomes increasingly difficult to justify, leaving them effectively orphaned when compared to periods where investors were chasing yield.

Conclusion

While CLOs will play a crucial role in financing higher-quality assets, and large-scale private credit funds will likely make further inroads into funding blue-chip LBOs and large private companies, there is a significant risk of the orphaning of large parts of the High Yield market, comprising borrowers with smaller, more complex and more challenged capital structures. We believe this will leave a pronounced gap in the European High Yield market, necessitating the development of new funding sources.

European investment managers that combine a rigorous understanding of key European industry sectors with continuous underwriting of key borrowers will be well-positioned to provide the bespoke capital solutions needed to plug the widening funding gap in the post-QE era.

Disclaimers?

Arini and Arini Capital are trading names for a business division of Squarepoint Ops LLC and Squarepoint Capital LLP. Squarepoint Ops LLC is registered with the US SEC as an investment advisor, with the CFTC as a commodity pool operator and is a member of the National Futures Association. Squarepoint Ops LLC is registered with the US Securities and Exchange Commission as an investment adviser and with the US Securities and Exchange Commission as an investment adviser, with the US Commodity and Futures Trading Commission as a Commodity Pool Operator and is a member of the National Futures Association. Registration with the SEC does not imply a skill or a level of training. Squarepoint Capital LLP is authorized and regulated by the UK Financial Conduct Authority, registration number 3344281.

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