OREANDA-NEWS. April 22, 2016. Fitch Ratings says in its latest European Leveraged Finance Highlight that private equity sponsors have contributed a higher portion of equity or quasi-equity funds into primary market leveraged buy-outs in 1Q16 compared with the same period last year. Based on Fitch's leveraged credit opinions portfolio, shareholder contributions represented around 45% of the total enterprise value (EV), up from around 35% in 1Q15.

The combination of high valuations and constrained junior debt capital markets has led to financial sponsors funding their acquisitions with additional equity. Recovered equity markets and active international trade buyer interest in European vendor auctions means median EV multiples remain at a post-crisis high of around 9.5x. However, lingering capital market volatility from early 2016 for single-B category credits in the European high yield bond and loan markets contributed to a decline in median total gross leverage to 5.2x in 1Q16 compared with 5.6x in 1Q15.

In the current cycle, financial sponsors cannot rely as much on junior debt as in the 2005-2007 period to help them increase total leverage and correspondingly lower their equity contribution to win auctions and achieve their target investment returns. Fitch has observed only three loan transactions out of 14 featuring second lien debt and none with mezzanine in 1Q16. Corral Petroleum Holdings AB's recent issuance of PIK toggle notes, which Fitch rates 'B(EXP)'/'RR5(EXP)' could signal recovering investor appetite for subordinated debt and entice other borrowers to issue. However, investors are likely to remain focused on higher quality assets and borrowers likely to wait until volatility concerns ease.

Fierce competition from industrial trade buyers, especially on large-size assets that represent opportunities to boost top-line revenue and achieve economies of scale, means that financial sponsors have increasingly shifted their attention to mid-stage growth oriented technology services sectors and smaller-sized companies as evidenced by a lower median EBITDA in 1Q16 primary market deals versus 1Q15. Transactions such as Salad Signature, Photobox, Vermaat or Lima Corporate are representative of this trend. Fitch has only seen three transactions out of 14 where the total debt committed exceeded EUR500m in 1Q16.

Despite lower leverage and more equity contribution in general, heightened credit concerns amid broader volatility and risk aversion in late 2015 and early 2016, together with smaller size deals, generally translated into better compensation in primary market transactions as median senior secured interest margin increased to 475bp in 1Q16 from 425bp in 1Q15.

However, higher equity contributions and reduction in total leverage have not translated into materially better issuer default credit opinions than a year ago. Fitch has assigned a b-* issuer default credit opinion (IDCO) to around 50% of the new transactions in 1Q16, in line with our broader credit opinions universe. The b-* credit opinion reflects the idiosyncratic business risks of small issuers, uncertainty in achieving growth and deleveraging plans under primarily non-amortising and covenant-lite debt structures as well as some reliance on favourable credit market conditions when maturities fall due.

Fitch's European Leveraged Finance Highlight series features trends in the high yield and leveraged finance markets with analysis and the factors to watch in the near term.