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Falling cash cover sends warning signs to European leveraged finance investors, says S&P

European speculative-grade companies recorded lower cash coverage to make interest payments in the first quarter of 2008 than in 2007, when they were already at record thin levels, accordi

European speculative-grade companies recorded lower cash coverage to make interest payments in the first quarter of 2008 than in 2007, when they were already at record thin levels, according to a report from Standard & Poor’s Ratings Services.

The report, entitled Lending Standards in Europe Continue to Loosen Despite a Small Reduction in Leverage, highlights deteriorating ratios, with three different measures of cash coverage falling since last year, and ongoing aggressive structures despite the liquidity crunch.

‘Thin credit metrics mean that companies have less of a cash cushion if market conditions change or additional capital needs to be invested in the business, resulting in a greater risk of default,’ says Standard & Poor’s research analyst Taron Wade.

The report says lenders should be vigilant in a market where defaults are expected to rise from record lows, demanding structures that provide an appropriate interest coverage cushion at a time when economic difficulties are already beginning in Europe.

One good sign for senior lenders, however, is that senior leverage has fallen to 4.4 times debt to earning before interest, tax, depreciation and amortisation, a level well below the 5.2 times multiple average of 2007 and lower than the 4.5 times average in 2006.

In addition to cash coverage and leverage, the report examines recent credit quality trends. ‘Ratings or credit estimates of companies that have issued speculative-grade debt in the first quarter of 2008 have not improved relative to transactions outstanding in 2007,’ Wade says.

In the first quarter of 2008, of 14 newly-rated transactions or those assigned credit estimates, 92.9 per cent were in the B category, compared with 78 per cent of companies in the existing broad market.

Although a large majority of the transactions underwritten during the first quarter have credit estimates or ratings in the B category, investors may have found comfort because many of the companies either operate in strong sectors, have well-diversified portfolios, or benefit from good market positions in certain regions. In addition, many have adequate liquidity positions to meet debt repayments in the short term. Higher equity contributions from sponsors for leveraged buyouts have also given lenders some comfort.

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