The 2005 US syndicated loan market will be remembered for its record volume of large LBO and M&A related transactions. Sponsors opened up their sizable war chests and generated some record-breaking LBOs like SunGard and Hertz. The growing institutional investor base lapped up the paper at tighter spreads as demand outstripped supply. Colette Campbell and Tim Sifert report.
The US syndicated loan market proved its mettle in 2005 as record liquidity absorbed chunky institutional loans backing jumbo LBOs. Leveraged loan volumes grew in 2005 as supply hit US$79bn in the first quarter, US$68bn in the second quarter and was approaching US$53.06bn as the third quarter drew to an end, according to data from Thomson Financial.
More than US$60bn of this backed LBOs as improving economic conditions and an accommodating lending environment empowered the private equity community.
“There is a tremendous amount of liquidity in the system among asset classes such as syndicated loans and high-yield bonds,” said Andrew O’Brien, head of US syndications at JP Morgan. “In addition, private equity firms have been successful at fundraising and the same is true for CLO managers, where both the new players and the existing lenders have more dollars to spend.”
Market technicals played a big part in setting the scene. “Add to the excess liquidity the fact that credit spreads are attractive for issuers and the default rate remains low and it was a recipe for record new issuance volume,” said O’Brien.
From the outset bankers did their best to ensure volumes matched or exceeded 2004's levels. Warner Chilcott opened the year with its US$1.79bn LBO financing with investors gobbling up the paper at Libor plus 250bp.
With the floodgates open, arrangers got to work bringing a host of large, heavily leveraged buyouts to market. Buyout volumes totalled just over US$110bn in the first nine months of the year.
The most notable buyouts were SunGard (US$11.3bn), Hertz (US$15.6bn), Neiman Marcus (US$5.1bn), Masonite (US$2.5bn), Telcordia (US$1.35bn), MGM/Sony (US$4.84bn), School Speciality (US$1.5bn) and NewPage (US$2.3bn). M&A related deals for DaVita (US$3.05bn), MGM Mirage (US$6bn) and LifePoint (US$1.7bn) also fed the market.
Most LBO financings featured large institutional tranches with SunGard’s US$3.5bn in term loans being the largest. The size of these LBOs was matched only by the equally aggressive lending practices, which grew with them. Leveraged multiples rose as covenants packages got looser.
“Covenant packages are generally looser for these large deals, just as corresponding leverage is often higher for these larger corporates since the borrowing risk is seen as lower,” said Kathryn Swintek, head of leveraged finance at BNP Paribas.
Bankers thought that 2004’s average leverage of 4.9x was aggressive but by the mid-point of this year it had risen to 5.5x, although it eased to 5.2x by August. While this is close to the LBO hey days of 1997 and 1998, of 5.9x and 5.8x, respectively, but they not expected to hit those heights again.
“While you can factually observe an increase in leverage, it's still within historic averages. Where the market is more aggressive is in areas such as spreads, covenants, and use of proceeds,” said Mark Okada, chief investment officer at Highland Capital Management.
Feeding demand
In tandem with an increase in LBO activity and loan business in general, the institutional investor base also continued to grow.
The investor base grew steadily in 2005, doubling since 2002. In 2002, fewer than 100 manager groups and just over 250 active loan investment groups were operating in the leveraged space, compared to 200 active manager groups and close to 500 active loan investment vehicles now.
“The senior secured nature of loans, their low volatility and low correlation relative to other asset classes is very attractive to investors,” said Highland’s Okada. “Add to this the fact that loans have the highest risk adjusted returns, or highest sharp ratio, of any asset class over the past decade and it is no wonder investors continue to think it’s an attractive place to put money to work.”
The increased demand for loans helped to absorb the steady supply of LBOs. Although buyouts made up the lion's share of leveraged loan business, dividend recaps also contributed as sponsors saw a chance to claw back some of their investments through dividend recaps.
Intelsat, American Safety Razor, New Skies, GenTek and Billings Concepts were just some of the issuers that tapped to raise dividends for sponsors.
Supply also came from stock and bond buybacks, the largest being the US$5bn loan to back Kerr McGee’s stock buyback. Proceeds went towards funding a stock repurchase, which staved off a threatened proxy fight by vocal shareholder Carl Icahn.
Inflection point
By the end of March, loan and bond technicals had begun to pull in opposite directions: the bond market began to weaken but the loan market chugged on. Until then, both markets had acted as the primary fund raising bins for LBOs.
In March, the market was hit with the realisation that GM and Ford were on their way towards junk status. The high-yield bond market was also hit hard after the FOMC’s hawkish comments regarding inflation and rising rates. Investors, primarily hedge funds, who were rumoured to have sustained extensive losses, pulled money out of high-yield mutual funds at the prospect of a rising rate environment.
The result was a back-up in the bond market, which led to an almost complete shut down, leaving the leveraged loan market to pick up the slack. A host of issuers were forced to pull their planned bonds and instead lock up bridge financings to allow them to complete their LBOs, which would be taken out when conditions improved in the bond. This further highlighted the inherent strength in the loan market and its ability to weather a tough market.
“When compared to high-yield bonds - loans have less credit risk, less interest rate risk due to its floating rate structure and less volatility,” said Okada.
Issuers like Masonite, Whitebirch, DirecTV, LifePoint and Hughes Network Systems reworked plans, which planned to tap the high-yield bond and instead turned to the leveraged loan market.
By May, conditions began to improve, as speculation around hedge funds abated and volatility surrounding the correlation trade with GM and Ford steadied.
The inflection point in the loan market had led, among other things, to spreads widening, in particular for second-lien financings, which had seen average pricing climb by close to 100bp to 725bp, according to Standard & Poor's. This brought second-lien pricing back to 2003 levels and in line with market expectations.
M&A spices up high-grade lending
For the high-grade loan market 2005 was buoyed by a host of M&A related deals and refinancings, which bankers had wrongly assumed the need for had been diminished after the level of refinancings completed in 2004.
Refinancings continued to prop up overall volumes, comprising about half of this year’s US$629.4bn market, but the steady rise in acquisition-related loans gave bankers a few extra basis points.
As much as US$50bn worth in M&A related loans were booked for the first nine months of 2005, compared to US$29.7bn and US$14.5bn for the same periods in 2004 and 2005. Lenders launched deals for Federated Department Stores, Medco Health, Adolph Coors, Sears and Valero Energy, among others.
M&A particularly enlivened the market through the typically slow summer. In July, JP Morgan and Bank of America wrapped up the US$2bn five-year acquisition financing for Federated Department Stores. A month later, Medco Health was out with a US$1.25bn acquisition loan via the same duo. The activity extended to Canada as well, with the US$2.55bn deal backing the Coors-Molson merger earlier in 2005.
However, bankers had expected more of a windfall from these event-driven financings, as most of the M&A-related transactions were not widely syndicated. In some cases acquirers signed bilateral bridge loan agreements so did not spread the wealth. “We hope the M&A volumes will continue to grow,” said Peter Kettle, director global loans capital markets at Citigroup. “But so far this year they haven’t been broadly syndicated, nothing like the Cox Communications deal from last year.”
In 2005, new money also came courtesy of the American Jobs Creation Act as companies took advantage of the tax holiday within the act to return profits earned abroad and incur only 5.25% taxation not the usual 35% for this fiscal year only. To do this they needed loans. McDonald’s, Bristol-Myers Squibb and Philip Morris International have all tapped the loan market this year for several billion dollars in loans to repatriate profits.
Bankers anticipate many more such deals with proceeds often earmarked for new investment in the US, including for M&A.
Nonetheless, for all the evident demand, 2005 is also defined by limits set by liquid lenders, even as they left no stone unturned in their search for ways to put money to work.
Borrowers have enjoyed leeway on pricing levels, which continue to fall, but lenders have stood firm on tenors. Bar one transaction for Pacific Life.
In June, Citigroup was able to complete a US$500m seven-year revolver for Pacific Life, the first transaction with a tenor longer than five years. The deal tainted a few of the insurer’s relationships with money centre banks, which made a point that they were unsatisfied with such long-dated paper, by backing away from committing.