US investors regain influence
US leveraged loan volumes rose almost 32% this year but even this was not enough to satisfy investor appetite. Early in the year, record tight spreads and covenant-light agreements accompanied the mammoth leveraged buyouts that often failed to sate investors, who were frequently compelled to invest on borrowers’ terms or not at all. But as the year progressed, these liquid investors were able to stand their ground. Loans were still completed, but lenders ended up with better terms in the bargain. Michelle Sierra Laffitte reports.
Volumes in the North American leveraged loan market rose to US$508.8bn for the year to September 19, up from US$386.2bn and US$329.4bn for the same periods in 2005 and 2004 respectively, according to data from Thomson Financial. Even as volumes expanded, hungry investors were there at every turn to lend to companies of varying credit quality. And demand dictated that they often faced heavy scalebacks on their original commitments.
“Market conditions for the first several months of the year were very favourable and you had continually tighter margins and more aggressive capital structures,” said Bill Hughes, managing director and head of U.S. Loan Capital Markets at Lehman Brothers in New York.
Leveraged loans appeared to be structured at the issuer’s behest. Few deals reflected this more than Covalence Specialty Materials’ LBO financing. All the elements were there: the issuer flexed pricing down, cancelled a bond offering in favour of a second lien loan and, months after launch, took out the original credit facility with a new covenant-light deal.
On January 23, Bank of America, Credit Suisse, Merrill Lynch and Morgan Stanley launched the US$995m debt for Apollo Management's LBO of Covalence. After several alterations, the loan portion comprised a US$175m six-year revolver, a US$350m seven-year term loan B and a US$175m second-lien piece. High demand for the deal allowed the issuer to flex pricing. It also replaced the US$200m bond offering with the US$175m second-lien tranche and increased the US$325m TLB to US$350m.
Just over three months later, the former plastics division of Tyco International returned to market to replace the US$175m revolver with an US$200m asset-based revolver and remove maintenance covenants on the TLB (which became a US$300m TLC) and second lien. The amendment also proposed to split the collateral between ABR and term loan, leaving term loan lenders secured by a first lien on only fixed assets and a second lien on current assets. It offered ABR lenders, meanwhile, a first lien on current assets and a second lien on fixed assets. The move infuriated lenders, because of the blatant erosion of covenant protection. The agreement went through after Covalence offered investors an additional first-lien on all intangible assets.
Strong demand allowed the issuer to flex pricing down. The loan also replaced the US$200m bond offering with the US$175m second-lien tranche and increased the US$325m term loan B to US$350m. Just over three months later, the former plastics division of Tyco International returned to market to replace that deal with a covenant-light term loan and an asset-based revolver. Lenders were furious because of the blatant erosion of covenant protection. But their objections went largely unheeded.
Investors gain clout
But the situation did stay hugely in borrower's favour all year. Attractive financing conditions eventually brought enough issuers to market that investors were able to be more discerning with their cash.
“Investors entered the year with ample liquidity, but record amounts of new issuance eventually chewed away at excess cash and conditions turned more bearish by mid-year,” Lehman Brothers' Hughes said.
Issuers and arrangers started to listen when investors said “no” to repricing calls and other developments that limited their control. As investors started to push back and spreads started to widen, secondary trading levels started feeling the pinch as well. Secondary levels softened as market participants began backing away from repriced deals likely repricing candidates. This affected deals for Charter Communications, Lear Corp and Sports Authority, all of which broke for trading in April and immediately traded in the low pars. The average secondary price for par loans hovered around 101 in the first half of the year, but declined to trade around par as conditions weakened.
DaVita's decision in late May to put an end to its month-long repricing attempt illustrates how investors’ became increasingly influential as more deals flooded the market. Mandated lead arranger JPMorgan sought to cut pricing to 150bp over Libor from 200bp for the dialysis centre operator. Early investor pushback forced DaVita to ask for Libor plus 175bp instead. And last, amid one of the busiest new issue calendars in memory, the company pulled the proposal, deciding instead to wait until later in the year. Had DaVita been looking for a similar price cut in the first quarter, bankers said it probably would have succeeded.
Warner Chilcott and Six Flags faced similar hurdles. Warner Chilcott came to market for a 50bp price cut, but investor push back forced the company to decrease the price cut to 25bp, with a step-down provision. Deutsche Bank and Credit Suisse led the deal. Investors similarly balked at Six Flags’ repricing attempt, which came to market on April 12. Mandated lead arranger Lehman Brothers asked for a price cut on its term loan from Libor plus 250bp to Libor plus 200bp. Investors fought back and pricing was pushed to Libor plus 225bp with a step down to Libor plus 200bp based on ratings.
“Many investors were tired of seeing bull market structures,” said a loan trader. “The pushback on DaVita and Covalence marked the end of the bull market.”
Thus, spreads widened on new issues, a process which ended the proliferation of repricings that dominated the market. And, as the summer set in, the new issue market was a relative calm. “Things looked pretty gloomy in July with spreads widening a quarter (25bp) to 75bp depending on where you were on the credit spectrum,” Lehman Brothers' Hughes said.
However, the market rebounded with the onset of autumn. “The tone of the market has been favourable post Labor Day. Deals have generally been well subscribed, spreads have tightened a bit, and some aggressive structures are back and the market seems to be receptive,” Hughes said.
Second lien here to stay
Second lien loan agreements also proved their staying power this year. Issuers often issued second liens in lieu of bonds, as was the case with Covalence. But unlike covenant-light agreements, investors welcomed second-lien paper in a market where near all-time-low pricing was eroding investor returns. Second lien loans offered investors more spread for the greater risk. According to Moody’s, second lien loan volumes reached US$5bn in the second quarter of 2006, compared with US$3.3bn for the same quarter in 2005 and less than US$2bn in 2004 (see chart).
“Certain market observers question whether second liens were a fad or whether they are a more permanent component of the capital structures,” said Denis Coleman, managing director at Goldman Sachs’ financing group. “I think that 2006 demonstrates that second liens now represent a permanent position in leveraged capital structures.”
Second lien loans offer a more compelling set of pricing, structure and terms, than high-yield bonds do. “It is not controversial to suggest that the growth in the loan market has in part cannibalized the high-yield market as some of the second lien tranches have been put in place by issuers and sponsors as an alternative to high-yield bonds,” Coleman said.
Bank loans have also become the principal financing instrument for first-time debt issuers. Through August, about 51% of all rated leveraged financings were new issuers funding themselves solely with bank debt, according to Moody’s. Compare that to 48% for all of 2005 and only 17% in 2002.
This trend is a result of a fundamental change in the way companies are raising money in the debt markets. “Instead of having senior secured financing combined with unsecured and subordinated notes, capital market issues over the past year have shifted towards senior secured structures with first and second lien tranches,” said Neal Schweitzer, senior vice president in Moody’s Corporate Finance Group (see chart).
The growth in the leveraged loan market also was also reflected in the emergence of loan credit default swaps as a viable risk management option. As selling protection obviates much of the documentation necessary to participate in the cash market, it gives investment bankers competing for top mandates a way to level the playing field. Trading volume has reached US$100m a day and is expected to grow more.
The upshot of this year's developments is that the leverage loan market is showing few signs of capitulation. LBO financings are in full swing and, while investors have gained clout since the beginning of the year, new money is still in hot demand. The market is still awaiting general syndication of HCA’s US$16.8bn credit facility to finance one of the largest LBOs ever. Other sizeable deals in the pipeline include transactions for Kinder Morgan, TXU, Michaels Stores and ARAMARK. The primary pipeline is expected bring about US$80bn of new issuance to the market.
Some speculate on how well the market will be able to digest the volume. “When some of these larger deals hit the market, I’d expect that you could see some pressure in liquidity and spreads,” said Lehman Brother’ Hughes, adding that performance would depend largely on CLO’s capacity to absorb new volume.