Driven by the proliferation of the US LBO market, debt levels on many deals have risen to unimaginable heights. To leverage up their companies and consummate jumbo transactions, bankers are using more creative finance structures, tapping into second-lien, mezzanine and asset-based lenders and providing indebted borrowers with more flexibility via covenant-light loans. As deals get bigger and more aggressive, borrowers will have to continue to push the envelope. Timothy Sifert reports.
Lending volumes in the US increased 5.8% in the first quarter of this year compared to the same period last year, according to data from Thomson Financial. In that same period investors have not only experienced more loan volumes, but also novel structures.
Clearly the market has become used to the fact that second lien loans are here to stay, despite the absence of any major restructuring event to indicate how lenders would fare in a bankruptcy (the chief concern among second-lien investors). Second lien lending in the first quarter rose 27.4% to US$7.1bn compared to the US$5.6bn last year.
Probably the most important recent development in structuring has been the erosion of covenant packages. Aided by low default rates and aggressiveness among sponsors, covenant-light credit agreements – those that contain only incurrence covenants – have increased in volume exponentially. Bankers, lenders and borrowers are mixed on the trend and on what the potential fallout would be should default rates increase. But as the secondary loan market develops and investors become more fluent with loan credit default swaps, it is generally perceived as less risky than before to hold paper that is light on covenants.
Investors can trade out of risk more easily than before. That said, covenants act more like an early-warning system than a cure-all for market woes. With most of the financial disasters in the history of the loan market, the loans involved were covenant protected. When defaults begin to increase – and they will – covenants will do little to correct it.
These maintenance-only transactions are occurring more frequently and in larger size. Investors recently piled into jumbo deals for Freeport McMoRan and Univision. Univision’s covenant-light US$7bn term loan B pays 225bp over Libor. Freeport’s US$2.5bn term loan A pays 150bp over Libor. Even at those tight spreads investors could not seem to get enough of them. “Almost every deal we’ve looked at this year has been covenant light,” a banker said. “Before it was an exception to the rule, now it’s the rule.”
Although covenant-light deals are now being actively employed, bankers expect them to be cyclical. Soon enough investors will be able to gain ground once again and maintenance covenants will begin to creep their way back into credit agreement.
Asset-based deals
Asset-based loans are another financing structure that is usually included along side covenant-light loans in buyout financing packages. Asset-based loans are secured by a company’s receivables, inventory, equipment and/or real estate and are often used today in larger deals for retail companies, for instance. Michaels Stores completed a US$400m asset-based revolver late last year as a part of the financing behind the buyout of the company.
Bain Capital and the Blackstone Group bought the specialty crafts retailer for about US$6bn. The ABL was part of the US$3.4bn loan that financed the transaction. Among other advantages to asset-based deals – in which borrowing capacity is often based on inventory level – is that it targets another group of investors, this time asset-based lenders. While some of these larger transactions might be able to find full financing in among cash flow-loan investors, the use of ABLs reflects arrangers desire to diversify the investor base – to the benefit of investors and issuers.
Taking a PIK
Another financing structure that is providing borrowers with financial flexibility at the expense of lenders is the use of pay-in-kind toggle loans and notes. In a typical PIK credit agreement, usually done at the holding company level, a company can elect to pay its interest expense in cash or with more debt – with obvious implications for lender and borrower. PIK notes have been ideal for sponsors that want to take out a quick dividend following their purchase. Sponsors may not want to tie a potentially cash-strapped portfolio company to strict payment schedule for the purpose of paying a dividend with the possibility of a market downturn in sight. PIK toggles, which have been tailored for loan and bond investors, allow the company to elect to defer payments for whatever reason. In that, companies can weather downturns and sponsors can take dividends. At the beginning of this year, for instance, Apollo Management returned to market with deal for a pair of its portfolio companies, Affinion Group and Verso Paper Holdings.
Affinion brought to market a US$300m five-year unsecured term loan via Deutsche bank and Bank of America. The loan was issued at the holding company level to pay a US$206m dividend to Apollo and redeem US$77m of preferred stock. Verso launched a US$225m six-year senior unsecured term loan with a similar structure. Market demand for the deals – both of which pay L+625 with an OID at 99 – was high, allowing Affinion to increase to US$350m and Verso to US$250m. On both names if the company elects to exercise the PIK toggle, interest payments will step up by 75bp from the original Libor spread. Affinion's loan is not callable for the first six months, then is callable at par for months seven to 18, and at 102, 101 and par in subsequent years. Verso's loan is callable immediately at 102, then at 101 and par.
Elsewhere, mezzanine debt continues to be used in buyouts, demonstrating how borrowers are increasingly using their whole capital structure to finance deals. Mezzanine debt is somewhat closer to equity than senior secured loans, but it enables companies to tap into another class of debt investors, effectively ratcheting up their overall leverage.
Aggressive second- and first-lien tranches
Second-lien loans have continued their steady rise over the past year. Not only are they occurring frequently but these loans are growing in size reflecting how comfortable yield-starved CLOs are becoming with second-liens. Infor Global Solutions recently completed US$750m second-lien loan, one of the largest ever. The deal pays 625bp over Libor.
Nonetheless, while second-lien portions of deals are getting more aggressive, liquidity among lenders is driving the demand for first-lien paper enough that companies are now able to push up the leverage levels among first-lien portions of buyout financings. While issuers have been able to reduce pricing on deals already in market they are trying to increase the first-lien leverage on those same deals.
Some of these companies are abstaining for second-lien altogether. Earlier this year, for instance, Paetec Communications abandoned its plans to complete a US$125m second-lien tranche. Instead the company increased its US$675m first-lien term loan to US$800m. That deal illustrated how the market had changed since underwriters committed to the transaction months before its February close. It had become unnecessary to have a second-lien piece to get the deal done. Proceeds financed the merger of Paetec and US LEC. Recent deals for ClientLogic and McJunkin, a banker said, would have included second-lien debt, in part to lure lenders with the attractive spread. Those deals, however, were all first-lien debt.
Years ago first-lien leverage was held at 2.5x-2.75x. Now investors are vetting deals with leverage reaching 4x and higher. Despite all this aggressiveness at the first-lien level, second-lien loans are still has strong as ever – if not stronger. It is just that the overall US leverage loan volume has increase to such an extent that more structures have been possible. That is also goaded along by the liquidity among investors, particularly collateralised loan obligations, which have raise record amounts of cash. The result is that first-lien debt is rising along with overall debt.
One important effect of the evolution of leveraged loan structures is that loans are becoming more like bonds – especially in the covenant packages. And as loans have become bond-like they have retained the added protection of being higher up in the capital structure than bonds. That has led more deals to become loan-dominated – with the leveraged loan market practically stealing business from bond investors (see chart). Often sponsors launch deals with the intention financing them in part in the bond market. But the comparably high demand among loan investors – in particular CLOs – allows them to go exclusively to the inexpensive loan market where the sky seems to be the limit. Over the past few years volumes of high-yield bonds have remained constant. No so leveraged loans. So the creatively that marked this spate of LBO-related debt indicates that financiers are borrowing the tactics of one financial market to be used to full effect in another. And loan investors are – for now – getting most of the volume.
It’s anyone’s guess just how much further sponsors and debt arrangers can push the market. No doubt there have been some signs that things might be slowing down in the loan market, given a recent pushback on pricing levels and repricing attempts. But as issuers know very well, even if the loan market is off by 50bp to 100bp from its recent tights, historically it would still be as strong as ever.