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Fridson – Amid Tesla Talk: Is a $72B LBO Feasible?

Within hours of Elon Musk tweeting on Aug. 7 that he was considering taking Tesla private, analysts concluded that if it happened, it would not be by the route of a conventional leveraged buyout. The automaker’s CEO instead expected a substantial portion of existing stockholders to trade in their public shares for more highly valued private ones, with as-yet-unidentified sources providing additional financing. In any case, the company’s negative cash flow was generally seen as an unsuitable basis for a heavily debt-financed transaction.

Experts who weighed in on the headline-grabbing affair also debated whether it was even possible to create an LBO as large as a Tesla buyout would be. The most frequently cited figure for Tesla’s size, derived by multiplying the number of outstanding shares by Musk’s proposed $420/share valuation, was $72 billion. Numbers ranging from $70 billion to $82 billion were published, however. In any event, commentators generally cast doubt on the feasibility of such a large transaction, given that the biggest previous LBO was the $44.4 billion TXU deal in 2007.

Barron’s (see note 1) spotted the basic flaw in that comparison, which is the failure to take inflation into account. It might be that a nominal amount that would have strained the market many years ago could be raised fairly easily with today’s cheaper dollars. The business weekly’s “Up and Down Wall Street” columnist Randall Forsyth put the TXU deal’s value in current terms at $53.5 billion.

Even that figure understates what leveraged finance has been capable of in the past. Business Insider’s 2015 list of the largest LBOs of all time (see note 2) ranked the 1989 RJR Nabisco deal #1. This source shows the nominal deal size at $31.1 billion and translates that into $59.6 billion in inflation-adjusted terms. By that measure, the 2007 TXU deal ranks second at $50.9 billion. According to our calculations, derived from the Consumer Price Index, the inflation-adjusted value of the RJR Nabisco deal now stands at $63.2 billion. Suddenly, a $72 billion deal, for a company that fits the LBO profile better than Tesla does, seems less of a flight of fancy than it did at first blush.

But wait, there’s more!
The U.S. high-yield market is much bigger now than it was in 1989, and not solely as a function of inflation. On Dec. 31, 1989, the face amount of the ICE BofAML US High Yield Index stood at $141.637 billion. The comparable current figure is 8.8 times as great, at $1,251.920 billion. Even excluding the impact of inflation, the outstanding size of the high-yield market is 4.4 times what it was in the year of the RJR Nabisco deal, by our calculation.

high yield historical

If a $72 billion LBO were to be financed entirely in the U.S. high-yield bond market, with equity accounting for 30% of the capital structure, the deal’s bonds would account for 3.9% of the ICE BAML High Yield Index. (This calculation takes into account the increase in the denominator resulting from the buyout’s assumed $50.4 billion issuance.) That percentage is below the typical 5% maximum concentration per issuer allowed for high-yield funds. In practice, portfolio managers tend to self-impose lower per-issuer caps, but it is hardly likely that the U.S. high-yield market would be called on to finance the entire debt portion of the deal.

For one thing, the leveraged loan market, too, has grown a good bit since 1989. In 2017, for example, LCD reports that leveraged loan issuance totaled $649.8 billion, up from $187.7 billion in 2000. The 2017 loan volume exceeded the high-yield total of $276.3 billion. In addition, the European high-yield market, which barely existed in 1989, now stands at $389.945 billion (face amount) as measured by the ICE BofAML European Currency High Yield Index. At its Dec. 31, 1997 inception, that index’s face amount was a mere $1.197 billion. All in all, financing sources outside the U.S. high-yield market appear likely to reduce the burden to a point where U.S. managers would not have to allocate excessively to the name in order for the deal to get done. By the same token, many managers would be reluctant to underweight a name that could potentially have a major impact on their performance benchmark.

There may not be a Tesla-size LBO waiting in the wings, but it so happens that now would not be a bad time to try it. Private equity firms have more than $1 trillion in their war chests, according to data provider Preqin, so it would not be hard for the right deal—or even a semi-right deal—to attract the necessary equity financing. Investors’ appetite for high-yield paper is currently whetted by a reduction in supply. The ICE BAML High Yield Index’s face amount is down by 9% from its peak of $1.38 billion in March 2016.

Bottom line: Tesla would be the wrong company to test the proposition, but a $72 billion LBO is not out of the question. In nominal terms, that is 62% bigger than the biggest dollar deal ever done, but feasibility is also a function of inflation and growth in the debt markets. If the right target company were to appear, right now might be a good time to attempt the seemingly impossible.

Marty Fridson, Chief Investment Officer of Lehmann Livian Fridson Advisors LLC, is a contributing analyst to S&P Global Market Intelligence. His weekly leveraged finance commentary appears exclusively on LCD, an offering of S&P Global Market Intelligence. Marty can be reached at [email protected]

Research assistance by Kai Zhao and Jaden Ma.

ICE BofAML Index System data is used by permission. Copyright © 2018 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann, Livian, Fridson Advisors, LLC’s use of such information. The information is provided “as is” and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.

Notes
1. Randall W. Forsyth, “Musk’s buyout plan may signal market woes ahead.” Barron’s (Aug. 10, 2018).
2. https://www.businessinsider.com/the-biggest-private-equity-buyouts-2015-10#1-kkrs-1989-lbo-of-rjr-nabisco-is-an-industry-legend-14

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Defaults Remain Scarce but Leveraged Loan ‘Weakest Links’ Spike to New High

loan weakest links

The number of leveraged loan “Weakest Links,” or at-risk debt issuers that can be viewed as potential default candidates, spiked to 87 in 2018’s second quarter, the most since LCD started tracking this indicator in 2013. The recent figure is up from 78 in the first quarter and from 81 at the start of the year.

The second-quarter activity brings the Weakest Links share of the outstanding U.S. leveraged loan issuer universe to 7.2%, the second-highest level on record.

LCD’s Weakest Links analysis tracks the queue of at-risk credits—defined as U.S. loan issuers with a corporate credit rating of B– or lower (excluding defaults) by S&P Global Ratings, with a negative outlook or implication. The analysis is based on credits in the S&P/LSTA Leveraged Loan Index, but if a credit exits the Index it remains in the Weakest Links universe until its rating is withdrawn or until it defaults.

Of note, several high-profile consumer-related industries continue to contribute heavily to the Weakest Links, including retail and oil & gas.

As far as Weakest Links go, there is good news. Of the 78 issuers that were Weakest Links at the end of 2017, 10% (eight issuers) have been upgraded out of the Weakest Links category. Additionally, two issuers have had ratings withdrawn due to positive actions: Aricent was acquired by Altran and Caribbean Restaurants withdrew its rating after paying down debt.

The bad news: 14% (11 issuers) of those 2017 year-end Weakest Links defaulted or completed distressed exchanges in the first half of 2018. The defaulters include iHeart Communications, of course (iHeart entails $6.3 billion in Clear Channel bank debt), retailer Nine West, and two Oil & Gas producers—Fieldwood Energy and Philadelphia Energy SolutionsDel MonteProserv, and Sears each underwent distressed exchanges.

While the number of leveraged loan Weakest Links climbs, defaults in the market remain stubbornly rare. The current U.S. loan default rate is roughly 2%, according to LCD, compared to an historical average of about 3%. While a low default rate generally points to a healthy asset class, loan market detractors note the booming share of covenant-lite leveraged loans now in place, saying those credits could be especially hard hit when the credit cycle turns, and defaults surge. – Ruth Yang

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Leveraged Loans: Another New Record for Covenant-Lite

cov-lite us leveraged loans

The share of the $1.06 trillion in outstanding U.S. leveraged loans that is covenant-lite hit yet another record in July, at 77.8%, according to LCD. It is the 15th straight month that cov-lite credits have set an all-time high.

That could well continue.

So far in 2018, 82% of leveraged loans that have been completed in the U.S. syndications market has been cov-lite, amid solid market demand, as institutional investors and retail loan funds continue to sit atop impressive stores of cash. Indeed, assets under management at U.S. loan funds hit a record $176 billion in July, according to Lipper and LCD. That figure has grown from roughly $110 billion in early 2016, when investor interest in the asset class took off amid expectations of long-awaited rate hikes by the Fed (leveraged loans are floating rate, an asset class that tends to fare well in rising rate environments).

Cov-lite loans are in some ways structured akin to high yield bonds, in that they feature incurrence covenants, as opposed to the more restrictive maintenance covenants.

With an incurrence covenant a debt issuer would have to meet a specific financial test only if it wanted to undertake a particular action (like borrow money to fund a dividend to a private equity sponsor, for instance). Under a maintenance covenant the issuer would need to meet regular, specific financial tests, even if it did not want to undertake that dividend deal.

Market pros agree that the cov-lite loan structure will hinder recoveries on bank loans, whenever the current credit cycle turns and defaults begin to mount, though the jury is out as to just how much of a hit recoveries will take.

One hint: S&P’s LossStats, and LCD, conducted analysis on recoveries of cov-lite loans that defaulted before the 2008-09 financial crisis, versus those that were structured and defaulted after the crisis. The later-vintage group of cov-lite loans saw an average discounted recovery of 56%, compared to a 78% average recovery on the earlier deals (though the data in the later sample is thin, as there have been few leveraged loan defaults during this cycle). You can read more about this LossStats analysis here. – Staff reports

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US Leveraged Loan Market Grows to Another Record

The U.S. leveraged loan market grew to $1.06 trillion in July, another record for the asset class, according to the S&P/LSTA Loan Index.

The Index measures the amount of outstanding institutional leveraged loans; these are term loans with little or no amortization, sold to institutions such as CLOs, loan funds and ETFs, pensions funds, and similar.

The U.S. leveraged loan market has grown steadily since the financial crisis, fueled by investment into the floating rate asset class (this type of debt tends to fare better in a rising rate economic environment).

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Amid M&A Frenzy, LBO Leveraged Loans Surge to Record Size

europe LBO loan

Propelled by the ongoing M&A binge and mountains of cash for private equity shops to spend, leveraged loans backing LBOs in Europe have shot to record size in 2018.

These credits, which traditionally have been arranged by large banks, then syndicated to institutional investors such as collateralized loan obligations vehicles (CLOs), pension funds, and other institutional investors, have grown to an average of €689 million so far this year, according to LCD. That’s a big leap from €447 million in 2017.

Why the increase?

These mega-buyout financings are being driven by a combination of factors, including readily available and cheap debt (despite a recent widening of spreads charged to borrowers), a record amount of dry powder raised by private equity firms, strong corporate earnings, and big assets coming up for sale — especially through divestments of non-core businesses from large corporates, as well as break-ups as a result of increased shareholder activism, PE firms say.

Private equity players add that large buyouts are particularly attractive in the current market, which has become tougher due to fiercer competition, including more sovereign wealth funds and pension funds coming in, and rising valuations. Indeed, on a rolling three-month basis, average purchase-price multiples reached 11.3x in March this year, according to LCD. That’s the most since the financial crisis (though it has dipped since March).

This story is abstracted from an LCD News story by Isabell Witt.

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Amid Cov-Lite Leveraged Loan Binge, Borrower Interest Coverage Remains Solid

leveraged loan interest coverage

Amid continued focus on deteriorating credit quality in the U.S. leveraged loan market, borrowers remain relatively well-positioned to service the growing amounts of debt they’re incurring, according to one important metric.

The share of loan issuers with an interest coverage ratio of less than 1.5x – a level typically indicative of a company that is struggling to service debt – just hit its lowest level since late 2012, when LCD began tracking this statistic on a quarterly basis. A slim 3% of issuers in the S&P/LSTA Loan Index now have an interest coverage ratio below that level.

By way of comparison, at the height of the financial crisis – at year-end 2008 – the share of issuers with an interest coverage ratio below 1.5% was 18% (before 2012 LCD tracked this data on an annual basis, not quarterly).

Roughly defined, interest coverage is a company’s earnings, divided by the interest payments on debt that are due.

One reason interest coverage is relatively high: Earnings continue robust. Buoyed by tax cuts passed late last year, EBITDA growth for companies underlying the Index hit 9.25% in the first quarter, up from 5% in the fourth quarter, according to LCD. That’s the highest since the third quarter of 2014.

This relatively bullish take might surprise market bears who see the widespread acceptance of covenant-lite loans, and other examples of easing credit structure in the $1 trillion U.S. leveraged loan market, as nothing short of a pale horse on the economic horizon.

Some concern is warranted, of course. With almost 80% of loans underlying the S&P/LSTA Index now cov-lite there is broad expectation that, when the current, long-running credit cycle finally turns, recoveries on cov-lite loans that default will indeed be less than seen on traditionally structured deals.

The questions, of course, are how severely will loan defaults spike, and how impacted will recoveries on those cov-lite loans be? – Staff reports

This story was abstracted from analysis by LCD’s Rachelle Kakouris

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Video: Global Leveraged Loan Issuance Surges Past 2017 Benchmarks

In the latest Capital Markets View video, LCD’s Taron Wade and S&P Global’s Chris Porter talk about the main trends in the European leveraged loan space during the second quarter, including a comparison with the U.S. market.

xborder loan issuance

Discussed this month:

  • Volumes are up globally. To end 2Q18, global loan issuance reached $446 (€381) billion, which is ahead of the same period in 2017.
  • M&A is still the fuel. In the U.S., M&A was responsible for 58% of all institutional issuance in 2Q, with a record $84.2 (€71.9) billion. In Europe meanwhile, M&A drove more than 80% of loan activity in 2Q, generating €22.6 ($26.5) of supply.
  • This activity is not all sponsor-driven. Corporate M&A has been a big component, with large cross-border deals coming from Cineworld and Stars Group.
  • The volume of cross-border deals in the U.S. and European leveraged finance markets is well ahead of where it was this time last year, driven both by larger deals and widely diverging funding rates between the two regions.
  • Although headline leverage is not too elevated currently, market players say they continue to see aggressive EBITDA add-backs in deals.
  • Institutional investors’ share of the market in Europe still lags behind that of the U.S.
  • The ratio of investor-friendly price flexes to issuer-friendly flexes in the U.S. and Europe has risen in recent months.

The URL for the video:https://www.spratings.com/en_US/video/-/render/video-detail/capital-markets-view-july-2018

Taron Wade heads up LCD’s European Research efforts. Chris Porter is Head of Loan Recovery & CLO Business Development, S&P Global.

As ever, please feel free to contact Taron or Chris if you’d like a particular topic discussed in the next video.
Note: Capital Markets View will be on hiatus during August, and will return in September.

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US Leveraged Loan Default Rate Holds at Low 1.97%

After a blemish-free July, the default rate for U.S. leveraged loans continues stubbornly low, holding at 1.97%, according to LCD.

The rate has been inside the historical norm of 3.1% since early in 2015, when the behemoth TXU/Energy Future default, which entailed more than $20 billion of outstanding loan debt, was part of the calculation (that issue dropped off the 12-month roll in April 2015).

U.S. leveraged loan defaults have remained scarce as the current issuer-friendly credit cycle heads into its tenth year.

One reason for the lack of defaults: corporate earnings continue robust, enabling borrowers to service debt they incur (unless they refinance it, of course).

Speaking of refinancing: Easy access to leveraged loans is another reason defaults have been rare.

With interest rates rising, institutional and retail investors have been throwing cash into this floating-rate asset class, allowing issuers to quickly refinance existing debt or – more alarming to some – structure the credits with few restrictions. In theory, these covenant-lite loans could allow borrowers to gloss over poor financial performance, with little warning for investors, until the company defaults. – Staff reports

This story was abstracted from analysis by LCD’s Rachelle Kakouris

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After 2-Month Surge, US Leveraged Loan Issuance Stalls

US leveraged loan issuance

Issuance of U.S. leveraged loans dipped sharply in July after a ferocious stretch of activity the previous two months, according to LCD.

Institutional term debt volume slumped to $29 billion last month as loan investors continued to digest the roughly $108 billion that was launched to the syndications market in May and June.

Institutional credits are term loans with little or no amortization. Because they’re somewhat riskier than amortizing term loans, which are repaid on a regular schedule, and revolving credits (together known as pro rata debt), they are more richly priced, and in greater demand to a broad swath of a growing investor base.

Year to date, U.S. institutional issuance totals $300 billion, down 9% from the same period last year, when there was a record $503 billion recorded, according to LCD.

The U.S. leveraged loan market has grown rapidly over the past few years, and earlier in 2018 topped $1 trillion in size. Because of its floating-rate nature, loans have been in demand from both institutional and retail investors of late. That demand has enabled borrowers to demand thinner spreads and notably looser loan structures, prompting concern from those involved in the market, and on the sidelines, as to how these often-hefty credits will fare once the current, long-running credit cycle turns.  – Staff reports

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Amid Surge of Deals, Risk/Reward on US Leveraged Loans Hits 6-Year High

Long-suffering investors in the $1 trillion U.S. leveraged loan market saw some relief in 2018’s second quarter, as the reward for participating in LBO loans, vs the risk incurred, hit its highest level in six years, according to LCD.

For this analysis LCD employed yield per unit of leverage (YPL) to gauge risk/reward, and looks only at loans backing LBOs.

Specifically, in the second quarter, U.S. loan investors saw an average 126 bps of YPL on LBO loans offered in the syndications market, up sharply from 95 bps in the first quarter. To calculate YPL, the yield to maturity of a credit is divided by the deal’s total leverage (debt/EBITDA).

It’s important to note that this increase was almost entirely a result of higher credit spreads in the market, as opposed to an increase in LIBOR, on which U.S. loan pricing is based (three-month LIBOR climbed steeply in Q1, but largely held steady in Q2).

The brighter risk/reward scenario for U.S. loan investors came as cash inflows from retail players – via loan funds and ETFs – slowed, compared to heavy net deposits earlier in the year. The relative slowdown, combined with a hefty $25 billion of LBO loans entering the market in May and June, had investors in the rare position of calling some shots during the syndications process in July, forcing increasing numbers of issuers to sweeten pricing and/or alter terms. Hence the notable increase in YPL (and spread per leverage).

After a slow start, however, loan issuance in the latter half of July has picked up, with issuer-friendly price flexes resuming, so it will be interesting to see how the risk/reward profile in the leveraged loan market shifts going forward. – Staff reports

This story was abstracted from a longer piece of analysis by LCD’s Marina Lukatsky.

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