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Phoenix-like CLO market takes another turn in the loan spotlight

Over its 25-year history, the CLO product has been written off as dead, or at the very least hobbled, at least twice: (1) in the wake of the early-2000s default spike, and (2) after the 2008 credit crunch, when the entire structured-finance market came under intense regulatory scrutiny. Over the past 12 months, however, CLO technology has proved resilient yet again, and in fact is thriving like never before. For one thing, the number of managers that printed a new vehicle over the past 12 months increased to 101, from 92 in 2013 and 66 a year earlier. Further, the current figure is within sight of the all-time high of 110, from 2006.

LCD subscribers can click here to read full story, analysis, and charts, including:

  • CLO volume
  • CLO market history
  • European CLO volume


– Steve Miller

Follow Steve on Twitter for an early look at LCD analysis, plus market commentary.

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July CLO market: $10B in U.S. issuance, and counting …

global CLO volume
Issuance in the U.S. CLO market continued apace last week, even with August right around the corner. Four new-issue deals priced, totaling some $2.21 billion, with more expected this week. With no new deals pricing in Europe, global CLO issuance year to date stands at $80.6 billion.

This chart is part of a longer LCD analytical story, available to LCD News subscribers. It includes charts detailing U.S. arbitrage CLO issuance vs. U.S. institutional loan volume, the U.S. CLO deal pipeline for what’s left of July, a European CLO deal pipeline, and European arbitrage CLO issuance vs. European institutional loan volume.

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SunTrust Robinson Humphrey hires four in leveraged finance group: Caldwell, Psarris, Simon, Holbrook

suntrust logoSunTrust Robinson Humphrey hired four for its syndicated and leveraged finance team, who will be reporting to Chris Wood.

Ron Caldwell will become head of healthcare syndicated and leveraged finance. He joins as a managing director with his most recent 14 years of experience at Bank of America Merrill Lynch, where he originated leveraged loan, bridge and high-yield transactions backing corporate and sponsor clients across healthcare.

Akis Psarris also joined as a managing director, and will head liability management. He joins from Lloyds Bank where he was managing director in debt capital markets. He had been managing director at J.P. Morgan for 11 years in its U.S. debt capital markets group.

Two others, Ricardo Simon and Matt Holbrook, join as directors.

Simon will head commercial real estate and REIT syndicated finance in his new role. He had been a director in the real estate syndicated finance group at Wells Fargo, where he worked with clients who required debt financing for recapitalizations, project loans and mergers and acquisitions.

Holbrook joins the group with 10 years of experience at Bank of America Merrill Lynch’s Leveraged Finance team in Charlotte, where he was most recently responsible for originating and structuring debt financings for consumer and retail clients. – Abby Latour

Follow Abby on Twitter @abbynyhk for middle-market deals, leveraged M&A, distressed debt, private equity, and more

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Bankruptcy: As it nixes its RSA, Energy Future’s old, vexing issues return

energyfutureholdings

Energy Future Holdings said it would conduct a “court supervised bid process with respect to” its restructuring and that of its unit, Energy Future Intermediate Holdings (EFIH), the intermediate holding company that is the direct owner of the company’s 80% interest in regulated utility Oncor, in order “to maximize their respective enterprise values for all stakeholders.”

Meanwhile, according to a Form 8-K the company filed this morning with the Securities and Exchange Commission, the company sent official notice that it would terminate its restructuring support agreement. The agreement, reached by the company and various clusters of creditor groups in late April ahead of Energy Future’s April 29 filing for Chapter 11, will officially terminate on July 31.

The pact’s termination was expected. As reported, the company told the bankruptcy court overseeing its Chapter 11 case last Friday that it would either terminate the agreement in coming days, or amend it to expire by its own terms on Aug. 8. Obviously, immediate termination won the day, but as reported the RSA was, for all intents and purposes, dead regardless of the path the company followed (see “Energy Future to scrap current reorg deal; sees potential new offers,” July 18, 2014).

At last week’s bankruptcy court hearing in Wilmington, Del., the company explained that the RSA was being terminated because since it was negotiated, higher trading prices for the company’s debt in secondary markets, along with amplified interest in the company’s assets (and higher valuations resulting from that interest) as exemplified by the efforts of NextEra Energy to acquire EFIH, had resulted in “parties … reaching out to the company to suggest transactions that were not previously available to it.”

Among other things, the company said during last week’s hearing that the NextEra offer for EFIH was “very promising.”

Looking ahead
In today’s Form 8-K filing, the company provided the first clues as to the shape of the coming negotiations over the company’s future. At this early stage, at least, it appears to present a mixed picture for the company’s prospects, suggesting that notwithstanding the improved opportunities the company says it sees in the market, the difficult issues arising from the company’s size, complexity, and capital structure that consumed nearly a year of pre-filing negotiation among creditors, and ultimately its entry into a RSA that is now being abandoned three months into the Chapter 11 process, have not significantly changed.

Among other things, the termination of the RSA suggests that the company’s stay in Chapter 11 will be longer than the 11 months the company was hoping for when it filed for Chapter 11. Indeed, the company filed a motion today with the bankruptcy court seeking to extend the exclusive period during which only the company could file a reorganization plan by 180 days, through Feb. 23, 2015. The company is also seeking to extend the corresponding exclusive period to solicit votes to a reorganization plan through April 25, 2015. A hearing on the exclusivity motion is set for Aug. 6.

The company’s initial exclusivity period is set to expire on Aug. 27, according to the motion, so even if the RSA remained in place the company was going to require an extension. That said, in its motion, the company states, “While the debtors remain focused on reaching consensus, they recognize that full consensus may not come right away or, at the end of the day, be possible given the diverse interests of their stakeholders.”

The EFIH bid process
In the Form 8-K, meanwhile, the company reiterated its comments from last week’s bankruptcy court hearing in Wilmington, Del., saying in the filing that it was “encouraged by the interest in EFIH and its subsidiaries, including Oncor.” In addition to pursuing a court-supervised bid process, the company said, it “intends to continue to negotiate with each party that has submitted bids to date with respect to the reorganization of EFH and EFIH.”

One of those bids, incorporated into the now defunct RSA, would have left EFH and EFIH in the hands of holders of unsecured 11.25% toggle notes due 2018 at EFIH and holders of unsecured debt, primarily Fidelity, at parent Energy Future Holdings (EFH), through a combination of the exchange of a proposed $1.9 billion second-lien DIP that EFIH and EFH unsecured creditors were to back for about 65% of the reorganized company’s equity, and the remainder of the equity distributed to EFIH and EFIH unsecured holders via the terms of a reorganization plan (with a small amount of equity reserved for holders of EFH legacy debt and EFH’s equity holders).

That transaction was premised on an enterprise value of EFIH and EFH of about $3.325 billion.

On June 18, however, NextEra, acting together with a group of EFIH second-lien lenders, submitted an offer to acquire the company out of Chapter 11 that valued EFIH and EFH at about $3.6 billion. NextEra and the second-lien lenders upped that offer on July 16, proposing a two-step merger transaction that it said would provide an additional $180 million of value for EFIH and EFH creditors (see “NextEra, noteholder group up offer for Energy Future Holdings,” July 17, 2014).

One significant difference between the two offers on the table, at least insofar as second-lien lenders are concerned, is the payment of a make-whole claim asserted by holders of the second-lien debt. The total claim is roughly $700 million, according to an affidavit filed by CFO Paul Keglovic in connection with the company’s Chapter 11 filing.

Under the RSA and the unsecured creditor proposal for EFH/EFIH, the company offered second-lien lenders a settlement offer of 50% of the asserted make-whole claim, launching a tender offer encompassing the settlement offer on May 9 (see “Energy Future launches tender offer for EFIH second-lien debt,” LCD, May 12, 2014). According to the company, 43% of second-lien holders had participated in the tender offer by the early participation deadline of June 11.

The NextEra/second lien acquisition proposal, in contrast, would pay the second-lien make-whole claims in full.

Meanwhile, adversary actions are also pending in the case as to whether, first, the second-lien lenders are entitled to the make-whole payment, and second, whether first-lien lenders at EFIH (who also claim a make-whole payment in excess of $700 million) need to be paid in full before any make-whole claim can be paid to second-lien lenders, in light of inter-creditor agreements among the secured lenders governing the treatment of collateral (see “EFIH first-lien lawsuit opens new front in make-whole claims fight,” LCD, June 24, 2014).

Those second-lien make-whole issues, at least, appear to have been mooted for the time being by the recent developments. According to the Form 8-K, the tender offer for the second-lien settlement, which will terminate on July 25, will not be extended or consummated due to the termination of the RSA.

The TCEH tax-free spin-off
Meanwhile, the company said that it “remains committed” to a tax-free spin off of Texas Competitive Electric Holding (TCEH), the intermediate holding company for Energy Future’s unregulated power generation and sales units, TXU Energy and Luminant.

The spin-off of TCEH remains on the table, obviously, because of the company’s plan to pursuing a bid process for the restructuring of EFIH and EFH. Indeed, the rationale the company provides for pursuing this bidding process – increasing valuation – suggests that the same dynamic that drove the structure of the RSA and the tax free spin-off of TCEH – the growing and stable enterprise value of the company’s regulated utility, Oncor, as compared to the uncertainty of its unregulated operations that are at the mercy of volatile and unpredictable energy markets – remains in place today. That said, the contrast between the company’s two sides is arguably not as stark as it had been over the prior year of negotiations leading up to the Chapter 11 filings thanks to rising natural gas prices that benefit TCEH.

The tax-free spin-off of TCEH was a critical component of the RSA, arising out of a determination that, in light of intractable disputes over the company’s enterprise value and how to allocate that value in any reorganization among the many layers of its complex capital structure, the company’s only path to a consensual reorganization was through a deconsolidation. That deconsolidation strategy, however, would potentially give rise to significant tax liabilities, either immediately or in the future, that would come to rest either with the first-lien TCEH lenders, or the unsecured creditors at EFIH and EFH.

The proposed tax-free spin-off of TCEH, combined with the application of certain of EFH’s tax attributes to the transaction – a structure that, incidentally, remains subject to approval of the Internal Revenue Service – was the key to securing the agreement of TCEH first-lien lenders, who would acquire the reorganized TCEH equity, to the deal in that it would permit the transaction to occur quickly, and let TCEH’s new owners (the lenders) to offset tax liabilities they would incur as a result of the tax-free spin-off.

But the proposed tax-free spin-off of TCEH potentially presents an issue for junior creditors at TCEH, comprised of holders of about $1.57 billion of second-lien notes and $4.9 billion of unsecured debt issued in connection with the company’s 2007 LBO. Under the RSA, both groups would have been, for the most part, out of the money. At last week’s hearing, an attorney for second-lien lenders suggested that a reorganization structure that was not based on a tax-free spin off of TCEH could yield significant enterprise value for TCEH. – Alan Zimmerman

 

 

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Bursting The ‘Bubble’ Talk: Today’s Leveraged Loan Market, By The Numbers

From stories in the popular press to dire analytical reports to pronouncements from Federal Reserve Chair Janet Yellen to statements from the OCC, a growing chorus is warning of a bubble in the leveraged loan market. Driven in part by the liquidity that (ironically) has resulted from the Fed’s zero-interest-rate/QE policy, banks and other lenders are said to be seeding the loan market with increasingly aggressive transactions and could end up reaping a bitter harvest of high defaults and stinging credit losses.

Our analysis of how far the pendulum has swung is based on hard data and is informed by conversations with loan market participants. One point on which everyone agrees: structure and terms are looser than they were earlier in the cycle, when liquidity was scarce and the economy was fragile.

Where views diverge, however, is on the question of whether we are witnessing the excesses normally associated with late-cycle booms such as those of the late 1980s (hyper leverage on thin-margin retail businesses), 1999-2000 (blueprint telecom deals), or 2006-2007 (highly leveraged, jumbo take-private LBO trades). Many market participants argue that the answer is no – or at least not yet.

To illustrate this point, the state of play in the leveraged loan market can be viewed along three broad lines:

  • Credit: Today’s loan issuers sport higher-than-average leverage multiples, but levels are well inside the peak readings of the past. However, this theme is mitigated in two ways. First, today’s low borrowing costs offset higher leverage by bolstering coverage ratios. Second, few 2014-model deals carry either the heroic leverage associated with the large-scale LBOs of 2007 or the negative out-of-the-blocks cash flow.
  • Risk/return: Though loan yields are low on an absolute basis, spreads relative to the base rate are still in the middle of the historical fairway.
  • Terms and conditions: Loan T&Cs have evolved in the post-crisis period in a way that offers issuers unprecedented optionality, most notably in the widespread use of incurrence tests and incremental tranches.

We’ll take each of these in turn.

New-issue credit profile
Large LBO deals provide a consistent gauge by which to measure the credit hygiene of the loan market. And, indeed, the average leverage ratio at which these deals have been struck has crept higher in recent quarters from the more conservative levels of 2010-2011.

At the same time, PE firms are reeling in equity contributions:

Still, what is missing from the recent mix is the large tail of highly leveraged, thin-coverage deals that were rampant in 2006/2007. This chart, for instance, shows the share of LBO deals structured at 7x-plus leverage:

In the past, such loans produced an outsized share of defaults when the cycle ultimately turned.

As well, rising leverage levels are being ameliorated by low borrowing costs, which bolster coverage ratios, as this chart illustrates:

More to the point, the super-thin-coverage deals of the 2006/2007 period are not in play. So far this year, just 2% of LBO loans had an initial ratio of EBITDA less capex to cash interest of less than 2.0x, versus 64% in 2007.

Here again, narrower coverage produced the expected spike in defaults.

Of course, some of this cushion could evaporate if interest rates spike. After all, just 14% of the average debt stack for first-half LBOs is in the form of fixed-rate bonds, and provisions that once required borrowers to hedge half of their floating-rate exposure are a relic of a bygone era, participants say. Thus, if LIBOR climbs past the average floor of 1%, issuers could be in for higher interest costs, and loans will reset higher. That said, forward three-month LIBOR doesn’t cross the 1% barrier until January 2016, according to Bloomberg, with expectations for 2% in January 2017 and 3% in April 2019. As these figures imply, the market believes it is unlikely that rising rates will crimp coverage any time soon.

Credit profile of the S&P/LSTA Index universe
By most measures, the credit profile of the loan market remains robust, despite the fact that leverage levels across the S&P/LSTA Index have climbed steady – if slowly – in recent quarters as a result of (1) record recap activity and (2) as noted above, more highly geared new-issue transactions.

Loan issuers’ ability to service debt, for instance, has improved dramatically in recent years as a result of two salutatory trends: (1) muscular EBITDA growth since the recession ended in June 2009 and (2) shrinking financing costs.

The result: fatter cash-flow-coverage multiples across the universe of S&P/LSTA Index issuers that file publicly.

While wider coverage doesn’t rule out defaults, it obviously affords issuers greater wherewithal in the event of a downturn.

Looking at rating dispersion shows a similar pattern. The share of performing S&P/LSTA Index loans outstanding that Standard & Poor’s rates CCC+ or lower climbed to a two-year high of 5.98% by June, from a five-year low of 4.19% in January. In the interim, S&P downgraded a few borrowers’ loans to triple-hook territory, including Caesars EntertainmentGymboreeEducation Management, and Auxilium. Despite the recent run-up, however, the share of CCC paper in the Index remains well inside the historical highs of 10-13%, from 2009.

Yield versus risk
Lining up the loan market’s current risk/return proposition with those of the past is a difficult exercise, given today’s historically low interest rates. In terms of absolute yields, today’s loans clearly offer a low prospective return.

In part, this situation is a product of razor-thin underlying base rates. Loan spreads, by contrast, are more generous. This chart shows the same trend but uses the discounted spread over LIBOR.

Putting this trend in context, BB Index loans offered a discounted spread of L+361, on average, as of July 11, which is 23 bps wide of the historical median level (we use median here because the heights of the dislocation skew the averages). Single-B loans, meanwhile, were at L+473, or one basis point wide.

It gets more interesting when we exclude the benefit of LIBOR floors, which many players see as a way to compensate lenders for a particularly steep yield curve, with three-month LIBOR lingering in the 0.20-0.25% range and 10-year Treasuries recently in a 2.5-2.6% band. Excluding LIBOR floors, the current BB discounted spread is L+296, 15 bps inside the long-term median, with single-Bs at L+391, or 20 bps lower.

Taken together, these metrics show that the market remains in the historical fairway between boom and bust.

Looking at the data another way, the average discounted spread of the S&P/LSTA Index was L+441 as of July 11, which implies an imputed default rate of 2.83%, outside both June’s reading of 1.08% (excluding Energy Future Holdings) and managers’ average June 2015 forecast of 1.76%.

As this chart makes plain, the margin of safety has tightened significantly in recent years in the face of robust market liquidity and consistent economic growth. That said, loans are not priced today as if there will never be another default, as was the case in late 2006/early 2007.

Documentation
Where the factors discussed above suggest a Goldilocks scenario in the loan market, the erosion in documentation protections is the poster-boy trend of the bubble brigade. Covenant-lite is the most visible example. So far this year, 62% of new institutional loans cleared with only incurrence tests, topping 2013’s prior high of 57%. As a result, a record 56% of S&P/LSTA Index loans are now covenant-lite, up from 46% at year-end 2013.

There is no doubt that managers see the proliferation of covenant-lite technology as an unfortunate outcome of today’s market liquidity. But the reason is not that covenant-lite loans are inherently more risky. In fact, the historical record shows that maintenance tests did not produce either (1) lower default rates or, more to the point, (2) lower losses given default. As reported, Energy Future Holdings’ $19.5 billion loan default, from April, pushed the 2008-to-date default experience of covenant-heavy S&P/LSTA Index loans to 19.0%, from 16.6%. By comparison, the corresponding figure for covenant-lite loans is 10.3%. Drilling down to loans that S&P initially rated single-B, the stats are similar, at 19.8% for loans with maintenance tests and 11.0% for those with incurrence tests. As for recovery rates, the average price at which defaulted incurrence-test-only loans exited bankruptcy was 70.0 cents on the dollar, versus 65.6 for loans with traditional tests.

That’s not to say that toggling from maintenance to incurrence tests is without consequence to lenders. Clearly, traditional financial covenants provide an effective repricing option for lenders when an issuer’s financial performance slides. Take the default spike 2008-2010. During that three-year period, issuers loosened tests on roughly 21% of covenanted loans that were outstanding at year-end 2007. On average, these waivers cost the borrowers in question a fee of 57 bps and 201 bps of incremental spread. Taking this calculation a step further, 86% of Index loans had maintenance tests when 2007 ended. Thus, from 2008-2010, lenders were able to increase the average spread of their legacy portfolio by 36 bps.

Apply those same statistics to today’s Index universe (44% of which is are subject to maintenance covenants), and the spread lift – based on the same pace of waivers for covenanted loans and average spread increase – would be just 19 bps.

Where covenant-lite is viewed more as a damper on future returns than a spur for higher credit losses when the cycle turns, managers do worry about the credit implications of free-and-clear incremental tranches. These provisions, which allow issuers to tap the market for additional loans unfettered by the restrictions of incurrence tests, have become a pervasive feature of newly minted covenant-lite loans over the past 18 months. Some parameters:

An anecdotal scan of recent deals shows that the vast majority of covenant-lite loans have an incremental carve-out under incurrence tests that allow issuers to add another turn, give or take, of fresh loans outside the scope of the covenant. In LCD’s review of the data, 2014 covenant-lite loans allowed free-and-clear tranches equal to 0.96x pro forma EBITDA.

The lenders have some protection, in that with rare exception – Gates Global being a notable recent example – loans are fortified with most-favored-nation provisions that do not sunset and therefore provide pricing protection for the life of the loan. So far this year, the average MFN is 50 bps. Moreover, managers have scored small victories by pushing back against excessively large incremental amounts. Recent examples include Vantiv, which scaled back its free-and-clear limit to $650 million, from $800 million; Phillips Medisize (to $80 million, from $100 million); and Nextgen (to $65 million, from $80 million).

Still, credit vigilantes worry that in an extreme case an issuer could raise an incremental tranche at some high rate to pay a dividend, thereby allowing a PE firm to get some (or all) of its bait back while lenders are left with a less creditworthy debtor vulnerable to default. Another potential downside risk: struggling issuers might use incremental tranches to effect a distressed exchange that converts subordinated debt into a lower-face-value amount of secured loans, but, in the process, dilutes first-lien collateral coverage. Those are just two obvious ways in which free-and-clear tranches could work to the detriment of secured lenders, managers say. Because free-and-clear technology is a recent innovation, however, there may be other pitfalls as yet unseen.

More issuer-friendly documentation in the form of incremental tranches, incurrence tests, and equity cures may well be a direct response to the rising liquidity in the loan asset class, which allows managers to enter and exit positions more easily and therefore may obviate the need for the buttoned-up terms that were necessary when the lender was married to a loan until maturity or repayment. Of course, this is cold comfort to managers who studied credit at the old school and are concerned that today’s less-restrictive terms may result in less-favorable recovery outcomes down the road.

Risk assessment
Innings of a baseball game is useful shorthand to describe where the market stands relative to the overall cycle. Some managers, however, prefer to describe the current cycle as a three-game series, with the first game over and the second now underway. To wit:

  • Game One (recovery/QE): That part of the cycle, which produced outsized returns for loans and virtually every other risk asset, concluded in 2013 as the Fed began tapering bond purchases and 10-year Treasury yields climbed from a decades-long low of 1.43% in July 2012 to the recent level of 2.5-2.6%.
  • Game Two (rate/event risks): The large early-cycle gains of Game One are now in the rearview mirror, but there appears to be little risk of a default spike over the next 12-24 months. Instead, managers say the paramount risks of this part of the cycle are a sudden change in the interest-rate curve or a disruptive outside shock, either of which could send liquidity to the sidelines and cause loan prices to fall.
  • Game Three (default/loss spike): This game will be played eventually, as it always is. The timing, however, will likely be several years into the future based on most economic prognostication, which views the chance of a near-term recession as remote – unless, of course, the U.S. economy is rocked by a catastrophic outside shock.

Given this framework, managers say the market is likely to be in the middle game of the cycle for a while longer. For the time being, the biggest risks for investors will be:

  • Event risk, in the form of an outside shock that sends investors to the sidelines and causes outflows from loan mutual funds to accelerate, while the CLO window slams shut.
  • Rate risk, such as either (1) an unexpected decline in rates or (2) a steeper rate curve that, in either case, could drive money from short-duration products like loans to longer-duration products like bonds, thereby crimping loan demand.

– Steve Miller

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