A leveraged loan is a commercial loan provided by a group of lenders. It is first structured, arranged, and administered by one or several commercial or investment banks, known as arrangers. It is then sold (or syndicated) to other banks or institutional investors. Leveraged loans can also be referred to as senior secured credits.
LCD’s Primer/Almanac details the main leveraged loan market mechanics and historical trends, and is aimed at those new to or interested in the leveraged loan asset class. We invite you to take a look.
A good place to start? This terrific video, featuring Paddy Hirsch.
Primary volume in the leveraged loan market fell in the third quarter, as opportunistic activity stalled amid choppy conditions. A prolonged August break due to the late Labor Day contributed to the slowdown. Pro rata volume fell to $45.3 billion in the third quarter, from $54.8 billion in the second quarter, but it exceeded the year-ago total of $41.5 billion. In this chart YTD = thru 3Q.
Starting with the large leveraged buyout (LBO) loans of the mid-1980s, the leveraged/syndicated loan market has become the dominant way for corporate borrowers (issuers) to tap banks and other institutional capital providers for loans. The reason is simple: Syndicated loans are less expensive and more efficient to administer than traditional bilateral – one company, one lender – credit lines.
Arrangers serve the time-honored investment-banking role of raising investor dollars for an issuer in need of capital. The issuer pays the arranger a fee for this service and, naturally, this fee increases with the complexity and riskiness of the loan.
As a result, the most profitable loans are those to leveraged borrowers – those whose credit ratings are speculative grade (traditionally double-B plus and lower), and who are paying spreads (premiums above LIBOR or another base rate) sufficient to attract the interest of nonbank term loan investors, (that spread typically will be LIBOR+200 or higher, though this threshold rises and falls, depending on market conditions).
By contrast, large, high-quality, investment-grade companies – those rated triple-B minus and higher – usually forego leveraged loans and pay little or no fee for a plain-vanilla loan, typically an unsecured revolving credit instrument that is used to provide support for short-term commercial paper borrowings or for working capital (as opposed to a fully drawn loan used to fund an acquisition of another company).
In many cases, moreover, these highly rated borrowers will effectively syndicate a loan themselves, using the arranger simply to craft documents and administer the process.
For a leveraged loan, the story is very different for the arranger. And by different we mean more lucrative.
A new leveraged loan can carry an arranger fee of 1% to 5% of the total loan commitment, depending on
Because investment-grade loans are infrequently drawn down and, therefore, offer drastically lower yields, the ancillary business that banks hope to see is as important as the credit product in arranging such deals, especially because many acquisition-related financings for investment-grade companies are large, in relation to the pool of potential investors, which would consist solely of banks.
Once the loan issuer (borrower) picks an arranging bank or banks and settles on a structure of the deal, the syndications process moves to the next phase. The “retail” market for a syndicated loan consists of banks and, in the case of leveraged transactions, finance companies and institutional investors such as mutual funds, structured finance vehicles and hedge funds (more on that in section 5).
Before formally offering a loan to these retail accounts, arrangers will often read the market by informally polling select investors to gauge appetite for the credit.
Based on these discussions, the arranger will launch the credit at a spread and fee it believes will “clear” the market.
Until 1998, this would have been all there is to it. Once the pricing was set, it was set, except in the most extreme cases. If the loan were undersubscribed – if investor interest in the loan was less than the amount arrangers were looking to syndicate – the arrangers could very well be left above their desired hold level.
As of 1998, however, the leveraged issuers, arrangers and investors adopted a “market flex” model, which figures heavily in how the sector operates today. Market Flex is detailed in the following section.
After the Russian debt crisis roiled the market in 1998, arrangers adopted “market-flex” language. Market flex allows arrangers to change the pricing of the loan based on investor demand—in some cases within a predetermined range—as well as shift amounts between various tranches of a loan, as a standard feature of loan commitment letters.
Market-flex language, in a single stroke, pushed the loan syndication process, at least in the leveraged arena, across the Rubicon to a full-fledged capital markets exercise.
Initially, arrangers invoked flex language to make loans more attractive to investors by hiking the spread or lowering the price. This was logical after the volatility introduced by the Russian debt debacle. Over time, however, market-flex became a tool either to increase or decrease pricing of a loan, based on investor demand.
Leveraged loan price flexes evened out a bit more in 2015’s third quarter as the market spent much of the period in what it calls ‘price-discovery’, where issuers and investors give/take re pricing and terms during the syndications process.
For example, an account may put in for $25 million at LIBOR+275 or $15 million at LIBOR+250. At the end of the process, the arranger will tally the commitments, then make a call as to where to price, or “print,” the paper.
Following the example above, if the loan is oversubscribed at LIBOR+250, the arranger may slice the spread further. Conversely, if it is undersubscribed, even at LIBOR+275, then the arranger may be forced to raise the spread to bring more money to the table.
M&A is the lifeblood of leveraged finance. There are the three primary types of acquisition loans:
1) Leveraged buyouts (LBOs)
Most LBOs are backed by a private equity firm, which funds the transaction with a significant amount of debt in the form of leveraged loans, mezzanine finance, high-yield bonds and/or seller notes. Debt as a share of total sources of funding for the LBO can range from 50% to upwards of 75%. The nature of the transaction will determine how highly it is leveraged. Issuers with large, stable cash flows usually are able to support higher leverage. Similarly, issuers in defensive, less-cyclical sectors are given more latitude than those in cyclical industry segments. Finally, the reputation of the private equity backer (sponsor) also plays a role, as does market liquidity (the amount of institutional investor cash available). Stronger markets usually allow for higher leverage; in weaker markets lenders want to keep leverage in check.
The third quarter saw a slight increase in LBO volume, though this segment of the M&A market continues to face headwinds in the form of (1) regulatory pressure and (2) stubbornly high purchase multiples, which remain historically high according to participants despite the recent stock market retreat. LBO loan volume, meanwhile, inched to $20.5 billion in the third quarter, versus $19.3 billion in the second quarter and $16.9 billion the year-ago period.
There are three main types of LBO deals:
Public-to-private (P2P) – also called go-private deals – in which the private equity firm purchases a publicly traded company via a tender offer. In some P2P deals a stub portion of the equity continues to trade on an exchange. In others the company is bought outright
Sponsor-to-sponsor (S2S) deals, where one private equity firm sells a portfolio property to another
Non-core acquisitions, in which a corporate issuer sells a division to a private equity firm.
2) Platform acquisitions
Transactions in which private-equity-backed issuers buys a business that they judge will be accretive by either creating cost savings and/or generating expansion synergies.
3) Strategic acquisitions
These are similar to a platform acquisitions but are executed by an issuer that is not owned by a private equity firm.
A leveraged loan backing a recapitalization results in changes in the composition of an entity’s balance sheet mix between debt and equity either by (1) issuing debt to pay a dividend or repurchase stock or (2) selling new equity, in some cases to repay debt.
Some common examples:
Dividend. Dividend financing is straightforward. A company takes on debt and uses proceeds to pay a dividend to shareholders. Activity here tends to track market conditions. Bull markets inspire more dividend deals as issuers tap excess liquidity to pay out equity holders. In weaker markets activity slows as lenders tighten the reins, and usually look skeptically upon transactions that weaken an issuer’s balance sheet.
Stock repurchase. In this form of recap deal a company uses debt proceeds to repurchase stock. The effect on the balance sheet is the same as a dividend, with the mix shifting toward debt.
Equity infusion. These transactions typically are seen in distressed situations. In some cases, the private equity owners agree to make an equity infusion in the company, in exchange for a new debt package. In others, a new investor steps in to provide fresh capital. Either way, the deal strengthens the company’s balance sheet.
IPO (reverse LBO). An issuer lists – or, in the case of a P2P LBO, relists – on an exchange. As part of such a deleveraging the company might revamp its loans or bonds at more favorable terms.
Refinancing Simply put, this entails a new loan or bonds issue to refinance existing debt.
Regulatory scrutiny on leverage-building deals and choppy market conditions reined in opportunistic activity during the 3rd quarter, limiting refinancings, and repricings. Clearly, issuers continue to make opportunistic hay when the sun shines, though even if the market were hot, such activity would likely fall below levels it otherwise would hit, absent today’s more restrictive regulatory regime.
General corporate purposes
These deals support working capital, general operations and other business-as-usual purposes.
Build-out financing supports a particular project, such as a utility plant, a land development deal, a casino or an energy pipeline.
In an underwritten deal the arrangers guarantee the entire amount committed, then syndicate the loan.
If the arrangers cannot get investors to fully subscribe the loan, they are forced to absorb the difference, which they may later try to sell sell. This is achievable, in most cases, if market conditions – or the credit’s fundamentals – improve. If not, the arranger may be forced to sell at a discount and, potentially, even take a loss on the paper (known as “selling through fees”). Or the arranger may just be left above its desired hold level of the credit.
So, why do arrangers underwrite loans? Two main reasons:
Offering an underwritten loan can be a competitive tool to win mandates.
Underwritten loans usually require more lucrative fees because the agent is on the hook if potential lenders balk.
Of course, with flex-language now common, underwriting a deal does not carry the same risk it once did, when the pricing was set in stone prior to syndication.
In a “best-efforts” syndication the arranger group commits to underwrite less than the entire amount of the loan, leaving the credit to the vicissitudes of the market. If the loan is undersubscribed, the credit may not close, or may need major surgery – such as an increase in pricing or additional equity from a private equity sponsor – to clear the market.
Traditionally, best-efforts syndications were used for riskier borrowers or for complex transactions.
Before awarding a mandate, an issuer might solicit bids from arrangers. The banks will outline their syndication strategy and qualifications, as well as their view on the way the loan will price in market.
Once the mandate is awarded, the syndication process starts.
The arranger will prepare an information memo (IM) describing the terms of the transactions. The IM typically will include an executive summary, investment considerations, a list of terms and conditions, an industry overview, and a financial model. Because loans are not securities, this will be a confidential offering made only to qualified banks and accredited investors.
If the issuer is speculative grade and seeking capital from non-bank investors, the arranger will often prepare a “public” version of the IM. This version will be stripped of all confidential material, such as financial projections from management, so that it can be viewed by accounts that operate on the public side of the wall, or that want to preserve their ability to buy bonds, stock or other public securities of the particular issuer (see the Public Versus Private section below).
Naturally, investors that view materially nonpublic information of a company are disqualified from buying the company’s public securities for some period of time.
As the IM is being prepared the syndicate desk will solicit informal feedback from potential investors regarding potential appetite for the deal, and at what price they are willing to invest. Once this intelligence has been gathered the agent will formally market the deal to potential investors.
Arrangers will distribute most IMs—along with other information related to the loan, pre- and post-closing – to investors through digital platforms. Leading vendors in this space are Intralinks, Syntrak and Debt Domain.
Executive summary: A description of the issuer, an overview of the transaction and rationale, sources and uses, and key statistics on the financials
Investment considerations: Basically, management’s sales “pitch” for the deal
Terms and conditions: A preliminary term sheet describing the pricing, structure, collateral, covenants, and other terms of the credit (covenants are usually negotiated in detail after the arranger receives investor feedback)
Industry overview: A description of the company’s industry and competitive position relative to its industry peers
Financial model: A detailed model of the issuer’s historical, pro forma, and projected financials, including management’s high, low, and base case for the issuer
Most new acquisition-related loans kick off at a bank meeting, wherepotential lenders hear management and the private equity/sponsor group (if there is one) describe what the terms of the loan are and what transaction it backs. Understandably, bank meetings are more often than not conducted via a Webex or conference call, although some issuers still prefer old-fashioned, in-person gatherings.
Whatever the format, management uses the bank meeting to provide its vision for the transaction and, most important, tell why and how the lenders will be repaid on or ahead of schedule. In addition, investors will be briefed regarding the multiple exit strategies, including second ways out via asset sales. (If it is a small deal or a refinancing instead of a formal meeting, there may be a series of calls. or one-on-one meetings with potential investors.)
Once the loan is closed, the final terms are then documented in detailed credit and security agreements. Subsequently, liens are perfected and collateral is attached.
Loans, by their nature, are flexible documents that can be revised and amended from time to time. These amendments require different levels of approval (see Voting Rights section). Amendments can range from something as simple as a covenant waiver to as complex as a change in the collateral package, or allowing the issuer to stretch out its payments or make an acquisition.
A bank investor can be a commercial bank, a savings and loan institution, or a securities firm that usually provides investment-grade loans. These are typically large revolving credits that back commercial paper or general corporate purposes. In some cases they support acquisitions.
For leveraged loans, banks typically provide unfunded revolving credits, letters of credit (LOCs) and – less and less, these days – amortizing term loans, under a syndicated loan agreement.
Institutional investors in the loan market usually are structured vehicles known as collateralized loan obligations (CLOs) and loan participation mutual funds (known as “Prime funds” because they were originally pitched to investors as a money market-like fund that would approximate the Prime rate).
In addition, hedge funds, high-yield bond funds, pension funds, insurance companies, and other proprietary investors do participate opportunistically in loans focusing usually on wide-margin (or “high-octane”) paper.
CLOs are special-purpose vehicles set up to hold and manage pools of leveraged loans.
The special-purpose vehicle is financed with several tranches of debt (typically a ‘AAA’ rated tranche, a ‘AA’ tranche, a ‘BBB’ tranche, and a mezzanine tranche) that have rights to the collateral and payment stream, in descending order. In addition, there is an equity tranche, but the equity tranche usually is not rated.
CLOs are created as arbitrage vehicles that generate equity returns via leverage, by issuing debt 10 to 11 times their equity contribution.
There are also market-value CLOs that are less leveraged – typically 3 to 5 times. These vehicles allow managers greater flexibility than more tightly structured arbitrage deals.
CLOs are usually rated by two of the three major ratings agencies and impose a series of covenant tests on collateral managers, including minimum rating, industry diversification, and maximum default basket.
Loan mutual funds are how retail investors can access the loan market. They are mutual funds that invest in leveraged loans. These funds – originally known as Prime funds, because they offered investors the chance to earn the Prime interest rate that banks charge on commercial loans – were first introduced in the late 1980s.
Today there are three main categories of funds:
Daily-access funds: These are traditional open-end mutual fund products into which investors can buy or redeem shares each day at the fund’s net asset value.
Continuously offered closed-end funds: These were the first loan mutual fund products. Investors can buy into these funds each day at the fund’s net asset value (NAV). Redemptions, however, are made via monthly or quarterly tenders, rather than each day, as with the open-end funds described above. To make sure they can meet redemptions, many of these funds, as well as daily access funds, set up lines of credit to cover withdrawals above and beyond cash reserves.
Exchange-traded closed-end funds (ETF): These funds, which have skyrocketed in popularity over the past few years, trade on a stock exchange. Typically the funds are capitalized by an initial public offering. Thereafter, investors can buy and sell shares, but may not redeem them. The manager can also expand the fund via rights offerings. Usually they are able to do so only when the fund is trading at a premium to NAV, however – a provision that is typical of closed-end funds regardless of the asset class.
In March 2011, Invesco introduced the first index-based exchange traded fund, PowerShares Senior Loan Portfolio (BKLN), which is based on the S&P/LSTA Loan 100 Index. By the second quarter of 2013 BKLN had topped $4.53 billion in assets under management.
In the old days, a bright red line separated public and private information in the loan market. Leveraged loans were strictly on the private side of the line, and any information transmitted between the issuer and the lender group remained confidential.
In the late 1980s that line began to blur as a result of two market innovations.
The first was a more active secondary trading market, which sprung up to support (1) the entry of non-bank investors into the market (investors such as insurance companies and loan mutual funds) and (2) to help banks sell rapidly expanding portfolios of distressed and highly leveraged loans that they no longer wanted to hold.
This meant that parties that were insiders on loans might now exchange confidential information with traders and potential investors who were not (or not yet) a party to the loan.
The second innovation that weakened the public/private divide was trade journalism focusing on the loan market.
Despite these two factors, the public versus private line was well understood, and rarely was controversial, for at least a decade.
This changed in the early 2000s as a result of:
The proliferation of loan ratings which, by their nature, provide public exposure for loan deals
The explosive growth of non-bank investors groups, which included a growing number of institutions that operated on the public side of the wall, including a growing number of mutual funds, hedge funds, and even CLO boutiques
The growth of the credit default swaps market, in which insiders like banks often sold or bought protection from institutions that were not privy to inside information
Again, a more aggressive effort by the press to report on the loan market
Some background is in order. The vast majority of loans are unambiguously private financing arrangements between issuers and lenders. Even for issuers with public equity or debt, and which file with the SEC, the credit agreement becomes public only when it is filed – months after closing, usually – as an exhibit to an annual report (10-K), a quarterly report (10-Q), a current report (8-K), or some other document (proxy statement, securities registration, etc.).
Beyond the credit agreement there is a raft of ongoing correspondence between issuers and lenders that is made under confidentiality agreements, including quarterly or monthly financial disclosures, covenant compliance information, amendment and waiver requests, and financial projections, as well as plans for acquisitions or dispositions. Much of this information may be material to the financial health of the issuer, and may be out of the public domain until the issuer formally issues a press release, or files an 8-K or some other document with the SEC.
In recent years there was growing concern among issuers, lenders, and regulators that migration of once-private information into public hands might breach confidentiality agreements between lenders and issuers. More important, it could lead to illegal trading. How has the market contended with these issues?
Traders. To insulate themselves from violating regulations, some dealers and buyside firms have set up their trading desks on the public side of the wall. Consequently, traders, salespeople, and analysts do not receive private information even if somewhere else in the institution the private data are available. This is the same technique that investment banks have used from time immemorial to separate their private investment banking activities from their public trading and sales activities.
Underwriters. As mentioned above, in most primary syndications, arrangers will prepare a public version of information memoranda that is scrubbed of private information (such as projections). These IMs will be distributed to accounts that are on the public side of the wall. As well, underwriters will ask public accounts to attend a public version of the bank meeting, and will distribute to these accounts only scrubbed financial information.
Buyside accounts. On the buyside there are firms that operate on either side of the public-private divide.
Accounts that operate on the private side receive all confidential materials and agree not to trade in public securities of the issuers in question. These groups are often part of wider investment complexes that do have public funds and portfolios but, via Chinese walls, are sealed from these parts of the firms.
There are also accounts that are public. These firms take only public IMs and public materials and, therefore, retain the option to trade in the public securities markets even when an issuer for which they own a loan is involved. This can be tricky to pull off in practice because, in the case of an amendment, the lender could be called on to approve or decline in the absence of any real information. To contend with this issue the account could either designate one person who is on the private side of the wall to sign off on amendments or empower its trustee, or the loan arranger to do so. But it’s a complex proposition.
Vendors. Vendors of loan data, news, and prices also face many challenges in managing the flow of public and private information. In general, the vendors operate under the freedom of the press provision of the U.S. Constitution’s First Amendment and report on information in a way that anyone can simultaneously receive it (for a price, of course). Therefore, the information is essentially made public in a way that doesn’t deliberately disadvantage any party, whether it’s a news story discussing the progress of an amendment or an acquisition, or a price change reported by a mark-to-market service. This, of course, doesn’t deal with the underlying issue: That someone who is a party to confidential information is making it available via the press or pricing services, to a broader audience.
Another way in which participants deal with the public-versus-private issue is to ask counterparties to sign “big-boy” letters. These letters typically ask public-side institutions to acknowledge that there may be information they are not privy to, and they are agreeing to make the trade in any case. They are, effectively, big boys, and will accept the risks.
Pricing a loan requires arrangers to evaluate the risk inherent in a loan and to gauge investor appetite for that risk.
The principal credit risk factors that banks and institutional investors contend with in buying loans
Among the primary ways that accounts judge these risks are ratings, collateral coverage, seniority, credit statistics, industry sector trends, management strength, and sponsor. All of these, together, tell a story about the deal.
Default risk is simply the likelihood of a borrower being unable to pay interest or principal on time.
It is based on the issuer’s financial condition, industry segment, and conditions in that industry, as well as economic variables and intangibles, such as company management.
Default risk will, in most cases, be most visibly expressed by a public rating from Standard & Poor’s Ratings Services or another ratings agency. These ratings range from ‘AAA’ for the most creditworthy loans to ‘CCC’ for the least.
The market is roughly divided into two segments:
Investment grade (loans to issuers rated ‘BBB-’ or higher)
Leveraged (borrowers rated ‘BB+’ or lower).
Default risk, of course, varies widely within each of these broad segments.
Since the mid-1990s, public loan ratings have become a de facto requirement for issuers that wish to do business with a wide group of institutional investors. Unlike banks, which typically have large credit departments and adhere to internal rating scales, fund managers rely on agency ratings to bracket risk, and to explain the overall risk of their portfolios to their own investors.
As of mid-2011, then, roughly 80% of leveraged loan volume carried a loan rating, up from 45% in 1998. Before 1995 virtually no leveraged loans were rated.
Where an instrument ranks in priority of payment is referred to as seniority. Based on this ranking, an issuer will direct payments with the senior most creditors paid first and the most junior equityholders last. In a typical structure, senior secured and unsecured creditors will be first in right of payment – though in bankruptcy, secured instruments typically move the front of the line – followed by subordinate bond holders, junior bondholders, preferred shareholders and common shareholders. Leveraged loans are typically senior, secured instruments and rank highest in the capital structure.
Loss-given-default risk measures how severe a loss the lender is likely to incur in the event of default.
Investors assess this risk based on the collateral (if any) backing the loan and the amount of other debt and equity subordinated to the loan. Lenders will also look to covenants to provide a way of coming back to the table early – that is, before other creditors – and renegotiating the terms of a loan if the issuer fails to meet financial targets.
Investment-grade loans are, in most cases, senior unsecured instruments with loosely drawn covenants that apply only at incurrence. That is, only if an issuer makes an acquisition or issues debt. As a result, loss-given-default may be no different from risk incurred by other senior unsecured creditors.
Leveraged loans, in contrast, are usually senior secured instruments that, except for covenant-lite loans, have maintenance covenants that are measured at the end of each quarter, regardless of the issuer is in compliance with pre-set financial tests.
Loan holders, therefore, almost always are first in line among pre-petition creditors and, in many cases, are able to renegotiate with the issuer before the loan becomes severely impaired. It is no surprise, then, that loan investors historically fare much better than other creditors on a loss-given-default basis.
Calculating loss given default is tricky business. Some practitioners express loss as a nominal percentage of principal or a percentage of principal plus accrued interest. Others use a present-value calculation, employing an estimated discount rate – typically the 15-25% demanded by distressed investors.
Credit statistics are used by investors to help calibrate both default and loss-given-default risk. These statistics include a broad array of financial data, including credit ratios measuring leverage (debt to capitalization and debt to EBITDA) and coverage (EBITDA to interest, EBITDA to debt service, operating cash flow to fixed charges). Of course, the ratios investors use to judge credit risk vary by industry.
In addition to looking at trailing and pro forma ratios, investors look at management’s projections, and the assumptions behind these projections, to see if the issuer’s game plan will allow it to service debt.
There are ratios that are most geared to assessing default risk. These include leverage and coverage.
Then there are ratios that are suited for evaluating loss-given-default risk. These include collateral coverage, or the value of the collateral underlying the loan, relative to the size of the loan. They also include the ratio of senior secured loan to junior debt in the capital structure.
Logically, the likely severity of loss-given-default for a loan increases with the size of the loan, as a percentage of the overall debt structure. After all, if an issuer defaults on $100 million of debt, of which $10 million is in the form of senior secured loans, the loans are more likely to be fully covered in bankruptcy than if the loan totals $90 million.
Industry segment is a factor because sectors, naturally, go in and out of favor.
For that reason, having a loan in a desirable sector, like telecom in the late 1990s or healthcare in the early 2000s, can really help a syndication along.
Also, loans to issuers in defensive sectors (like consumer products) can be more appealing in a time of economic uncertainty, whereas cyclical borrowers (like chemicals or autos) can be more appealing during an economic upswing.
Sponsorship is a factor too. Needless to say, many leveraged companies are owned by one or more private equity firms. These entities, such as Kohlberg Kravis & Roberts or Carlyle Group, invest in companies that have leveraged capital structures. To the extent that the sponsor group has a strong following among loan investors, a loan will be easier to syndicate and, therefore, can be priced lower. In contrast, if the sponsor group does not have a loyal set of relationship lenders, the deal may need to be priced higher to clear the market. Among banks, investment factors may include whether the bank is party to the sponsor’s equity fund. Among institutional investors, weight is given to an individual deal sponsor’s track record in fixing its own impaired deals by stepping up with additional equity or replacing a management team that is failing. For reference, here’s some of the largest sponsor-backed leveraged loans in 2015, along with the private equity firm associated with each deal. You can read about each loan by clicking on the issuer name below.
Most loans are structured and syndicated to accommodate the two primary syndicated lender constituencies: banks (domestic and foreign) and institutional investors (primarily structured finance vehicles, mutual funds, and insurance companies). As such, leveraged loans consist of:
Pro rata debt consists of the revolving credit and amortizing term loan (TLa), which are packaged together and, usually, syndicated to banks. In some loans, however, institutional investors take pieces of the TLa and, less often, the revolving credit, as a way to secure a larger institutional term loan allocation. Why are these tranches called “pro rata?” Historically, arrangers syndicated revolving credit and TLa tranches on a pro rata basis to banks and finance companies.
Institutional debt consists of term loans structured specifically for institutional investors, though there are also some banks that buy institutional term loans. These tranches include first- and second-lien loans, as well as pre-funded letters of credit. Traditionally, institutional tranches were referred to as TLbs because they were bullet payments, and are repaid after the TLa tranches.
Finance companies also play in the leveraged loan market, and buy both pro rata and institutional tranches. With institutional investors playing an ever-larger role, however, by the late 2000s many executions were structured simply as revolving credit/institutional term loans, with the TLa falling by the wayside.
Pricing loans for the institutional market is a straightforward exercise based on simple risk/return consideration and market technicals. Pricing a loan for the bank market, however, is more complex. Indeed, banks often invest in loans for more than just spread income. Rather, banks are driven by the overall profitability of the issuer relationship, including noncredit revenue sources.
Since the early 1990s almost all large commercial banks have adopted portfolio-management techniques that measure the returns of loans and other credit products, relative to risk. By doing so, banks have learned that loans are rarely compelling investments on a stand-alone basis.
Therefore, banks are reluctant to allocate capital to issuers unless the total relationship generates attractive returns – whether those returns are measured by risk-adjusted return on capital, by return on economic capital, or by some other metric.
If a bank is going to put a loan on its balance sheet, it takes a hard look not only at the loan’s yield, but at other sources of revenue from the relationship, including noncredit businesses – like cash-management services and pension-fund management – and economics from other capital markets activities, like bonds, equities, or M&A advisory work.
This process has had a breathtaking result on the leveraged loan market, to the point that it is an anachronism to continue to call it a “bank” loan market.
Of course, there are certain issuers that can generate a bit more bank appetite. As of mid-2011 these included issuers with a European or even a Midwestern U.S. angle. Naturally, issuers with European operations are able to better tap banks in their home markets (banks still provide the lion’s share of loans in Europe) and, for Midwestern issuers, the heartland remains one of the few U.S. regions with a deep bench of local banks.
What this means is that the spread offered to pro rata investors is important. But so too, in most cases, is the amount of other, fee-driven business a bank can capture by taking a piece of a loan. For this reason issuers are careful to award pieces of bond- and equity-underwriting engagements and other fee-generating business to banks that are part of its loan syndicate.
For institutional investors the investment decision process is far more straightforward because, as mentioned above, they are focused not on a basket of returns but on loan-specific revenue.
In pricing loans to institutional investors it’s a matter of the spread of the loan, relative to credit quality and market-based factors. This second category can be divided into liquidity and market technicals (i.e., supply/demand).
Liquidity is the tricky part but, as in all markets, all else being equal, more liquid instruments command thinner spreads than less liquid ones.
In the old days – before institutional investors were the dominant investors and banks were less focused on portfolio management – the size of a loan didn’t much matter. Loans sat on the books of banks and stayed there.
But now that institutional investors and banks put a premium on the ability to package loans and sell them, liquidity has become important. As a result, smaller executions – generally those of $200 million or less – tend to be priced at a premium to the larger loans.
Of course, once a loan gets large enough to demand extremely broad distribution the issuer usually must pay a size premium. The thresholds range widely. During the go-go mid-2000s it was upwards of $10 billion. During more parsimonious late-2000s a $1 billion credit was considered a stretch.
Market technicals, or supply relative to demand, is a matter of simple economics. If there are many dollars chasing little product then, naturally, issuers will be able to command lower spreads. If, however, the opposite is true, then spreads will need to increase for loans to be successfully syndicated.
Beginning in 2000 the SEC directed bank loan mutual fund managers to use available price data (bid/ask levels reported by dealer desks and compiled by mark-to-market services), rather than fair value (estimates based on whether the loan is likely to repay lenders in whole or part), to determine the value of broadly syndicated loan portfolios.
In broad terms this policy has made the market more transparent, improved price discovery and, in doing so, made the market far more efficient and dynamic than it was in the past.
A revolving credit line allows borrowers to draw down, repay, and reborrow.
An RC acts much like a corporate credit card, except that borrowers are charged an annual fee on unused amounts (a facility fee).
Revolvers to speculative-grade issuers are sometimes tied to borrowing-base lending formulas. This limits borrowings to a certain percentage of specified collateral, most often receivables and inventory (see “Asset-based loan” section below for a full discussion of this topic).
Revolving credits often run for 364 days. These revolving credits – called, not surprisingly, 364-day facilities – are generally limited to the investment-grade market. The reason for what seems like an odd term is that regulatory capital guidelines mandate that, after one year of extending credit under a revolving facility, banks must then increase their capital reserves to take into account the unused amounts.
Therefore, banks can offer issuers 364-day facilities at a lower unused fee than a multiyear revolving credit. There are a number of options that can be offered within a revolving credit line:
A swingline is a small, overnight borrowing line, typically provided by the agent.
A multicurrency line allows the borrower to borrow in one or more alternative currencies (in most agreements this option is capped).
A competitive-bid option (CBO) allows borrowers to solicit the best bids from its syndicate group. The agent will conduct what amounts to an auction to raise funds for the borrower, and the best bids are accepted. CBOs typically are available only to large, investment-grade borrowers.
A term-out will allow the borrower to convert borrowings into a term loan at a given conversion date. This, again, is usually a feature of investment-grade loans. Under the option, borrowers may take what is outstanding under the facility and pay it off according to a predetermined repayment schedule. Often the spreads ratchet up if the term-out option is exercised.
An evergreen is an option for the borrower – with consent of the syndicate group – to extend the facility each year, for an additional year. For instance, at the end of each year, a three-year facility would be reset to three years if the lenders and borrower agree. If the evergreen is not exercised, the agreement would simply run to term.
A term loan is simply an installment loan, such as a loan you’d use to buy a car.
The borrower may draw on the loan during a short commitment period (during which lenders usual chare a ticking fee, akin to a commitment fee on a revolver), and repay it based on either a scheduled series of repayments or a one-time lump-sum payment at maturity (bullet payment). There are two principal types of term loans:
An amortizing term loan (“A” term loans, or TLa) is a term loan with a progressive repayment schedule that typically runs six years or less. These loans are normally syndicated to banks along with revolving credits as part of a larger syndication.
An institutional term loan (“B” term loans, “C” term loans or “D” term loans) is a term loan facility carved out for nonbank, institutional accounts. These loans came into broad usage during the mid-1990s as the institutional loan investor base grew. This institutional category includes second-lien loans and covenant-lite loans.
Acquisition/equipment lines (delayed-draw term loans) are credits that may be drawn down for a given period to purchase specified assets or equipment, or to make acquisitions. The issuer pays a fee during the commitment period (a ticking fee). The lines are then repaid over a specified period (the term-out period). Repaid amounts may not be reborrowed.
Bridge loans are loans that are intended to provide short-term financing to provide a “bridge” to an asset sale, bond offering, stock offering, divestiture, etc. Generally, bridge loans are provided by arrangers as part of an overall financing package. Typically the issuer will agree to increasing interest rates if the loan is not repaid as expected. For example, a loan could start at a spread of L+250 and ratchet up 50 basis points every six months the loan remains outstanding past one year.
Equity bridge loan is a bridge loan provided by arrangers that is expected to be repaid by a secondary equity commitment to a leveraged buyout. This product is used when a private equity firm wants to close on a deal that requires, say, $1 billion of equity, of which it ultimately wants to hold half. The arrangers bridge the additional $500 million, which would be then repaid when other sponsors come into the deal to take the $500 million of additional equity. Needless to say, this is a hot-market product.
As their name implies, the claims on collateral of second-lien loans are junior to those of first-lien loans. Although they are really just another type of syndicated loan facility, second-liens are sufficiently complex to warrant detailed discussion here.
After a brief flirtation with second-lien loans in the mid-1990s, these facilities fell out of favor after the 1998 Russian debt crisis caused investors to adopt a more cautious tone. But after default rates fell precipitously in 2003 arrangers rolled out second-lien facilities to help finance issuers struggling with liquidity problems.
By 2007 the market had accepted second-lien loans to finance a wide array of transactions, including acquisitions and recapitalizations. Arrangers tap nontraditional accounts – hedge funds, distressed investors, and high-yield accounts – as well as traditional CLO and prime fund accounts to finance second-lien loans.
Again, the claims on collateral of second-lien loans are junior to those of first-lien loans. Second-lien loans also typically have less restrictive covenant packages, in which maintenance covenant levels are set wide of the first-lien loans. For these reasons, second-lien loans are priced at a premium to first-lien loans. This premium typically starts at 200 bps when the collateral coverage goes far beyond the claims of both the first- and second-lien loans, to more than 1,000 bps for less generous collateral.
There are, lawyers explain, two main ways in which the collateral of second-lien loans can be documented. Either the second-lien loan can be part of a single security agreement with first-lien loans, or they can be part of an altogether separate agreement. In the case of a single agreement, the agreement would apportion the collateral, with value going first, obviously, to the first-lien claims, and next to the second-lien claims.
Alternatively, there can be two entirely separate agreements. Here’s a brief summary:
In a single security agreement second-lien lenders are in the same creditor class as first-lien lenders from the standpoint of a bankruptcy, according to lawyers who specialize in these loans. As a result, for adequate protection to be paid the collateral must cover both the claims of the first- and second-lien lenders. If it does not the judge may choose to not pay adequate protection or to divide it pro rata among the first- and second-lien creditors.In addition, the second-lien lenders may have a vote as secured lenders equal to those of the first-lien lenders. One downside for second-lien lenders is that these facilities are often smaller than the first-lien loans and, therefore, when a vote comes up, first-lien lenders can out-vote second-lien lenders to promote their own interests.
In the case of two discrete security agreements, divided by a standstill agreement, the first- and second-lien lenders are likely to be divided into two creditor classes. As a result, second-lien lenders do not have a voice in the first-lien creditor committees. As well, first-lien lenders can receive adequate protection payments even if collateral covers their claims, but does not cover the claims of the second-lien lenders. This may not be the case if the loans are documented together and the first- and second-lien lenders are deemed a unified class by the bankruptcy court.
Like second-lien loans, covenant-lite loans are a particular kind of syndicated loan facility. At the most basic level, covenant-lite loans are loans that have bond-like financial incurrence covenants, rather than traditional maintenance covenants that are normally part and parcel of a loan agreement. What’s the difference?
Incurrence covenants generally require that if an issuer takes an action (paying a dividend, making an acquisition, issuing more debt), it would need to still be in compliance. So, for instance, an issuer that has an incurrence test that limits its debt to 5x cash flow would only be able to take on more debt if, on a pro forma basis, it was still within this constraint. If not it would have breached the covenant and be in technical default on the loan. If, on the other hand, an issuer found itself above this 5x threshold simply because its earnings had deteriorated, it would not violate the covenant.
Maintenance covenants are far more restrictive. This is because they require an issuer to meet certain financial tests every quarter, whether or not it takes an action. So, in the case above, had the 5x leverage maximum been a maintenance rather than incurrence test, the issuer would need to pass it each quarter, and would be in violation if either its earnings eroded or its debt level increased.
For lenders, clearly, maintenance tests are preferable because it allows them to take action earlier if an issuer experiences financial distress. What’s more, the lenders may be able to wrest some concessions from an issuer that is in violation of covenants (a fee, incremental spread, or additional collateral) in exchange for a waiver.
Conversely, issuers prefer incurrence covenants precisely because they are less stringent.
These are carve-outs in covenant-lite loans that allow borrowers to issue debt without triggering incurrence financial tests. For instance, a leverage test may say that an issuer cannot take on new debt if, on a pro forma basis, total debt to EBITDA would be 4x or more – but the test only kicks in once the issuer incurs more than, say, $100 million of new debt. That effectively gives the borrower the ability to issue up to $100 million of new debt at a market clearing rate whether or not leverage exceeds 4x. Lenders, in most cases, have most-favored-nations (MFN) protection that resets the yield of the existing loan to the rate of the new loan to make sure it remains on market. In rare cases, however, this protection is limited to a certain period of time by what is known as an MFN sunset. In other cases, the rate adjustment is capped, to perhaps 50 bps.
Free-and-clear tranches are an innovation that grew out of the proliferation of covenant-lite loans since 2013. Lenders expect the use of these provisions to ebb and flow with the strength of market conditions.
In the formative days of the syndicated loan market (the late 1980s) there was usually one agent that syndicated each loan. “Lead manager” and “manager” titles were doled out in exchange for large commitments. As league tables gained influence as a marketing tool, “co-agent” titles were often used in attracting large commitments, or in cases where these institutions truly had a role in underwriting and syndicating the loan.
During the 1990s the use of league tables – and, consequently, title inflation – exploded. Indeed, the co-agent title has become largely ceremonial today, routinely awarded for what amounts to no more than large retail commitments. In most syndications there is one lead arranger. This institution is considered to be on the “left” (a reference to its position in an old-time tombstone ad). There are also likely to be other banks in the arranger group, which may also have a hand in underwriting and syndicating a credit. These institutions are said to be on the “right.”
The different titles used by significant participants in the syndications process are administrative agent, syndication agent, documentation agent, agent, co-agent or managing agent, and lead arranger or book runner:
The administrative agent is the bank that handles all interest and principal payments and monitors the loan.
The syndication agent is the bank that handles, in purest form, the syndication of the loan. Often, however, the syndication agent has a less specific role.
The documentation agent is the bank that handles the documents and chooses the law firm.
The agent title is used to indicate the lead bank when there is no other conclusive title available, as is often the case for smaller loans.
The co-agent or managing agent is largely a meaningless title used mostly as an award for large commitments.
The lead arranger or book runner title is a league table designation used to indicate the “top dog” in a syndication.
Secondary sales occur after the loan is closed and allocated, when primary market investors are free to trade the paper. Loan sales are structured as either assignments or participations, with investors usually trading through dealer desks at the large underwriting banks. Dealer-to-dealer trading is almost always conducted through a “street” broker.
In an assignment, the assignee becomes a direct signatory to the loan and receives interest and principal payments directly from the administrative agent.
Assignments typically require the consent of the borrower and agent, trhough consent may be withheld only if a reasonable objection is made. In many loan agreements the issuer loses its right to consent in the event of default.
The loan document often sets a minimum assignment amount, usually $5 million, for pro rata commitments. In the late 1990s, however, administrative agents started to break out specific assignment minimums for institutional tranches. In most cases, institutional assignment minimums were reduced to $1 million in an effort to boost liquidity. There were also some cases where assignment fees were reduced or even eliminated for institutional assignments, but these lower assignment fees remained rare into 2012, and the vast majority was set at the traditional $3,500.
One market convention that became firmly established in the late 1990s was assignment-fee waivers by arrangers for trades crossed through its secondary trading desk. This was a way to encourage investors to trade with the arranger rather than with another dealer. This is a significant incentive to trade with the arranger – or a deterrent to not trade elsewhere, depending on your perspective – because a $3,500 fee amounts to between 7 bps to 35 bps of a $1 million to $5 million trade.
The term primary assignment is something of an oxymoron. It applies to primary commitments made by offshore accounts (principally CLOs and hedge funds). These vehicles, for a variety of reasons, suffer tax consequence from buying loans in the primary. The agent will therefore hold the loan on its books for some short period after the loan closes, then sell it to these investors via an assignment. These are called primary assignments and are effectively primary purchases.
As the name implies, in a participation agreement, the buyer takes a participating interest in the selling lender’s commitment.
The lender remains the official holder of the loan, with the participant owning the rights to the amount purchased. Consents, fees, or minimums are almost never required. The participant has the right to vote only on material changes in the loan document (rate, term, and collateral). Non-material changes do not require approval of participants.
A participation can be a riskier way of purchasing a loan because, if the lender becomes insolvent or defaults, the participant does not have a direct claim on the loan. In this case the participant then becomes a creditor of the lender, and often must wait for claims to be sorted out to collect on its participation.
Traditionally, accounts bought and sold loans in the cash market through assignments and participations. Aside from that, there was little synthetic activity outside over-the-counter total rate of return swaps. By 2008, however, the market for synthetically trading loans was budding.
This primer will look at three main types of loan derivatives:
Loan credit default swaps (LCDS) are standard derivatives that have secured loans as reference instruments. In June 2006, the International Settlement and Dealers Association issued a standard trade confirmation for LCDS contracts.
Like all credit default swaps (CDS), an LCDS is basically an insurance policy. The seller is paid a spread in exchange for agreeing to buy at par, or a pre-negotiated price, a loan if that loan defaults. LCDS enables participants to synthetically buy a loan by going short the LCDS or sell the loan by going long the LCDS. Theoretically, then, a loanholder can hedge a position either directly (by buying LCDS protection on that specific name) or indirectly (by buying protection on a comparable name or basket of names).
Moreover, unlike the cash markets, which are long-only markets for obvious reasons, the LCDS market provides a way for investors to short a loan. To do so, the investor would buy protection on a loan that it doesn’t hold. If the loan subsequently defaults, the buyer of protection should be able to purchase the loan in the secondary market at a discount and then deliver it at par to the counterparty from which it bought the LCDS contract.
For instance, say an account buys five-year protection for a given loan, for which it pays 250 bps a year. Then, in year two, the loan goes into default and the market price of the debt falls to 80% of par. The buyer of the protection can then buy the loan at 80 and deliver it to the counterparty at 100, a 20-point pickup.
Or instead of physical delivery, some buyers of protection may prefer a cash settlement in which the difference between the current market price and the delivery price is determined by polling dealers or using a third-party pricing service. Cash settlement could also be employed if there’s not enough paper to physically settle all LCDS contracts on a particular loan.
Introduced in 2007, the LCDX is an index of 100 LCDS obligations that participants can trade. The index provides a straightforward way for participants to take long or short positions on a broad basket of loans, as well as hedge exposure to the market.
Markit Group administers the LCDX, a product of CDS Index Co., a firm set up by a group of dealers. Like LCDS, the LCDX Index is an over-the-counter product.
The LCDX is reset every six months, with participants able to trade each vintage of the index that is still active. The index will be set at an initial spread, based on the reference instruments, and trade on a price basis. According to the primer posted by Markit, “the two events that would trigger a payout from the buyer (protection seller) of the index are bankruptcy or failure to pay a scheduled payment on any debt (after a grace period), for any of the constituents of the index.”
The total rate of return swap is the oldest way for participants to purchase loans synthetically. In essence, a TRS allows an institution to by a loan on margin.
In simple terms, under a TRS program a participant buys from a counterparty, usually a dealer, the income stream created by a reference asset (in this case a syndicated loan). The participant puts down some percentage as collateral, say 10%, and borrows the rest from the dealer. Then the participant receives the spread of the loan less the financial cost. If the reference loan defaults the participant is obligated to buy the facility at par or cash settle the position based on a mark-to-market price or an auction price.
Here’s how the economics of a TRS work, in simple terms.
A participant buys via TRS a $10 million position in a loan paying L+250. To affect the purchase the participant puts $1 million in a collateral account and pays L+50 on the balance (meaning leverage of 9:1). Thus, the participant would receive:
L+250 on the amount in the collateral account of $1 million, plus 200 bps (L+250 minus the borrowing cost of L+50) on the remaining amount of $9 million.
The resulting income is L+250 * $1 million plus 200 bps * $9 million. Based on the participants’ collateral amount – or equity contribution – of $1 million, the return is L+2020. If LIBOR is 5% the return is 25.5%.
Of course, this is not a risk-free proposition. If the issuer defaults and the value of the loan goes to 70 cents on the dollar the participant will lose $3 million. And if the loan does not default, but is marked down for whatever reason – maybe market spreads widen, it is downgraded, its financial condition deteriorates – the participant stands to lose the difference between par and the current market price when the TRS expires. Or, in an extreme case, the value declines below the value in the collateral account, and the participant is hit with a margin call.
In addition to the type of single-name TRS, another way to invest in loans is via a TRS program in which a dealer provides financing for a portfolio of loans, rather than a single reference asset.
The products are similar in that an investor would establish a collateral account equal to some percent of the overall TRS program and borrow the balance from a dealer. The program typically requires managers to adhere to diversification guidelines as well as weighted average maturity maximums as well as weighted average rating minimums.
Like with a single-name TRS, an investor makes money by the carry between the cost of the line and the spread of the assets. As well, any price appreciation bolsters the returns. Of course, if loans loss value, the investor’s losses would be magnified by the leverage of the vehicle. As well, if collateral value declines below a predetermined level, the investor could face a margin call, or in the worst-case scenario, the TRS could be unwound.
TRS programs were widely used prior to the 2008 credit contraction. Since then, they have figured far less prominently into the loan landscape as investors across the capital markets shy away from leveraged, mark-to-market product.
Most loans are floating-rate instruments that are periodically reset to a spread over a base rate, typically LIBOR. In most cases, borrowers can lock in a given rate for one month to one year.
Syndication pricing options include Prime, as well as LIBOR, CDs, and other fixed-rate options:
Prime is a floating-rate option. Borrowed funds are priced at a spread over the reference bank’s Prime lending rate. The rate is reset daily, and borrowings may be repaid at any time without penalty. This is typically an overnight option, because the Prime option is more costly to the borrower than LIBOR or CDs.
The LIBOR (or Eurodollar) option is so called because, with this option, the interest on borrowings is fixed for a period of one month to one year. The corresponding LIBOR rate is used to set pricing. Borrowings cannot be prepaid without penalty.
The CD option works precisely like the LIBOR option, except that the base rate is certificates of deposit, sold by a bank to institutional investors.
Other fixed-rate options are less common but work like the LIBOR and CD options. These include federal funds (the overnight rate, which is set by the Federal Reserve, at which banks charge each other on overnight loans) and cost of funds (the bank’s own funding rate).
Borrower pays a specified spread over the base rate to borrow under loan agreements. The spread is typically expressed in basis points. Further, spreads on many loans are tied to performance grids. In this case, the spread adjusts based on one or more financial criteria. Ratings are typical in investment-grade loans. Financial ratios for leveraged loans. Media and communications loans are invariably tied o the borrower’s debt-to-cash-flow ratio.
An upfront fee is a fee paid by the issuer at close. It is often tiered, with the lead arranger receiving a larger amount in consideration for structuring and/or underwriting the loan. Co-underwriters will receive a lower fee, and then investors in the general syndicate will likely have fees tied to their commitment.
Most often, fees are paid on a lender’s final allocation. For example, a loan has two fee tiers: 100 bps (or 1%) for $25 million commitments and 50 bps for $15 million commitments. A lender committing to the $25 million tier will be paid on its final allocation rather than on commitment, which means that, in this example, if the loan is oversubscribed, lenders committing $25 million would be allocated $20 million and receive a fee of $200,000 (or 1% of $20 million).
Sometimes upfront fees will be structured as a percentage of final allocation plus a flat fee. This happens most often for larger fee tiers, to encourage potential lenders to step up for larger commitments. The flat fee is paid regardless of the lender’s final allocation.
Fees are usually paid to banks, mutual funds, and other non-offshore investors at close. CLOs and other offshore vehicles are typically brought in after the loan closes as a “primary” assignment, and they simply buy the loan at a discount equal to the fee offered in the primary assignment, for tax purposes.
A facility fee is paid on a facility’s entire committed amount, regardless of usage.
A facility fee is often charged instead of a commitment fee on revolving credits to investment-grade borrowers, because these facilities typically have competitive bid options that allow a borrower to solicit the best bid from its syndicate group for a given borrowing. The lenders that do not lend under the CBO are still paid for their commitment.
A prepayment fee is a feature generally associated with institutional term loans.
Typical prepayment fees will be set on a sliding scale. For instance: 2% in year one and 1% in year two. The fee may be applied to all repayments under a loan loan including from asset sales and excess cash flow (a “hard” fee) or specifically to discretionary payments made from a refinancing or out of cash on hand (a “soft” fee).
A letter of credit fee (LOC) can be any one of several types.
The most common – a fee for standby or financial LOCs – guarantees that lenders will support various corporate activities. Because these LOCs are considered “borrowed funds” under capital guidelines, the fee is typically the same as the LIBOR margin.
Fees for commercial LOCs (those supporting inventory or trade) are usually lower, because in these cases actual collateral is submitted.
The LOC is usually issued by a fronting bank (usually the agent) and syndicated to the lender group on a pro rata basis. The group receives the LOC fee on their respective shares while the fronting bank receives an issuing (or fronting, or facing) fee for issuing and administering the LOC. This fee is almost always 12.5 bps to 25 bps (0.125% to 0.25%) of the LOC commitment.
This is yet another term imported from the bond market.
The original-issue discount (OID), or the discount from par at which the loan is offered for sale to investors, is used in the new issue market as a spread enhancement. If a loan is issued at 99 cents on the dollar to pay par, the OID is said to be 100 bps, or 1 point.
OID vs Upfront Fees
So, what’s the difference between an OID and an upfront fee? After all, in both cases the lender effectively pays less than par for a loan.
From the perspective of the lender, actually, there is no practical difference. From an accounting perspective, an OID and a fee may be recognized, and potentially taxed, differently.
Amendments or changes to a loan agreement must be approved by a certain percentage of lenders. Most loan agreements have three levels of approval: required-lender level, full vote, and supermajority:
The “required-lenders” level, usually just a simple majority, is used for approval of non-material amendments and waivers or changes affecting one facility within a deal.
A full vote of all lenders, including participants, is required to approve material changes such as RATS rights (rate, amortization, term, and security; or collateral), but as described below, there are occasions when changes in amortization and collateral may be approved by a lower percentage of lenders (a supermajority).
A supermajority is typically 67-80% of lenders. It sometimes is required for certain material changes, such as changes in term loan repayments and release of collateral.
Loan agreements have a series of restrictions that dictate, to varying degrees, how borrowers can operate and carry themselves financially.
For instance, one covenant may require the borrower to maintain its existing fiscal-year end. Another may prohibit it from taking on new debt. Most agreements have financial compliance covenants, stipulating perhaps that a borrower must maintain a prescribed level of performance, which, if not maintained, gives banks the right to terminate the agreement or push the borrower into default.
The size of the covenant package increases in proportion to a borrower’s financial risk. Agreements to investment-grade companies are usually thin and simple. Agreements to leveraged borrowers are more restrictive.
The three primary types of loan covenants are affirmative, negative, and financial.
Affirmative covenants state what action the borrower must take to be in compliance with the loan.
These covenants are usually boilerplate, and require a borrower to pay the bank interest and fees, for instance, or to provide audited financial statements, maintain insurance, pay taxes, and so forth.
Negative covenants limit the borrower’s activities in some way, such as undertaking new investments.
Negative covenants, which are highly structured and customized to a borrower’s specific condition, can limit the type and amount of acquisitions and investments, new debt issuance, liens, asset sales, and guarantees.
Many negative covenants are structured with baskets that allow issuers flexibility to take certain actions – for example, to pay dividends or make acquisitions – as long as the amounts involved remain within a set range. In many cases, the agreement will provide initial capacity, known as a Starter Basket, as well as additional capacity based on a percent of free cash flow or net income, known as a Building Basket.
Financial covenants enforce minimum financial performance measures against the borrower, such: The company must maintain a higher level of current assets than of current liabilities.
Broadly speaking, there are two types of financial convenants: maintenance and incurrence.
Under maintenance covenants, issuers must pass agreed-to tests of financial performance such as minimum levels of cash flow coverage and maximum levels of leverage. If an issuer fails to achieve these levels, lenders have the right to accelerate the loan. In most cases, though, lenders will pass on this draconian option and instead grant a waiver in return for some combination of a fee and/or spread increase; a repayment or a structuring concenssion such as additional collateral or seniority.
An inccurence covenant is tested only if an issuer takes an action, such as issuing debt or making an acquisition. If, on a pro forma basis, the issuer fails the test then it is not allowed to proceed without permission of the lenders.
Historically, maintenance tests were associated with leveraged loans and incurrence tests with investment-grade loans and bonds. More recently, the evolution of covenant-lite loans (see above) has blurred the line.
In a traditional loan agreement, as a borrower’s risk increases, financial covenants become more tightly wound and extensive. In general, there are five types of financial covenants–coverage, leverage, current ratio, tangible net worth, and maximum capital expenditures:
A coverage covenant requires the borrower to maintain a minimum level of cash flow or earnings, relative to specified expenses, most often interest, debt service (interest and repayments), and fixed charges (debt service, capital expenditures, and/or rent).
A leverage covenant sets a maximum level of debt, relative to either equity or cash flow, with total-debt-to-EBITDA level being the most common. In some cases operating cash flow is used as the divisor. Moreover, some agreements test leverage on the basis of net debt (total less cash and equivalents) or senior debt.
A current-ratio covenant requires that the borrower maintain a minimum ratio of current assets (cash, marketable securities, accounts receivable, and inventories) to current liabilities (accounts payable, short-term debt of less than one year), but sometimes a “quick ratio,” in which inventories are excluded from the numerator, is substituted.
A tangible-net-worth (TNW) covenant requires that the borrower have a minimum level of TNW (net worth less intangible assets, such as goodwill, intellectual assets, excess value paid for acquired companies), often with a build-up provision, which increases the minimum by a percentage of net income or equity issuance.
A maximum-capital-expenditurescovenant requires that the borrower limit capital expenditures (purchases of property, plant, and equipment) to a certain amount, which may be increased by some percentage of cash flow or equity issuance, but often allowing the borrower to carry forward unused amounts from one year to the next.
Leveraged loans usually require a borrower to prepay with proceeds of excess cash flow, asset sales, debt issuance, or equity issuance.
Excess cash flow is typically defined as cash flow after all cash expenses, required dividends, debt repayments, capital expenditures, and changes in working capital. The typical percentage required is 50-75%.
Asset sales are defined as net proceeds of asset sales, normally excluding receivables or inventories. The typical percentage required is 100%.
Debt issuance is defined as net proceeds from debt issuance. The typical percentage required is 100%.
Equity issuance is defined as the net proceeds of equity issuance. The typical percentage required is 25% to 50%.
Often, repayments from excess cash flow and equity issuance are waived if the issuer meets a preset financial hurdle, most often structured as a debt/EBITDA test.
In the leveraged market, collateral usually includes all the tangible and intangible assets of the borrower and, in some cases, specific assets that back a loan.
Virtually all leveraged loans and some of the more shaky investment-grade credits are backed by pledges of collateral.
In the asset-based market, for instance, that typically takes the form of inventories and receivables, with the maximum amount of the loan that the issuer may draw down capped by a formula based off of these assets. The common rule is that an issuer can borrow against 50% of inventory and 80% of receivables. There are loans backed by certain equipment, real estate, and other property as well.
In the leveraged market there are some loans that are backed by capital stock of operating units. In this structure the assets of the issuer tend to be at the operating-company level and are unencumbered by liens, but the holding company pledges the stock of the operating companies to the lenders. This effectively gives lenders control of these subsidiaries and their assets if the company defaults.
The risk to lenders in this situation, simply put, is that a bankruptcy court collapses the holding company with the operating companies and effectively renders the stock worthless. In these cases – this happened on a few occasions to lenders to retail companies in the early 1990s – loan holders become unsecured lenders of the company and are put back on the same level with other senior unsecured creditors.
Those not collateral in the strict sense of the word, most leveraged loans are backed by the guarantees of subsidiaries so that if an issuer goes into bankruptcy all of its units are on the hook to repay the loan. This is often the case, too, for unsecured investment-grade loans.
Some loans have provisions stipulating that borrowers sitting on the cusp of investment-grade and speculative-grade must either attach collateral or release it if the issuer’s rating changes.
A ‘BBB’ or ‘BBB-’ issuer may be able to convince lenders to provide unsecured financing, but lenders may demand springing liens in the event the issuer’s credit quality deteriorates.
Often, an issuer’s rating being lowered to ‘BB+’ or exceeding a predetermined leverage level will trigger this provision. Likewise, lenders may demand collateral from a strong, speculative-grade issuer, but will offer to release under certain circumstances (if the issuer attains an investment-grade rating, for instance).
Invariably, one of the events of default in a credit agreement is a change of issuer control.
For both investment-grade and leveraged issuers, an event of default in a credit agreement will be triggered by a merger, an acquisition of the issuer, some substantial purchase of the issuer’s equity by a third party, or a change in the majority of the board of directors.
For sponsor-backed leveraged issuers, the sponsor’s lowering its stake below a preset amount can also trip this clause.
These provision allow issuers to fix a covenant violation – exceeding the maximum leverage test for instance – by making an equity contribution.
These provisions are generally found in private equity backed deals. The equity cure is a right, not an obligation. Therefore, a private equity firm will want these provisions, which, if they think it’s worth it, allows them to cure a violation without going through an amendment process, during which lenders will often ask for wider spreads and/or fees, in exchange for waiving the violation, even with an infusion of new equity.
Some agreements don’t limit the number of equity cures, while others cap the number to, say, one per year or two over the life of the loan. It’s a negotiated point, however, so there is no rule of thumb.
Most of the information above refers to “cash flow” loans, loans that may be secured by collateral, but are repaid by cash flow.
Asset-based lending is a distinct segment of the loan market. These loans are secured by specific assets and usually are governed by a borrowing formula (or a “borrowing base”). The most common type of asset-based loans are receivables and/or inventory lines. These are revolving credits that have a maximum borrowing limit, perhaps $100 million, but also have a cap based on the value of an issuer’s pledged receivables and inventories.
Usually the receivables are pledged and the issuer may borrow against 80%, give or take. Inventories are also often pledged to secure borrowings. However, because they are obviously less liquid than receivables, lenders are less generous in their formula. Indeed, the borrowing base for inventories is typically in the 50-65% range. In addition, the borrowing base may be further divided into subcategories – for instance, 50% of work-in-process inventory and 65% of finished goods inventory.
In many receivables-based facilities issuers are required to place receivables in a “lock box.” That means that the bank lends against the receivable, takes possession of it, and then collects it to pay down the loan.
In addition, asset-based lending is often done based on specific equipment, real estate, car fleets, and an unlimited number of other assets.
Most often, bifurcated collateral refers to cases where the issuer divides collateral pledge between asset-based loans and funded term loans.
The way this works, typically, is that asset-based loans are secured by current assets like accounts receivables and inventories, while term loans are secured by fixed assets like property, plant, and equipment. Current assets are considered to be a superior form of collateral because they are more easily converted to cash.
Though not collateral in the strict sense of the word, most leveraged loans are backed by the guarantees of subsidiaries, so that if an issuer goes into bankruptcy all of its units are on the hook to repay the loan. This is often the case, too, for unsecured investment-grade loans.
Calculating loan yields or spreads is not straightforward.
Unlike most bonds, which have long no-call periods and high-call premiums, most loans are prepayable at any time, typically without prepayment fees. And even in cases where prepayment fees apply they are rarely more than 2% in year one and 1% in year two. Therefore, affixing a spread-to-maturity or a spread-to-worst on loans is little more than a theoretical calculation.
This is because an issuer’s behavior is unpredictable. It may repay a loan early because a more compelling financial opportunity presents itself or because the issuer is acquired, or because it is making an acquisition and needs a new financing. Traders and investors will often speak of loan spreads, therefore, as a spread to a theoretical call.
Loans had a 15-month average life between 1997 and 2004. So, if you buy a loan with a spread of 250 bps at a price of 101, you might assume your spread-to-expected-life as the 250 bps less the amortized 100 bps premium, or LIBOR+170. Conversely, if you bought the same loan at 99, the spread-to-expected life would be LIBOR+330. Of course, if there’s a LIBOR floor, the minimum would apply.
There are two primary types of loan defaults: technical defaults, and the much more serious payment defaults.
Technical defaults occur when the issuer violates a provision of the loan agreement. For instance, if an issuer doesn’t meet a financial covenant test or fails to provide lenders with financial information or some other violation that doesn’t involve payments.
When this occurs, the lenders can accelerate the loan and force the issuer into bankruptcy. That’s the most extreme measure. In most cases, the issuer and lenders can agree on an amendment that waives the violation in exchange for a fee, spread increase, and/or tighter terms.
Payment defaults are a more serious matter. As the name implies, this type of default occurs when a company misses either an interest or principal payment. There is often a pre-set period of time, say 30 days, during which an issuer can cure a default (the “cure period”). After that, the lenders can choose to either provide a forbearance agreement that gives the issuer some breathing room or take appropriate action, up to and including accelerating, or calling, the loan.
If the lenders accelerate, the company will generally declare bankruptcy and restructure debt via Chapter 11. If the company is not worth saving, however, because its primary business has cratered, then the issuer and lenders may agree to a Chapter 7 liquidation, under which the assets of the business are sold and the proceeds dispensed to the creditors.
Debtor-in-possession (DIP) loans are made to bankrupt entities. These loans constitute super-priority claims in the bankruptcy distribution scheme, and thus sit ahead of all prepretition claims. Many DIPs are further secured by priming liens on the debtor’s collateral.
Traditionally, prepetition lenders provided DIP loans as a way to keep a company viable during the bankruptcy process and therefore protect their claims. In the early 1990s a broad market for third-party DIP loans emerged. These non-prepetition lenders were attracted to the market by the relatively safety of most DIPs, based on their super-priority status, and relatively wide margins. This was the case again the early 2000s default cycle.
In the late 2000s default cycle, however, the landscape shifted because of more dire economic conditions. As a result, liquidity was in far shorter supply, constraining availability of traditional third-party DIPs. Likewise, with the severe economic conditions eating away at debtors’ collateral – not to mention reducing enterprise values – prepetition lenders were more wary of relying solely on the super-priority status of DIPs, and were more likely to ask for priming liens to secure facilities.
The refusal of prepetition lenders to consent to such priming, combined with the expense and uncertainty involved in a priming fight in bankruptcy court, greatly reduced third-party participation in the DIP market. With liquidity in short supply, new innovations in DIP lending cropped up aimed at bringing nontraditional lenders into the market. These include:
Junior DIPs. These facilities are typically provided by bond holders or other unsecured debtors as part of a loan-to-own strategy. In these transactions the providers receive much or all of the post-petition equity interest as an incentive to provide the DIP loans.
Roll-up DIPs. In some bankruptcies – LyondellBasell and Spectrum Brands are two 2009 examples – DIP providers were given the opportunity to roll up prepetition claims into junior DIPs that rank ahead of other prepetition secured lenders. This sweetener was particularly compelling for lenders that had bought prepetition paper at distressed prices, and were able to realize a gain by rolling it into the junior DIPs.
Junior and roll-up DIPs are suited to challenging markets during which liquidity is scarce. During more liquid times, issuers can usual secure less costly financing in the form of traditional DIPs from prepetition lenders and/or third-party lenders.
Sub-par loan buybacks are another technique that grew out of the bear market, that began in 2007. Performing paper fell to a price not seen before in the loan market – with many names trading south of 70. This created an opportunity for issuers with the financial wherewithal and the covenant room to repurchase loans via a tender, or in the open market, at prices below par.
Sub-par buybacks have deep roots in the bond market. Loans didn’t suffer the price declines before 2007 to make such tenders attractive, however. In fact, most loan documents do not provide for a buyback. Instead, issuers typically need obtain lender approval via a 50.1% amendment.
This is a negotiated tender in which classholders will swap existing paper for a new series of bonds that typically have a lower principal amount and, often, a lower yield. In exchange the bondholders might receive stepped-up treatment, going from subordinated to senior, say, or from unsecured to second-lien.
Standard & Poor’s consider these programs a default and, in fact, the holders are agreeing to take a principal haircut in order to allow the company to remain solvent and improve their ultimate recovery prospects.
This technique is used frequently in the bond market but rarely for first-lien loans. One good example was courtesy Harrah’s Entertainment. In 2009 the gaming company issued $3.6 billion of 10% second-priority senior secured notes due 2018 for about $5.4 billion of bonds due between 2010 and 2018.
For default rate by number of loans: the number of loans that default over a given 12-month period divided by the number of loans outstanding at the beginning of that period.
For default rate by principal amount: the amount of loans that default over a 12-month period divided by the total amount outstanding at the beginning of the period.
Standard & Poor’s defines a default for the purposes of calculating default rates as a loan that is either (1) rated ’D’ by Standard & Poor’s, (2) to an issuer that has filed for bankruptcy, or (3) in payment default on interest or principal.
An amend-to-extend transaction allows an issuer to push out part of its loan maturities through an amendment, rather than a full-out refinancing.
Amend-to-extend transactions came into widespread use in 2009 as borrowers struggled to push out maturities in the face of difficult lending conditions that made refinancing prohibitively expensive.
Amend-to-extend transactions have two phases, as the name implies.
The first is an amendment in which at least 50.1% of the bank group approves the issuer’s ability to roll some or all existing loans into longer-dated paper. Typically the amendment sets a range for the amount that can be tendered via the new facility, as well as the spread at which the longer-dated paper will pay interest.
The new debt is pari passu with the existing loan. But because it matures later and, thus, is structurally subordinated, it carries a higher rate and, in some cases, more attractive terms. Because issuers with big debt loads are expected to tackle debt maturities over time, amid varying market conditions, in some cases accounts insist on most-favored-nation protection. Under such protection the spread of the loan would increase if the issuer in question prints a loan at a wider margin.
The second phase is the conversion, in which lenders can exchange existing loans for new loans. In the end, the issuer is left with two tranches: (1) the legacy paper at the initial spread and maturity and (2) the new longer-dated facility at a wider spread. The innovation here: amend-to-extend allows an issuer to term-out loans without actually refinancing into a new credit (which, obviously would require marking the entire loan to market, entailing higher spreads, a new OID, and stricter covenants).
In 2014, The Office of the Comptroller of the Currency along with the Federal Reserve and other regulatory agencies, issued guidelines under which loans that fail to meet credit standards will be deemed “criticized” or “special mention” by bank regulators. Banks that either underwrite or hold such loans could face penalties as a result.
As of this writing (July 2015), the primary criteria was whether an issuer is able, via normal cash flow generation, to repay either all of its senior debt or half of its total debt over seven years.
In addition to restrictions on arranging banks, CLO managers were to, beginning in 2016, face risk-retention requirements under Section 941 of Dodd-Frank. Under these rules, investment managers are required to retain no less than five percent of the credit risk of assets they securitized, except for pools of qualified mortgages.
These are lists from dealers with indicative secondary bids and offers for loans. Axes are simply price indications.
Simply, the price at which loans or bonds are initially traded into the secondary market after they close and allocate. It is called the break price because that is where the facility breaks into the secondary market.
Aka “Bids Wanted in Competition.” This is really just a fancy way of describing a secondary auction of loans or bonds. Typically, an account will offer up a portfolio of facilities via a dealer. The dealer will then put out a BWIC, asking potential
buyers to submit for individual names or the entire portfolio. The dealer will then collate the bids and award each facility to the highest bidder.
When a loan or bond is fully subscribed at a given price it is said to be circled. After that, the loan or bond moves to allocation and funding.
The level that a dealer agrees to essentially underwrite a BWIC or an auction. The dealer, to win the business, may give an account a cover bid, effectively putting a floor on the auction price.
This is calculated by either number of loans or principal amount. The formula is similar. For default rate by number of loans: the number of loans that default over a given 12-month period divided by the number of loans outstanding at the beginning of that period. For default rate by principal amount: the amount of loans that default over a 12-month period divided by the total amount outstanding at the beginning of the period. Standard & Poor’s defines a default for the purposes of calculating default rates as a loan that is either (1) rated ’D’ by Standard & Poor’s, (2) to an issuer that has filed for bankruptcy, or (3) in payment default on interest or principal.
In the loan market, loans traded at less than 80 cents on the dollar are usually considered distressed. In the bond market, the common definition is a spread of 1,000 bps or more. For loans, however, calculating spreads is an elusive art (see above) and
therefore a more pedestrian price measure is used.
Disintermediation refers to the process where banks are replaced (or disintermediated) by institutional investors. This is the process that the loan market has been undergoing for the past 20 years. Another example is the mortgage market where the primary capital providers have evolved from banks and savings and loan institutions to conduits structured by Fannie Mae, Freddie Mac, and the other mortgage securitization shops. Of course, the list of disintermediated markets is long and growing. In addition to leveraged loans and mortgages, this list also includes auto loans and credit card receivables.
A list of loans or bonds that have been announced but not yet closed. These include both instruments that are yet to come to market and those that are actively being sold but have yet to be circled.
Leveraged loan Just what is a leveraged loan is a discussion of long standing. Some participants use a spread cut-off: i.e., any loan with a spread of LIBOR+ 125 or LIBOR+150 or higher qualifies.
Others use rating criteria: i.e., any loan rated ‘BB+’ or lower qualifies. But what of loans that are not rated? At Standard & Poor’s LCD we have developed a more complex definition. We include a loan in the leveraged universe if it is rated ‘BB+’ or lower or it is not rated or rated ‘BBB-‘ or higher but has (1) a spread of LIBOR +125 or higher and (2) is secured by a first or second lien. Under this definition, a loan rated ‘BB+’ that has a spread of LIBOR+75 would qualify, but a non-rated loan with the same spread would not. It is hardly a perfect definition, but one that Standard & Poor’s thinks best captures the spirit of loan market participants when they talk about leveraged loans.
A strategy in which lenders—typically hedge funds or distressed investors—provide financing to distressed companies. As part of the deal, lenders receive either a potential ownership stake if the company defaults, or, in the case of a bankrupt company, an explicit equity stake as part of the deal.
This is simply a measure of how much creditors lose when an issuer defaults. The loss will vary depending on creditor class and the enterprise value of the business when it defaults. All things being equal, secured creditors will lose less than unsecured creditors. Likewise, senior creditors will lose less than subordinated creditors. Calculating loss given default is tricky business. Some practitioners express loss as a nominal percentage of principal or a percentage of principal plus accrued interest. Others use a present value calculation using an estimated discount rate, typically 15-25%, demanded by distressed investors.
As this phrase implies, the price or spread at which a deal clears the primary market. Running the books. Generally the loan arranger is said to be “running the books,” i.e., preparing documentation and syndicating and administering the loan.
The loan market can be roughly divided into two segments: large corporate and middle market. There are as many ways to define middle market as there are bankers. But, in the leveraged loan market, the standard has become an issuer with no more than $50 million of EBITDA. Based on this, Standard & Poor’s uses the $50 million threshold in its reports and statistics.
Most favored nation clauses
Some loans will include a provision to protect lenders for some specified amount of time if the issuer subsequently places a new loan at a higher spread. Under these provisions, the spread of the existing paper ratchets up to the spread at which the new loan cleared (though in some cases the increase is capped).
Some agreements end the MFN period after some specified period of say 12 or 18 months after which yield protection ends.
This stands for “offers wanted in competition” and is effectively a BWIC in reverse. Instead of seeking bids, a dealer is asked to buy a portfolio of paper and solicits potential sellers for the best offer.
Printing (or “inking”) a deal Refers to the price or spread at which the loan clears.
Recovery is the opposite of loss-given-default—it is the amount a creditor recovers, rather than loses, in a given default.
This can refer to the relative return or spread between (1) various instruments of the same issuer, comparing for instance the loan spread with that of a bond; (2) loans or bonds of issuers that are similarly rated and/or in the same sector, comparing for instance the loan spread of one ‘BB’ rated healthcare company with that of another; and (3) spreads between markets, comparing for instance the spread on offer in the loan market with that of high-yield or corporate bonds. Relative value is a way of uncovering undervalued, or overvalued, assets.
This is terminology imported from the bond market to the loan market. If you refer to a loan as rich, it means it is trading at a spread that is low compared with other similarly rated loans in the same sector. Conversely, referring to something as cheap
means that it is trading at a spread that is high compared with its peer group. That is, you can buy it on the cheap.
Staple financing is a financing agreement “stapled on” to an acquisition, typically by the M&A advisor. So, if a private equity firm is working with an investment bank to acquire a property, that bank, or a group of banks, may provide a staple financing to ensure that the firm has the wherewithal to complete the deal. Because the staple
financing provides guidelines on both structure and leverage, it typically forms the basis for the eventual financing that is negotiated by the auction winner, and the staple provider will usually serve as one of the arrangers of the financing, along with the lenders that were backing the buyer.
LCD’sLoan Market Primer is in available in PDF format. (Though it does not include the eye-popping charts and graphs displayed above. It does, however, feature an overview from S&P Capital IQ on rating leveraged loans, as well as criteria guidelines for recovery ratings on speculative-grade debt.) Enjoy.