Leveraged Loan Market Guide


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What is a leveraged loan? S&P/LCD's Leveraged Loan Market guide is the definitive explanation of how today's global leveraged finance market works.

The Guide covers the new-issue (primary) market, as well as the secondary, and details defaults/recoveries, among many other topics.

Also in the guide:

Pro rata vs. term/institutional debt
The syndications process
Best efforts vs. underwritten vs. club deal
The loan investor market: prime funds, finance cos., banks, CLOs
Public vs. private
Defaults/default risk
Loss-given-default risk
Sponsors/Private equity shops
Loan credit stats
Pricing, fees, discounts
Second-lien loans
Covenant-lite loans
Loan Trading
Derivatives (CDS, TRS)
LIBOR floors
Debtor-in-possession loans

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Leveraged Loan Market Guide

  1. 1. A Guide to theLoan Market September 2011
  2. 2. I don’t like surprises—especially in my leveraged loan portfolio. That’s why I insist on Standard & Poor’s Bank Loan & Recovery Ratings.All loans are not created equal. And distinguishing the well secured from those thataren’t is easier with a Standard & Poor’s Bank Loan & Recovery Rating. Objective,widely recognized benchmarks developed by dedicated loan and recovery analysts,Standard & Poor’s Bank Loan & Recovery Ratings are determined throughfundamental, deal-specific analysis. The kind of analysis you want behind you whenyou’re trying to gauge your chances of capital recovery. Get the information you need.Insist on Standard & Poor’s Bank Loan & Recovery Ratings.The credit-related analyses, including ratings, of Standard & Poor’s and its affiliates are statements of opinion as of the date they are expressed and not statements of fact orrecommendations to purchase, hold, or sell any securities or to make any investment decisions. Ratings, credit-related analyses, data, models, software and output therefromshould not be relied on when making any investment decision. Standard & Poor’s opinions and analyses do not address the suitability of any security. Standard & Poor’s doesnot act as a fiduciary or an investment advisor.Copyright © 2011 Standard & Poor’s Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.STANDARD & POOR’S is a registered trademark of Standard & Poor’s Financial Services LLC.
  3. 3. A Guide To TheLoan MarketSeptember 2011
  4. 4. Copyright © 2011 by Standard & Poor’s Financial Services LLC (S&P) a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.No content (including ratings, credit-related analyses and data, model, software or other application or output therefrom) or any part thereof (Content) maybe modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior writtenpermission of S&P. The Content shall not be used for any unlawful or unauthorized purposes. S&P, its affiliates, and any third-party providers, as well astheir directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availabilityof the Content. S&P Parties are not responsible for any errors or omissions, regardless of the cause, for the results obtained from the use of the Content,or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALLEXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULARPURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED OR THATTHE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for anydirect, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, withoutlimitation, lost income or lost profits and opportunity costs) in connection with any use of the Content even if advised of the possibility of such damages.Credit-related analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statementsof fact or recommendations to purchase, hold, or sell any securities or to make any investment decisions. S&P assumes no obligation to update theContent following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience ofthe user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P’s opinions and analyses do notaddress the suitability of any security. S&P does not act as a fiduciary or an investment advisor. While S&P has obtained information from sources itbelieves to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives.S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities.As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies andprocedures to maintain the confidentiality of certain non-public information received in connection with each analytical process.S&P may receive compensation for its ratings and certain credit-related analyses, normally from issuers or underwriters of securities or from obligors.S&P reserves the right to disseminate its opinions and analyses. S&P’s public ratings and analyses are made available on its Web sites,www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription), and may be distributedthrough other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is availableat www.standardandpoors.com/usratingsfees.
  5. 5. To Our Clients tandard & Poors Ratings Services is pleased to bring you the 2011-2012 edition of ourS Guide To The Loan Market, which provides a detailed primer on the syndicated loan market along with articles that describe the bank loan and recovery rating process aswell as our analytical approach to evaluating loss and recovery in the event of default. Standard & Poor’s Ratings is the leading provider of credit and recovery ratings for leveragedloans. Indeed, we assign recovery ratings to all speculative-grade loans and bonds that we ratein nearly 30 countries, along with our traditional corporate credit ratings. As of press time,Standard & Poors has recovery ratings on the debt of more than 1,200 companies. We alsoproduce detailed recovery rating reports on most of them, which are available to syndicatorsand investors. (To request a copy of a report on a specific loan and recovery rating, please referto the contact information below.) In addition to rating loans, Standard & Poor’s Capital IQ unit offers a wide range of infor-mation, data and analytical services for loan market participants, including:● Data and commentary: Standard & Poors Leveraged Commentary & Data (LCD) unit is the leading provider of real-time news, statistical reports, market commentary, and data for leveraged loan and high-yield market participants.● Loan price evaluations: Standard & Poors Evaluation Service provides price evaluations for leveraged loan investors.● Recovery statistics: Standard & Poors LossStats(tm) database is the industry standard for recovery information for bank loans and other debt classes.● Fundamental credit information: Standard & Poor’s Capital IQ is the premier provider of financial data for leveraged finance issuers. If you want to learn more about our loan market services, all the appropriate contactinformation is listed in the back of this publication. We welcome questions, suggestions, andfeedback on our products and services, and on this Guide, which we update annually. Wepublish Leveraged Matters, a free weekly update on the leveraged finance market, whichincludes selected Standard & Poors recovery reports and analyses and a comprehensive listof Standard & Poors bank loan and recovery ratings. To be put on the subscription list, please e-mail your name and contact information todominic_inzana@standardandpoors.com or call (1) 212-438-7638. You can also access thatreport and many other articles, including this entire Guide To The Loan Market in electronicform, on our Standard & Poors loan and recovery rating website:www.bankloanrating.standardandpoors.com. For information about loan-market news and data, please visit us online atwww.lcdcomps.com or contact Marc Auerbach at marc_auerbach@standardandpoors.com or(1) 212-438-2703. You can also follow us on Twitter, Facebook, or LinkedIn.Steven Miller William ChewStandard & Poor’s ● A Guide To The Loan Market September 2011 3
  6. 6. ContentsA Syndicated Loan Primer 7Rating Leveraged Loans: An Overview 31Criteria Guidelines For Recovery Ratings On Global IndustrialsIssuers’ Speculative-Grade Debt 36Key Contacts 53Standard & Poor’s ● A Guide To The Loan Market September 2011 5
  7. 7. A Syndicated Loan PrimerSteven C. Miller syndicated loan is one that is provided by a group of lendersNew York(1) 212-438-2715steven_miller@standardandpoors.com A and is structured, arranged, and administered by one or several commercial or investment banks known as arrangers. Starting with the large leveraged buyout (LBO) loans of the mid- 1980s, the syndicated loan market has become the dominant way for issuers to tap banks and other institutional capital providers for loans. The reason is simple: Syndicated loans are less expen- sive and more efficient to administer than traditional bilateral, or individual, credit lines. At the most basic level, arrangers serve the these borrowers will effectively syndicate a time-honored investment-banking role of rais- loan themselves, using the arranger simply to ing investor dollars for an issuer in need of craft documents and administer the process. capital. The issuer pays the arranger a fee for For leveraged issuers, the story is a very dif- this service, and, naturally, this fee increases ferent one for the arranger, and, by “different,” with the complexity and riskiness of the loan. we mean more lucrative. A new leveraged As a result, the most profitable loans are loan can carry an arranger fee of 1% to 5% those to leveraged borrowers—issuers whose of the total loan commitment, generally credit ratings are speculative grade and who speaking, depending on (1) the complexity of are paying spreads (premiums above LIBOR the transaction, (2) how strong market condi- or another base rate) sufficient to attract the tions are at the time, and (3) whether the interest of nonbank term loan investors, typi- loan is underwritten. Merger and acquisition cally LIBOR+200 or higher, though this (M&A) and recapitalization loans will likely threshold moves up and down depending on carry high fees, as will exit financings and market conditions. restructuring deals. Seasoned leveraged Indeed, large, high-quality companies pay issuers, by contrast, pay lower fees for little or no fee for a plain-vanilla loan, typi- refinancings and add-on transactions. cally an unsecured revolving credit instru- Because investment-grade loans are infre- ment that is used to provide support for quently used and, therefore, offer drastically short-term commercial paper borrowings or lower yields, the ancillary business is as for working capital. In many cases, moreover, important a factor as the credit product in Standard & Poor’s ● A Guide To The Loan Market September 2011 7
  8. 8. A Syndicated Loan Primer arranging such deals, especially because many arranger will total up the commitments and acquisition-related financings for investment- then make a call on where to price the paper. grade companies are large in relation to the Following the example above, if the paper is pool of potential investors, which would oversubscribed at LIBOR+250, the arranger consist solely of banks. may slice the spread further. Conversely, if it is The “retail” market for a syndicated loan undersubscribed even at LIBOR+275, then the consists of banks and, in the case of leveraged arranger will be forced to raise the spread to transactions, finance companies and institu- bring more money to the table. tional investors. Before formally launching a loan to these retail accounts, arrangers will often get a market read by informally polling Types Of Syndications select investors to gauge their appetite for the There are three types of syndications: an credit. Based on these discussions, the arranger underwritten deal, a “best-efforts” syndica- will launch the credit at a spread and fee it tion, and a “club deal.” believes will clear the market. Until 1998, this would have been it. Once the pricing was set, Underwritten deal it was set, except in the most extreme cases. If An underwritten deal is one for which the the loan were undersubscribed, the arrangers arrangers guarantee the entire commitment, could very well be left above their desired hold and then syndicate the loan. If the arrangers level. After the Russian debt crisis roiled the cannot fully subscribe the loan, they are market in 1998, however, arrangers have forced to absorb the difference, which they adopted market-flex language, which allows may later try to sell to investors. This is easy, them to change the pricing of the loan based of course, if market conditions, or the credit’s on investor demand—in some cases within a fundamentals, improve. If not, the arranger predetermined range—as well as shift amounts may be forced to sell at a discount and, between various tranches of a loan, as a stan- potentially, even take a loss on the paper. Or dard feature of loan commitment letters. the arranger may just be left above its desired Market-flex language, in a single stroke, hold level of the credit. So, why do arrangers pushed the loan market, at least the leveraged underwrite loans? First, offering an under- segment of it, across the Rubicon, to a full- written loan can be a competitive tool to win fledged capital market. mandates. Second, underwritten loans usually Initially, arrangers invoked flex language to require more lucrative fees because the agent make loans more attractive to investors by is on the hook if potential lenders balk. Of hiking the spread or lowering the price. This course, with flex-language now common, was logical after the volatility introduced by underwriting a deal does not carry the same the Russian debt debacle. Over time, how- risk it once did when the pricing was set in ever, market-flex became a tool either to stone prior to syndication. increase or decrease pricing of a loan, based on investor reaction. Best-efforts syndication Because of market flex, a loan syndication A “best-efforts” syndication is one for which today functions as a “book-building” exercise, the arranger group commits to underwrite less in bond-market parlance. A loan is originally than the entire amount of the loan, leaving the launched to market at a target spread or, as credit to the vicissitudes of the market. If the was increasingly common by the late 2000s, loan is undersubscribed, the credit may not with a range of spreads referred to as price talk close—or may need major surgery to clear the (i.e., a target spread of, say, LIBOR+250 to market. Traditionally, best-efforts syndications LIBOR+275). Investors then will make com- were used for risky borrowers or for complex mitments that in many cases are tiered by the transactions. Since the late 1990s, however, spread. For example, an account may put in the rapid acceptance of market-flex language for $25 million at LIBOR+275 or $15 million has made best-efforts loans the rule even for at LIBOR+250. At the end of the process, the investment-grade transactions.8 www.standardandpoors.com
  9. 9. Club deal post-closing—to investors through digitalA “club deal” is a smaller loan (usually $25 platforms. Leading vendors in this space aremillion to $100 million, but as high as $150 Intralinks, Syntrak, and Debt Domain.million) that is premarketed to a group of The IM typically contain the followingrelationship lenders. The arranger is generally sections:a first among equals, and each lender gets a The executive summary will include afull cut, or nearly a full cut, of the fees. description of the issuer, an overview of the transaction and rationale, sources and uses, and key statistics on the financials.The Syndication Process Investment considerations will be, basically,The information memo, or “bank book” management’s sales “pitch” for the deal.Before awarding a mandate, an issuer might The list of terms and conditions will be asolicit bids from arrangers. The banks will preliminary term sheet describing the pricing,outline their syndication strategy and qualifi- structure, collateral, covenants, and othercations, as well as their view on the way the terms of the credit (covenants are usuallyloan will price in market. Once the mandate negotiated in detail after the arranger receivesis awarded, the syndication process starts. investor feedback).The arranger will prepare an information The industry overview will be a descriptionmemo (IM) describing the terms of the trans- of the company’s industry and competitiveactions. The IM typically will include an position relative to its industry peers.executive summary, investment considera- The financial model will be a detailedtions, a list of terms and conditions, an indus- model of the issuer’s historical, pro forma,try overview, and a financial model. Because and projected financials including manage-loans are not securities, this will be a confi- ment’s high, low, and base case for the issuer.dential offering made only to qualified banks Most new acquisition-related loans kick offand accredited investors. at a bank meeting at which potential lenders If the issuer is speculative grade and seek- hear management and the sponsor group (ifing capital from nonbank investors, the there is one) describe what the terms of thearranger will often prepare a “public” ver- loan are and what transaction it backs.sion of the IM. This version will be stripped Understandably, bank meetings are moreof all confidential material such as manage- often than not conducted via a Webex orment financial projections so that it can be conference call, although some issuers stillviewed by accounts that operate on the pub- prefer old-fashioned, in-person gatherings.lic side of the wall or that want to preserve At the meeting, call or Webex, manage-their ability to buy bonds or stock or other ment will provide its vision for the transac-public securities of the particular issuer (see tion and, most important, tell why and howthe Public Versus Private section below). the lenders will be repaid on or ahead ofNaturally, investors that view materially non- schedule. In addition, investors will bepublic information of a company are disqual- briefed regarding the multiple exit strate-ified from buying the company’s public gies, including second ways out via assetsecurities for some period of time. sales. (If it is a small deal or a refinancing As the IM (or “bank book,” in traditional instead of a formal meeting, there may be amarket lingo) is being prepared, the syndi- series of calls or one-on-one meetings withcate desk will solicit informal feedback from potential investors.)potential investors on what their appetite for Once the loan is closed, the final terms arethe deal will be and at what price they are then documented in detailed credit and secu-willing to invest. Once this intelligence has rity agreements. Subsequently, liens are per-been gathered, the agent will formally mar- fected and collateral is attached.ket the deal to potential investors. Arrangers Loans, by their nature, are flexible docu-will distribute most IM’s—along with other ments that can be revised and amendedinformation related to the loan, pre- and from time to time. These amendments requireStandard & Poor’s ● A Guide To The Loan Market September 2011 9
  10. 10. A Syndicated Loan Primer different levels of approval (see Voting rated. CLOs are created as arbitrage vehicles Rights section below). Amendments can that generate equity returns through leverage, range from something as simple as a by issuing debt 10 to 11 times their equity covenant waiver to something as complex as contribution. There are also market-value a change in the collateral package or allow- CLOs that are less leveraged—typically 3 to 5 ing the issuer to stretch out its payments or times—and allow managers more flexibility make an acquisition. than more tightly structured arbitrage deals. CLOs are usually rated by two of the three The loan investor market major ratings agencies and impose a series of There are three primary-investor consisten- covenant tests on collateral managers, includ- cies: banks, finance companies, and institu- ing minimum rating, industry diversification, tional investors. and maximum default basket. By 2007, CLOs Banks, in this case, can be either a com- had become the dominant form of institutional mercial bank, a savings and loan institution, investment in the leveraged loan market, tak- or a securities firm that usually provides ing a commanding 60% of primary activity by investment-grade loans. These are typically institutional investors. But when the structured large revolving credits that back commercial finance market cratered in late 2007, CLO paper or are used for general corporate pur- issuance tumbled and by mid-2010, CLO’s poses or, in some cases, acquisitions. For share had fallen to roughly 30%. leveraged loans, banks typically provide Loan mutual funds are how retail investors unfunded revolving credits, LOCs, and— can access the loan market. They are mutual although they are becoming increasingly less funds that invest in leveraged loans. These common—amortizing term loans, under a funds—originally known as prime funds syndicated loan agreement. because they offered investors the chance to Finance companies have consistently repre- earn the prime interest rate that banks charge sented less than 10% of the leveraged loan on commercial loans—were first introduced market, and tend to play in smaller deals— in the late 1980s. Today there are three main $25 million to $200 million. These investors categories of funds: ● Daily-access funds: These are traditional often seek asset-based loans that carry wide spreads and that often feature time-intensive open-end mutual fund products into which collateral monitoring. investors can buy or redeem shares each Institutional investors in the loan market day at the fund’s net asset value. ● Continuously offered, closed-end funds: are principally structured vehicles known as collateralized loan obligations (CLO) and These were the first loan mutual fund loan participation mutual funds (known as products. Investors can buy into these “prime funds” because they were originally funds each day at the fund’s net asset pitched to investors as a money-market-like valueNAV. Redemptions, however, are fund that would approximate the prime rate). made via monthly or quarterly tenders In addition, hedge funds, high-yield bond rather than each day like the open-end funds, pension funds, insurance companies, funds described above. To make sure they and other proprietary investors do participate can meet redemptions, many of these opportunistically in loans. funds, as well as daily access funds, set up CLOs are special-purpose vehicles set up to lines of credit to cover withdrawals above hold and manage pools of leveraged loans. and beyond cash reserves. ● Exchange-traded, closed-end funds: These The special-purpose vehicle is financed with several tranches of debt (typically a ‘AAA’ are funds that trade on a stock exchange. rated tranche, a ‘AA’ tranche, a ‘BBB’ tranche, Typically, the funds are capitalized by an and a mezzanine tranche) that have rights to initial public offering. Thereafter, investors the collateral and payment stream in descend- can buy and sell shares, but may not ing order. In addition, there is an equity redeem them. The manager can also expand tranche, but the equity tranche is usually not the fund via rights offerings. Usually, they10 www.standardandpoors.com
  11. 11. are only able to do so when the fund is not (or not yet) a party to the loan. The sec- trading at a premium to NAV, however—a ond innovation that weakened the public-pri- provision that is typical of closed-end funds vate divide was trade journalism that focuses regardless of the asset class. on the loan market. In March 2011, Invesco introduced the Despite these two factors, the public versusfirst index-based exchange traded fund, private line was well understood and rarelyPowerShares Senior Loan Portfolio controversial for at least a decade. This(BKLN), which is based on the S&P/LSTA changed in the early 2000s as a result of:Loan 100 Index. ● The proliferation of loan ratings, which, by The table below lists the 20 largest loan their nature, provide public exposure formutual fund managers by AUM as loan deals;of July 31, 2011. ● The explosive growth of nonbank investors groups, which included a growing number of institutions that operated on the publicPublic Versus Private side of the wall, including a growing num-In the old days, the line between public and ber of mutual funds, hedge funds, and evenprivate information in the loan market was a CLO boutiques;simple one. Loans were strictly on the private ● The growth of the credit default swapsside of the wall and any information trans- market, in which insiders like banks oftenmitted between the issuer and the lender sold or bought protection from institu-group remained confidential. tions that were not privy to inside In the late 1980s, that line began to blur as information; anda result of two market innovations. The first ● A more aggressive effort by the press towas more active secondary trading that report on the loan market.sprung up to support (1) the entry of non- Some background is in order. The vastbank investors in the market, such as insur- majority of loans are unambiguously privateance companies and loan mutual funds and financing arrangements between issuers and(2) to help banks sell rapidly expanding port- their lenders. Even for issuers with publicfolios of distressed and highly leveraged loans equity or debt that file with the SEC, thethat they no longer wanted to hold. This credit agreement only becomes public when itmeant that parties that were insiders on loans is filed, often months after closing, as anmight now exchange confidential information exhibit to an annual report (10-K), a quar-with traders and potential investors who were terly report (10-Q), a current report (8-K), or Largest Loan Mutual Fund Managers Assets under management (bil. $) DWS Investments 2.61 Eaton Vance Management 13.39 T. Rowe Price 2.00 Fidelity Investments 12.12 BlackRock Advisors LLC 1.84 Hartford Mutual Funds 7.25 ING Pilgrim Funds 1.84 Oppenheimer Funds 6.39 RS Investments 1.51 Invesco Advisers 4.44 Nuveen Investments 1.37 PIMCO Funds 4.16 MainStay Investments 1.34 Lord Abbett 4.16 Pioneer Investments 0.88 RidgeWorth Funds 4.13 Highland Funds 0.74 Franklin Templeton Investment Funds 2.71 Goldman Sachs 0.64 John Hancock Funds 2.61 Source: Lipper FMI.Standard & Poor’s ● A Guide To The Loan Market September 2011 11
  12. 12. A Syndicated Loan Primer some other document (proxy statement, secu- the public side of the wall. As well, under- rities registration, etc.). writers will ask public accounts to attend a Beyond the credit agreement, there is a raft public version of the bank meeting and dis- of ongoing correspondence between issuers tribute to these accounts only scrubbed and lenders that is made under confidentiality financial information. agreements, including quarterly or monthly ● Buy-side accounts. On the buy-side there financial disclosures, covenant compliance are firms that operate on either side of information, amendment and waiver requests, the public-private divide. Accounts that and financial projections, as well as plans for operate on the private side receive all acquisitions or dispositions. Much of this confidential materials and agree to not information may be material to the financial trade in public securities of the issuers in health of the issuer and may be out of the question. These groups are often part of public domain until the issuer formally puts wider investment complexes that do have out a press release or files an 8-K or some public funds and portfolios but, via other document with the SEC. Chinese walls, are sealed from these parts In recent years, this information has leaked of the firms. There are also accounts that into the public domain either via off-line con- are public. These firms take only public versations or the press. It has also come to IMs and public materials and, therefore, light through mark-to-market pricing serv- retain the option to trade in the public ices, which from time to time report signifi- securities markets even when an issuer for cant movement in a loan price without any which they own a loan is involved. This corresponding news. This is usually an indi- can be tricky to pull off in practice cation that the banks have received negative because in the case of an amendment the or positive information that is not yet public. lender could be called on to approve or In recent years, there was growing concern decline in the absence of any real infor- among issuers, lenders, and regulators that mation. To contend with this issue, the this migration of once-private information account could either designate one person into public hands might breach confidential- who is on the private side of the wall to ity agreements between lenders and issuers sign off on amendments or empower its and, more importantly, could lead to illegal trustee or the loan arranger to do so. But trading. How has the market contended with it’s a complex proposition. these issues? ● Vendors. Vendors of loan data, news, and ● Traders. To insulate themselves from vio- prices also face many challenges in man- lating regulations, some dealers and buy- aging the flow of public and private infor- side firms have set up their trading desks mation. In generally, the vendors operate on the public side of the wall. under the freedom of the press provision Consequently, traders, salespeople, and of the U.S. Constitution’s First analysts do not receive private informa- Amendment and report on information in tion even if somewhere else in the institu- a way that anyone can simultaneously tion the private data are available. This is receive it—for a price of course. the same technique that investment banks Therefore, the information is essentially have used from time immemorial to sepa- made public in a way that doesn’t deliber- rate their private investment banking ately disadvantage any party, whether it’s activities from their public trading and a news story discussing the progress of an sales activities. amendment or an acquisition, or it’s a ● Underwriters. As mentioned above, in most price change reported by a mark-to-mar- primary syndications, arrangers will pre- ket service. This, of course, doesn’t deal pare a public version of information mem- with the underlying issue that someone oranda that is scrubbed of private who is a party to confidential information information like projections. These IMs is making it available via the press or will be distributed to accounts that are on prices to a broader audience.12 www.standardandpoors.com
  13. 13. Another way in which participants deal overall risk of their portfolios to their ownwith the public versus private issue is to ask investors. As of mid-2011, then, roughlycounterparties to sign “big-boy” letters. 80% of leveraged-loan volume carried a loanThese letters typically ask public-side institu- rating, up from 45% in 1998 and virtuallytions to acknowledge that there may be none before 1995.information they are not privy to and theyare agreeing to make the trade in any case. Loss-given-default riskThey are, effectively, big boys and will accept Loss-given-default risk measures how severe athe risks. loss the lender is likely to incur in the event of default. Investors assess this risk based onCredit Risk: An Overview the collateral (if any) backing the loan and the amount of other debt and equity subordi-Pricing a loan requires arrangers to evaluate nated to the loan. Lenders will also look tothe risk inherent in a loan and to gauge covenants to provide a way of coming backinvestor appetite for that risk. The principal to the table early—that is, before other credi-credit risk factors that banks and institutional tors—and renegotiating the terms of a loan ifinvestors contend with in buying loans are the issuer fails to meet financial targets.default risk and loss-given-default risk. Investment-grade loans are, in most cases,Among the primary ways that accounts judge senior unsecured instruments with looselythese risks are ratings, credit statistics, indus- drawn covenants that apply only at incur-try sector trends, management strength, and rence, that is, only if an issuer makes ansponsor. All of these, together, tell a story acquisition or issues debt. As a result, lossabout the deal. given default may be no different from risk Brief descriptions of the major risk incurred by other senior unsecured creditors.factors follow. Leveraged loans, by contrast, are usually sen- ior secured instruments that, except forDefault risk covenant-lite loans (see below), have mainte-Default risk is simply the likelihood of a bor- nance covenants that are measured at the endrower’s being unable to pay interest or princi- of each quarter whether or not the issuer is inpal on time. It is based on the issuer’s compliance with pre-set financial tests. Loanfinancial condition, industry segment, and holders, therefore, almost always are first inconditions in that industry and economic line among pre-petition creditors and, invariables and intangibles, such as company many cases, are able to renegotiate with themanagement. Default risk will, in most cases, issuer before the loan becomes severelybe most visibly expressed by a public rating impaired. It is no surprise, then, that loanfrom Standard & Poor’s Ratings Services or investors historically fare much better thananother ratings agency. These ratings range other creditors on a loss-given-default basis.from ‘AAA’ for the most creditworthy loansto ‘CCC’ for the least. The market is divided, Credit statisticsroughly, into two segments: investment grade Credit statistics are used by investors to help(loans to issuers rated ‘BBB-’ or higher) and calibrate both default and loss-given-defaultleveraged (borrowers rated ‘BB+’ or lower). risk. These statistics include a broad array ofDefault risk, of course, varies widely within financial data, including credit ratios measur-each of these broad segments. Since the mid- ing leverage (debt to capitalization and debt1990s, public loan ratings have become a de to EBITDA) and coverage (EBITDA to inter-facto requirement for issuers that wish to do est, EBITDA to debt service, operating cashbusiness with a wide group of institutional flow to fixed charges). Of course, the ratiosinvestors. Unlike banks, which typically have investors use to judge credit risk vary bylarge credit departments and adhere to inter- industry. In addition to looking at trailingnal rating scales, fund managers rely on and pro forma ratios, investors look at man-agency ratings to bracket risk and explain theStandard & Poor’s ● A Guide To The Loan Market September 2011 13
  14. 14. A Syndicated Loan Primer agement’s projections and the assumptions tional investors, weight is given to an individ- behind these projections to see if the issuer’s ual deal sponsor’s track record in fixing its game plan will allow it to service its debt. own impaired deals by stepping up with addi- There are ratios that are most geared to tional equity or replacing a management team assessing default risk. These include leverage that is failing. and coverage. Then there are ratios that are suited for evaluating loss-given-default risk. These include collateral coverage, or the Syndicating A Loan By Facility value of the collateral underlying the loan rel- Most loans are structured and syndicated to ative to the size of the loan. They also include accommodate the two primary syndicated the ratio of senior secured loan to junior debt lender constituencies: banks (domestic and in the capital structure. Logically, the likely foreign) and institutional investors (primarily severity of loss-given-default for a loan structured finance vehicles, mutual funds, and increases with the size of the loan as a per- insurance companies). As such, leveraged centage of the overall debt structure so does. loans consist of: After all, if an issuer defaults on $100 million ● Pro rata debt consists of the revolving of debt, of which $10 million is in the form credit and amortizing term loan (TLa), of senior secured loans, the loans are more which are packaged together and, usually, likely to be fully covered in bankruptcy than syndicated to banks. In some loans, how- if the loan totals $90 million. ever, institutional investors take pieces of the TLa and, less often, the revolving Industry sector credit, as a way to secure a larger institu- tional term loan allocation. Why are these Industry is a factor, because sectors, natu- tranches called “pro rata?” Because rally, go in and out of favor. For that reason, arrangers historically syndicated revolving having a loan in a desirable sector, like tele- credit and TLas on a pro rata basis to com in the late 1990s or healthcare in the banks and finance companies. early 2000s, can really help a syndication ● Institutional debt consists of term loans along. Also, loans to issuers in defensive sec- structured specifically for institutional tors (like consumer products) can be more investors, although there are also some appealing in a time of economic uncertainty, banks that buy institutional term loans. whereas cyclical borrowers (like chemicals These tranches include first- and second- or autos) can be more appealing during an lien loans, as well as prefunded letters of economic upswing. credit. Traditionally, institutional tranches were referred to as TLbs because they were Sponsorship bullet payments and lined up behind TLas. Sponsorship is a factor too. Needless to say, Finance companies also play in the lever- many leveraged companies are owned by one aged loan market, and buy both pro rata or more private equity firms. These entities, and institutional tranches. With institutional such as Kohlberg Kravis & Roberts or investors playing an ever-larger role, how- Carlyle Group, invest in companies that have ever, by the late 2000s, many executions leveraged capital structures. To the extent were structured as simply revolving that the sponsor group has a strong following credit/institutional term loans, with the among loan investors, a loan will be easier to TLa falling by the wayside. syndicate and, therefore, can be priced lower. In contrast, if the sponsor group does not have a loyal set of relationship lenders, the Pricing A Loan In deal may need to be priced higher to clear the The Primary Market market. Among banks, investment factors Pricing loans for the institutional market is a may include whether or not the bank is party straightforward exercise based on simple to the sponsor’s equity fund. Among institu- risk/return consideration and market techni-14 www.standardandpoors.com
  15. 15. cals. Pricing a loan for the bank market, other fee-generating business to banks thathowever, is more complex. Indeed, banks are part of its loan syndicate.often invest in loans for more than justspread income. Rather, banks are driven by Pricing loans for institutional playersthe overall profitability of the issuer relation- For institutional investors, the investmentship, including noncredit revenue sources. decision process is far more straightforward, because, as mentioned above, they arePricing loans for bank investors focused not on a basket of returns, but onlySince the early 1990s, almost all large com- on loan-specific revenue.mercial banks have adopted portfolio-man- In pricing loans to institutional investors,agement techniques that measure the returns it’s a matter of the spread of the loan rela-of loans and other credit products relative tive to credit quality and market-based fac-to risk. By doing so, banks have learned tors. This second category can be dividedthat loans are rarely compelling investments into liquidity and market technicals (i.e.,on a stand-alone basis. Therefore, banks are supply/demand).reluctant to allocate capital to issuers unless Liquidity is the tricky part, but, as in allthe total relationship generates attractive markets, all else being equal, more liquidreturns—whether those returns are meas- instruments command thinner spreads thanured by risk-adjusted return on capital, by less liquid ones. In the old days—beforereturn on economic capital, or by some institutional investors were the dominantother metric. investors and banks were less focused on If a bank is going to put a loan on its bal- portfolio management—the size of a loanance sheet, then it takes a hard look not didn’t much matter. Loans sat on the booksonly at the loan’s yield, but also at other of banks and stayed there. But now thatsources of revenue from the relationship, institutional investors and banks put a pre-including noncredit businesses—like cash- mium on the ability to package loans and sellmanagement services and pension-fund man- them, liquidity has become important. As aagement—and economics from other capital result, smaller executions—generally those ofmarkets activities, like bonds, equities, or $200 million or less—tend to be priced at aM&A advisory work. premium to the larger loans. Of course, once This process has had a breathtaking result a loan gets large enough to demandon the leveraged loan market—to the point extremely broad distribution, the issuer usu-that it is an anachronism to continue to call it ally must pay a size premium. The thresholdsa “bank” loan market. Of course, there are range widely. During the go-go mid-2000s, itcertain issuers that can generate a bit more was upwards of $10 billion. During morebank appetite; as of mid-2011, these include parsimonious late-2000s $1 billion was con-issuers with a European or even a sidered a stretch.Midwestern U.S. angle. Naturally, issuers Market technicals, or supply relative towith European operations are able to better demand, is a matter of simple economics. Iftap banks in their home markets (banks still there are a lot of dollars chasing little prod-provide the lion’s share of loans in Europe), uct, then, naturally, issuers will be able toand, for Midwestern issuers, the heartland command lower spreads. If, however, theremains one of the few U.S. regions with a opposite is true, then spreads will need todeep bench of local banks. increase for loans to clear the market. What this means is that the spread offeredto pro rata investors is important, but so,too, in most cases, is the amount of other, Mark-To-Market’s Effectfee-driven business a bank can capture by Beginning in 2000, the SEC directed banktaking a piece of a loan. For this reason, loan mutual fund managers to use availableissuers are careful to award pieces of bond- mark-to-market data (bid/ask levelsand equity-underwriting engagements and reported by secondary traders and compiledStandard & Poor’s ● A Guide To The Loan Market September 2011 15
  16. 16. A Syndicated Loan Primer by mark-to-market services like Markit banks can offer issuers 364-day facilities at Loans) rather than fair value (estimated a lower unused fee than a multiyear revolv- prices), to determine the value of broadly ing credit. There are a number of options syndicated loans for portfolio-valuation that can be offered within a revolving purposes. In broad terms, this policy has credit line: made the market more transparent, 1. A swingline is a small, overnight borrow- improved price discovery and, in doing so, ing line, typically provided by the agent. made the market far more efficient and 2. A multicurrency line may allow the bor- dynamic than it was in the past. In the pri- rower to borrow in several currencies. mary market, for instance, leveraged loan 3. A competitive-bid option (CBO) allows spreads are now determined not only by rat- borrowers to solicit the best bids from its ing and leverage profile, but also by trading syndicate group. The agent will conduct levels of an issuer’s previous loans and, what amounts to an auction to raise often, bonds. Issuers and investors can also funds for the borrower, and the best look at the trading levels of comparable bids are accepted. CBOs typically loans for market-clearing levels. are available only to large, investment- grade borrowers. 4. A term-out will allow the borrower to con- Types Of Syndicated vert borrowings into a term loan at a given Loan Facilities conversion date. This, again, is usually a There are four main types of syndicated feature of investment-grade loans. Under loan facilities: the option, borrowers may take what is ● A revolving credit (within which are outstanding under the facility and pay it options for swingline loans, multicurrency- off according to a predetermined repay- borrowing, competitive-bid options, term- ment schedule. Often the spreads ratchet out, and evergreen extensions); up if the term-out option is exercised. ● A term loan; 5. An evergreen is an option for the bor- ● An LOC; and rower—with consent of the syndicate ● An acquisition or equipment line (a group—to extend the facility each year for delayed-draw term loan). an additional year. A revolving credit line allows borrowers A term loan is simply an installment loan, to draw down, repay, and reborrow. The such as a loan one would use to buy a car. facility acts much like a corporate credit The borrower may draw on the loan during a card, except that borrowers are charged an short commitment period and repays it based annual commitment fee on unused on either a scheduled series of repayments or amounts, which drives up the overall cost a one-time lump-sum payment at maturity of borrowing (the facility fee). Revolvers to (bullet payment). There are two principal speculative-grade issuers are often tied to types of term loans: borrowing-base lending formulas. This lim- ● An amortizing term loan (A-term loans, or its borrowings to a certain percentage of TLa) is a term loan with a progressive collateral, most often receivables and inven- repayment schedule that typically runs six tory. Revolving credits often run for 364 years or less. These loans are normally syn- days. These revolving credits—called, not dicated to banks along with revolving cred- surprisingly, 364-day facilities—are gener- its as part of a larger syndication. ally limited to the investment-grade market. ● An institutional term loan (B-term, C-term, The reason for what seems like an odd term or D-term loans) is a term loan facility is that regulatory capital guidelines man- carved out for nonbank, institutional date that, after one year of extending credit investors. These loans came into broad under a revolving facility, banks must then usage during the mid-1990s as the institu- increase their capital reserves to take into tional loan investor base grew. This institu- account the unused amounts. Therefore, tional category also includes second-lien16 www.standardandpoors.com
  17. 17. loans and covenant-lite loans, which are struggling with liquidity problems. By 2007, described below. the market had accepted second-lien loans to LOCs differ, but, simply put, they are guar- finance a wide array of transactions, includingantees provided by the bank group to pay off acquisitions and recapitalizations. Arrangersdebt or obligations if the borrower cannot. tap nontraditional accounts—hedge funds, Acquisition/equipment lines (delayed-draw distress investors, and high-yield accounts—asterm loans) are credits that may be drawn well as traditional CLO and prime funddown for a given period to purchase speci- accounts to finance second-lien loans.fied assets or equipment or to make acquisi- As their name implies, the claims on col-tions. The issuer pays a fee during the lateral of second-lien loans are junior tocommitment period (a ticking fee). The lines those of first-lien loans. Second-lien loansare then repaid over a specified period (the also typically have less restrictive covenantterm-out period). Repaid amounts may not packages, in which maintenance covenantbe reborrowed. levels are set wide of the first-lien loans. Bridge loans are loans that are intended to As a result, second-lien loans are priced atprovide short-term financing to provide a a premium to first-lien loans. This pre-“bridge” to an asset sale, bond offering, mium typically starts at 200 bps when thestock offering, divestiture, etc. Generally, collateral coverage goes far beyond thebridge loans are provided by arrangers as claims of both the first- and second-lienpart of an overall financing package. loans to more than 1,000 bps for lessTypically, the issuer will agree to increasing generous collateral.interest rates if the loan is not repaid as There are, lawyers explain, two mainexpected. For example, a loan could start at a ways in which the collateral of second-lienspread of L+250 and ratchet up 50 basis loans can be documented. Either the sec-points (bp) every six months the loan remains ond-lien loan can be part of a single secu-outstanding past one year. rity agreement with first-lien loans, or they Equity bridge loan is a bridge loan pro- can be part of an altogether separate agree-vided by arrangers that is expected to be ment. In the case of a single agreement, therepaid by secondary equity commitment to a agreement would apportion the collateral,leveraged buyout. This product is used when with value going first, obviously, to thea private equity firm wants to close on a deal first-lien claims and next to the second-lienthat requires, say, $1 billion of equity of claims. Alternatively, there can be twowhich it ultimately wants to hold half. The entirely separate agreements. Here’s aarrangers bridge the additional $500 million, brief summary:which would be then repaid when other ● In a single security agreement, the second-sponsors come into the deal to take the $500 lien lenders are in the same creditor class asmillion of additional equity. Needless to say, the first-lien lenders from the standpoint ofthis is a hot-market product. a bankruptcy, according to lawyers who specialize in these loans. As a result, for adequate protection to be paid the collat-Second-Lien Loans eral must cover both the claims of the first-Although they are really just another type of and second-lien lenders. If it does not, thesyndicated loan facility, second-lien loans are judge may choose to not pay adequate pro-sufficiently complex to warrant a separate sec- tection or to divide it pro rata among thetion in this primer. After a brief flirtation with first- and second-lien creditors. In addition,second-lien loans in the mid-1990s, these the second-lien lenders may have a vote asfacilities fell out of favor after the 1998 secured lenders equal to those of the first-Russian debt crisis caused investors to adopt a lien lenders. One downside for second-lienmore cautious tone. But after default rates fell lenders is that these facilities are oftenprecipitously in 2003, arrangers rolled out smaller than the first-lien loans and, there-second-lien facilities to help finance issuers fore, when a vote comes up, first-lienStandard & Poor’s ● A Guide To The Loan Market September 2011 17
  18. 18. A Syndicated Loan Primer lenders can outvote second-lien lenders to mum been a maintenance rather than incur- promote their own interests. rence test, the issuer would need to pass it ● In the case of two separate security each quarter and would be in violation if agreements, divided by a standstill agree- either its earnings eroded or its debt level ment, the first- and second-lien lenders increased. For lenders, clearly, maintenance are likely to be divided into two separate tests are preferable because it allows them to creditor classes. As a result, second-lien take action earlier if an issuer experiences lenders do not have a voice in the first- financial distress. What’s more, the lenders lien creditor committees. As well, first- may be able to wrest some concessions from lien lenders can receive adequate an issuer that is in violation of covenants (a protection payments even if collateral fee, incremental spread, or additional collat- covers their claims, but does not cover eral) in exchange for a waiver. the claims of the second-lien lenders. Conversely, issuers prefer incurrence This may not be the case if the loans are covenants precisely because they are less documented together and the first- and stringent. Covenant-lite loans, therefore, second-lien lenders are deemed a unified thrive when the supply/demand equation is class by the bankruptcy court. tilted persuasively in favor of issuers. For more information, we suggest Latham & Watkins’ terrific overview and analysis of second-lien loans, which was Lender Titles published on April 15, 2004 in the firm’s In the formative days of the syndicated loan CreditAlert publication. market (the late 1980s), there was usually one agent that syndicated each loan. “Lead manager” and “manager” titles were doled Covenant-Lite Loans out in exchange for large commitments. As Like second-lien loans, covenant-lite loans are league tables gained influence as a marketing a particular kind of syndicated loan facility. tool, “co-agent” titles were often used in At the most basic level, covenant-lite loans are attracting large commitments or in cases loans that have bond-like financial incurrence where these institutions truly had a role in covenants rather than traditional maintenance underwriting and syndicating the loan. covenants that are normally part and parcel During the 1990s, the use of league tables of a loan agreement. What’s the difference? and, consequently, title inflation exploded. Incurrence covenants generally require that Indeed, the co-agent title has become largely if an issuer takes an action (paying a divi- ceremonial today, routinely awarded for what dend, making an acquisition, issuing more amounts to no more than large retail commit- debt), it would need to still be in compliance. ments. In most syndications, there is one lead So, for instance, an issuer that has an incur- arranger. This institution is considered to be rence test that limits its debt to 5x cash flow on the “left” (a reference to its position in an would only be able to take on more debt if, old-time tombstone ad). There are also likely on a pro forma basis, it was still within this to be other banks in the arranger group, constraint. If not, then it would have which may also have a hand in underwriting breeched the covenant and be in technical and syndicating a credit. These institutions default on the loan. If, on the other hand, an are said to be on the “right.” issuer found itself above this 5x threshold The different titles used by significant par- simply because its earnings had deteriorated, ticipants in the syndications process are it would not violate the covenant. administrative agent, syndication agent, docu- Maintenance covenants are far more mentation agent, agent, co-agent or managing restrictive. This is because they require an agent, and lead arranger or book runner: issuer to meet certain financial tests every ● The administrative agent is the bank that quarter whether or not it takes an action. So, handles all interest and principal payments in the case above, had the 5x leverage maxi- and monitors the loan.18 www.standardandpoors.com
  19. 19. ● The syndication agent is the bank that han- these lower assignment fees remained rare dles, in purest form, the syndication of the into 2011, and the vast majority was set at loan. Often, however, the syndication agent the traditional $3,500. has a less specific role. One market convention that became firmly● The documentation agent is the bank that established in the late 1990s was assignment- handles the documents and chooses the fee waivers by arrangers for trades crossed law firm. through its secondary trading desk. This was● The agent title is used to indicate the lead a way to encourage investors to trade with bank when there is no other conclusive the arranger rather than with another dealer. title available, as is often the case for This is a significant incentive to trade with smaller loans. arranger—or a deterrent to not trade away,● The co-agent or managing agent is largely depending on your perspective—because a a meaningless title used mostly as an award $3,500 fee amounts to between 7 bps to 35 for large commitments. bps of a $1 million to $5 million trade.● The lead arranger or book runner title is a league table designation used to indicate Primary assignments the “top dog” in a syndication. This term is something of an oxymoron. It applies to primary commitments made bySecondary Sales offshore accounts (principally CLOs and hedge funds). These vehicles, for a variety ofSecondary sales occur after the loan is closed tax reasons, suffer tax consequence fromand allocated, when investors are free to buying loans in the primary. The agent willtrade the paper. Loan sales are structured as therefore hold the loan on its books for someeither assignments or participations, with short period after the loan closes and theninvestors usually trading through dealer desks sell it to these investors via an assignment.at the large underwriting banks. Dealer-to- These are called primary assignments and aredealer trading is almost always conducted effectively primary purchases.through a “street” broker. ParticipationsAssignments A participation is an agreement between anIn an assignment, the assignee becomes a existing lender and a participant. As thedirect signatory to the loan and receives inter- name implies, it means the buyer is takingest and principal payments directly from the a participating interest in the existingadministrative agent. lender’s commitment. Assignments typically require the consent The lender remains the official holder ofof the borrower and agent, although consent the loan, with the participant owning themay be withheld only if a reasonable objec- rights to the amount purchased. Consents,tion is made. In many loan agreements, the fees, or minimums are almost never required.issuer loses its right to consent in the event The participant has the right to vote only onof default. material changes in the loan document (rate, The loan document usually sets a mini- term, and collateral). Nonmaterial changesmum assignment amount, usually $5 mil- do not require approval of participants. Alion, for pro rata commitments. In the late participation can be a riskier way of pur-1990s, however, administrative agents chasing a loan, because, in the event of astarted to break out specific assignment min- lender becoming insolvent or defaulting, theimums for institutional tranches. In most participant does not have a direct claim oncases, institutional assignment minimums the loan. In this case, the participant thenwere reduced to $1 million in an effort to becomes a creditor of the lender and oftenboost liquidity. There were also some cases must wait for claims to be sorted out to col-where assignment fees were reduced or even lect on its participation.eliminated for institutional assignments, butStandard & Poor’s ● A Guide To The Loan Market September 2011 19
  20. 20. A Syndicated Loan Primer Loan Derivatives settlement could also be employed if there’s Loan credit default swaps not enough paper to physically settle all Traditionally, accounts bought and sold LCDS contracts on a particular loan. loans in the cash market through assign- ments and participations. Aside from that, LCDX there was little synthetic activity outside Introduced in 2007, the LCDX is an index of over-the-counter total rate of return swaps. 100 LCDS obligations that participants can By 2008, however, the market for syntheti- trade. The index provides a straightforward cally trading loans was budding. way for participants to take long or short Loan credit default swaps (LCDS) are stan- positions on a broad basket of loans, as well dard derivatives that have secured loans as as hedge their exposure to the market. reference instruments. In June 2006, the Markit Group administers the LCDX, a International Settlement and Dealers product of CDS Index Co., a firm set up by a Association issued a standard trade confirma- group of dealers. Like LCDS, the LCDX tion for LCDS contracts. Index is an over-the-counter product. Like all credit default swaps (CDS), an The LCDX is reset every six months with LCDS is basically an insurance contract. The participants able to trade each vintage of the seller is paid a spread in exchange for agree- index that is still active. The index will be set ing to buy at par, or a pre-negotiated price, a at an initial spread based on the reference loan if that loan defaults. LCDS enables par- instruments and trade on a price basis. ticipants to synthetically buy a loan by going According to the primer posted by Markit short the LCDS or sell the loan by going long (http://www.markit.com/information/affilia- the LCDS. Theoretically, then, a loanholder tions/lcdx/alertParagraphs/01/document/LCD can hedge a position either directly (by buy- X%20Primer.pdf), “the two events that ing LCDS protection on that specific name) would trigger a payout from the buyer (pro- or indirectly (by buying protection on a com- tection seller) of the index are bankruptcy or parable name or basket of names). failure to pay a scheduled payment on any Moreover, unlike the cash markets, which debt (after a grace period), for any of the are long-only markets for obvious reasons, constituents of the index.” the LCDS market provides a way for All documentation for the index is posted investors to short a loan. To do so, the at: http://www.markit.com/information/affili- investor would buy protection on a loan that ations/lcdx/alertParagraphs/01/document/LC it doesn’t hold. If the loan subsequently DX%20Primer.pdf. defaults, the buyer of protection should be able to purchase the loan in the secondary Total rate of return swaps (TRS) market at a discount and then and deliver it This is the oldest way for participants to pur- at par to the counterparty from which it chase loans synthetically. And, in reality, a bought the LCDS contract. For instance, say TRS is little more than buying a loan on mar- an account buys five-year protection for a gin. In simple terms, under a TRS program a given loan, for which it pays 250 bps a year. participant buys the income stream created Then in year 2 the loan goes into default and by a loan from a counterparty, usually a the market price falls to 80% of par. The dealer. The participant puts down some per- buyer of the protection can then buy the loan centage as collateral, say 10%, and borrows at 80 and deliver to the counterpart at 100, a the rest from the dealer. Then the participant 20-point pickup. Or instead of physical deliv- receives the spread of the loan less the finan- ery, some buyers of protection may prefer cial cost plus LIBOR on its collateral cash settlement in which the difference account. If the reference loan defaults, the between the current market price and the participant is obligated to buy it at par or delivery price is determined by polling dealers cash settle the loss based on a mark-to-mar- or using a third-party pricing service. Cash ket price or an auction price.20 www.standardandpoors.com
  21. 21. Here’s how the economics of a TRS work, because the prime option is more costly toin simple terms. A participant buys via TRS a the borrower than LIBOR or CDs.$10 million position in a loan paying L+250. ● The LIBOR (or Eurodollar) option is soTo affect the purchase, the participant puts called because, with this option, the inter-$1 million in a collateral account and pays est on borrowings is set at a spread overL+50 on the balance (meaning leverage of LIBOR for a period of one month to one9:1). Thus, the participant would receive: year. The corresponding LIBOR rate is L+250 on the amount in the collateral used to set pricing. Borrowings cannot beaccount of $1 million, plus prepaid without penalty. 200 bps (L+250 minus the borrowing cost of ● The CD option works precisely like theL+50) on the remaining amount of $9 million. LIBOR option, except that the base rate is The resulting income is L+250 * $1 million certificates of deposit, sold by a bank toplus 200 bps * $9 million. Based on the par- institutional investors.ticipants’ collateral amount—or equity contri- ● Other fixed-rate options are less commonbution—of $1 million, the return is L+2020. but work like the LIBOR and CD options.If LIBOR is 5%, the return is 25.5%. Of These include federal funds (the overnightcourse, this is not a risk-free proposition. If rate charged by the Federal Reserve tothe issuer defaults and the value of the loan member banks) and cost of funds (thegoes to 70 cents on the dollar, the participant bank’s own funding rate).will lose $3 million. And if the loan does notdefault but is marked down for whatever rea- LIBOR floorsson—market spreads widen, it is down- As the name implies, LIBOR floors put agraded, its financial condition floor under the base rate for loans. If a loandeteriorates—the participant stands to lose has a 3% LIBOR floor and three-monththe difference between par and the current LIBOR falls below this level, the base ratemarket price when the TRS expires. Or, in an for any resets default to 3%. For obviousextreme case, the value declines below the reasons, LIBOR floors are generally seenvalue in the collateral account and the partic- during periods when market conditions areipant is hit with a margin call. difficult and rates are falling as an incentive for lenders.Pricing TermsRates FeesLoans usually offer borrowers different inter- The fees associated with syndicated loans areest-rate options. Several of these options allow the upfront fee, the commitment fee, theborrowers to lock in a given rate for one facility fee, the administrative agent fee, themonth to one year. Pricing on many loans is letter of credit (LOC) fee, and the cancella-tied to performance grids, which adjust pric- tion or prepayment fee. ● An upfront fee is a fee paid by the issuer ating by one or more financial criteria. Pricingis typically tied to ratings in investment-grade close. It is often tiered, with the leadloans and to financial ratios in leveraged arranger receiving a larger amount in con-loans. Communications loans are invariably sideration for structuring and/or under-tied to the borrower’s debt-to-cash-flow ratio. writing the loan. Co-underwriters will Syndication pricing options include prime, receive a lower fee, and then the generalLIBOR, CD, and other fixed-rate options: syndicate will likely have fees tied to their● The prime is a floating-rate option. commitment. Most often, fees are paid on Borrowed funds are priced at a spread over a lender’s final allocation. For example, a the reference bank’s prime lending rate. loan has two fee tiers: 100 bps (or 1%) for The rate is reset daily, and borrowerings $25 million commitments and 50 bps for may be repaid at any time without penalty. $15 million commitments. A lender com- This is typically an overnight option, mitting to the $25 million tier will be paid on its final allocation rather than on initialStandard & Poor’s ● A Guide To The Loan Market September 2011 21
  22. 22. A Syndicated Loan Primer commitment, which means that, in this and 1% in year two. The fee may be example, the loan is oversubscribed and applied to all repayments under a loan or lenders committing $25 million would be “soft” repayments, those made from a refi- allocated $20 million and the lenders nancing or at the discretion of the issuer would receive a fee of $200,000 (or 1% of (as opposed to hard repayments made from $20 million). Sometimes upfront fees will excess cash flow or asset sales). be structured as a percentage of final allo- ● An administrative agent fee is the annual cation plus a flat fee. This happens most fee typically paid to administer the loan often for larger fee tiers, to encourage (including to distribute interest payments potential lenders to step up for larger com- to the syndication group, to update lender mitments. The flat fee is paid regardless of lists, and to manage borrowings). For the lender’s final allocation. Fees are usu- secured loans (particularly those backed ally paid to banks, mutual funds, and by receivables and inventory), the agent other non-offshore investors at close. often collects a collateral monitoring fee, CLOs and other offshore vehicles are typi- to ensure that the promised collateral is cally brought in after the loan closes as a in place. “primary” assignment, and they simply An LOC fee can be any one of several buy the loan at a discount equal to the types. The most common—a fee for standby fee offered in the primary assignment, for or financial LOCs—guarantees that lenders tax purposes. will support various corporate activities. ● A commitment fee is a fee paid to lenders Because these LOCs are considered “bor- on undrawn amounts under a revolving rowed funds” under capital guidelines, the fee credit or a term loan prior to draw-down. is typically the same as the LIBOR margin. On term loans, this fee is usually referred Fees for commercial LOCs (those supporting to as a “ticking” fee. inventory or trade) are usually lower, because ● A facility fee, which is paid on a facility’s in these cases actual collateral is submitted). entire committed amount, regardless of The LOC is usually issued by a fronting bank usage, is often charged instead of a com- (usually the agent) and syndicated to the mitment fee on revolving credits to invest- lender group on a pro rata basis. The group ment-grade borrowers, because these receives the LOC fee on their respective facilities typically have CBOs that allow a shares, while the fronting bank receives an borrower to solicit the best bid from its issuing (or fronting, or facing) fee for issuing syndicate group for a given borrowing. The and administering the LOC. This fee is lenders that do not lend under the CBO are almost always 12.5 bps to 25 bps (0.125% to still paid for their commitment. 0.25%) of the LOC commitment. ● A usage fee is a fee paid when the utiliza- tion of a revolving credit falls below a cer- Original issue discounts (OID) tain minimum. These fees are applied This is yet another term imported from the mainly to investment-grade loans and gen- bond market. The OID, the discount from erally call for fees based on the utilization par at loan, is offered in the new issue market under a revolving credit. In some cases, the as a spread enhancement. A loan may be fees are for high use and, in some cases, for issued at 99 bps to pay par. The OID in this low use. Often, either the facility fee or the case is said to be 100 bps, or 1 point. spread will be adjusted higher or lower based on a pre-set usage level. OID Versus Upfront Fees ● A prepayment fee is a feature generally At this point, the careful reader may be won- associated with institutional term loans. dering just what the difference is between an This fee is seen mainly in weak markets as OID and an upfront fee. After all, in both an inducement to institutional investors. cases the lender effectively pays less than par Typical prepayment fees will be set on a for a loan. sliding scale; for instance, 2% in year one22 www.standardandpoors.com
  23. 23. From the perspective of the lender, actually, changes such as RATS (rate, amortization,there isn’t much of a difference. But for the term, and security; or collateral) rights,issuer and arrangers, the distinction is far but, as described below, there are occasionsmore than semantics. Upfront fees are gener- when changes in amortization and collat-ally paid from the arrangers underwriting fee eral may be approved by a lower percent-as an incentive to bring lenders into the deal. age of lenders (a supermajority).An issuer may pay the arranger 2% of the ● A supermajority is typically 67% to 80%deal and the arranger, to rally investors, may of lenders and is sometimes required forthen pay a quarter of this amount, or 0.50%, certain material changes such as changes into lender group. amortization (in-term repayments) and An OID, however, is generally borne by the release of collateral.issuer, above and beyond the arrangementfee. So the arranger would receive its 2% feeand the issuer would only receive 99 cents for Covenantsevery dollar of loan sold. Loan agreements have a series of restrictions For instance, take a $100 million loan that dictate, to varying degrees, how borrow-offered at a 1% OID. The issuer would ers can operate and carry themselves finan-receive $99 million, of which it would pay the cially. For instance, one covenant may requirearrangers 2%. The issuer then would be obli- the borrower to maintain its existing fiscal-gated to pay back the whole $100 million, year end. Another may prohibit it from tak-even though it received $97 million after fees. ing on new debt. Most agreements also haveNow, take the same $100 million loan offered financial compliance covenants, for example,at par with an upfront fee of 1%. In this case, that a borrower must maintain a prescribedthe issuer gets the full $100 million. In this level of equity, which, if not maintained, givescase, the lenders would buy the loan not at banks the right to terminate the agreement orpar, but at 99 cents on the dollar. The issuer push the borrower into default. The size ofwould receive $100 million of which it would the covenant package increases in proportionpay 2% to the arranger, which would then to a borrower’s financial risk. Agreements topay one-half of that amount to the lending investment-grade companies are usually thingroup. The issuer gets, after fees, $98 million. and simple. Agreements to leveraged borrow- Clearly, OID is a better deal for the arranger ers are often much more onerous.and, therefore, is generally seen in more chal- The three primary types of loan covenantslenging markets. Upfront fees, conversely, are are affirmative, negative, and financial.more issuer friendly and therefore are staples Affirmative covenants state what actionof better market conditions. Of course, during the borrower must take to be in compliancethe most muscular bull markets, new-issue with the loan, such as that it must maintainpaper is generally sold at par and therefore insurance. These covenants are usually boil-requires neither upfront fees nor OIDs. erplate and require a borrower to, for example, pay the bank interest and fees,Voting rights provide audited financial statements, pay taxes, and so forth.Amendments or changes to a loan agreement Negative covenants limit the borrower’smust be approved by a certain percentage of activities in some way, such as regarding newlenders. Most loan agreements have three lev- investments. Negative covenants, which areels of approval: required-lender level, full highly structured and customized to a bor-vote, and supermajority: rower’s specific condition, can limit the type● The “required-lenders” level, usually just a and amount of acquisitions, new debt simple majority, is used for approval of issuance, liens, asset sales, and guarantees. nonmaterial amendments and waivers or Financial covenants enforce minimum finan- changes affecting one facility within a deal. cial performance measures against the bor-● A full vote of all lenders, including partici- rower, such as that he must maintain a higher pants, is required to approve materialStandard & Poor’s ● A Guide To The Loan Market September 2011 23