http://www.princeofwallstreet.com/2008/02/06/buyout-debt-it-just-wont-go...
When the leveraged loan and high yield debt markets shut down this July the speed of the problems shocked many. I remember hearing the heads of sponsors and leveraged finance teams say that the pullback of investor demands was the swiftest they had ever seen. From early July and throughout the summer the problems continued to mount. Banks wrote bridges to complete acquisitions and perpetually delayed the offering of paper that would relieve them of the bridge loans. The fact was that demand for buyout related debt was anemic and remains so today. Many believed that the initial shutdown of the market was caused when CLOs (Collateralized Loan Obligations) and other large bank loan investors began to sell LBO related debt to raise capital to meet marginal calls on their mortgage/CDO portfolios. The Prince tends to agree with this analysis. Many of the corporate loans used to finance giant buyouts in the past few years are reeling in secondary market trading, making it virtually impossible for banks to unload other commitments they have made.
Over the fall some deals where priced but at huge discounts to par. Some deal priced at 90% of par. Banks took huge hits on all the paper they sold but still had to mark to market the declining values of the bridge loans they had made. When the LBO related debt offering market shut down many banks quickly rushed to the PE firms to renegotiate terms. Some firms played ball and other, like KKR, held the banks to their original commitments. The losses on committed financings by Wall Street banks are enormous and would have been bigger news had they not been eclipsed by a much larger mortgage/CDO crisis. For the uneducated, a committed financing is when a bank agrees to provide a certain amount of debt to sponsor to complete an acquisition. After the commitment is accepted by the PE shop the bank holds the risk in the form of a bridge loan. Under normal market conditions the bank would then offer bank debt or high yield debt in the acquired company which would take the place of the bridge loan. If the bank is unable to sell the debt they either have to sell the debt at a loss or hold the bridge loan on its balance sheet.
In the secondary market LBO related debt hit its lowest levels in the summer and has recovered somewhat since then. For example, the loans of First Data Corp., which was taken private in September by Kohlberg Kravis Roberts & Co. for about $28 billion, were sold into the market this past fall at a 4% discount to their par value; they now trade in the market at a steep 11.5% discount to par value. Loans of Freescale Semiconductor Inc., taken private in December 2006 for about $28 billion, are trading at a 15.5% discount to their original value while Tribune Co., which was taken private in April by Sam Zell for $8.2 billion, issued loans now trading a 26% discount. The list goes on and on. Defaults on LBO related debt are still low but some of this is certainly attributable to the covenant lite and PIK toggle features of recently issued LBO debt. In many cases holders of PIK Toggle LBO debt have about the same protection during default as equity holders. The covenants on lots of LBO debt issued in the two years before this summer had constraints that were large enough to drive a truck through.
If you need more proof that banks are not able to get bridge loans off their books just look at how recent attempted offerings have faired. The Harrah’s Entertainment loan sale was a mess. Credit Suisse broke from a group of banks lined up to sell $7.25 billion in loans tied to Harrah’s buyout. It offloaded its commitment of about $1 billion through derivatives transactions in December. Other banks tried to sell some of their own Harrah’s loan commitments in January, and the price of the loans dropped to between 91 and 92 cents on the dollar. Last week a Lehman Brothers-led group of banks abandoned their three-week effort to sell CDW’s $2.2 billion loan to buyers. The deal failed to generate interest even though they were offering to sell the loans in the low 90s. In October, MDP and Providence acquired CDW, one of the country’s largest technology-equipment resellers, for $7.3 billion. Things have gotten so bad that some banks have decided that they would prefer to hold some of the loans on their books as investments, rather than sell them at deep discounts. JP Morgan’s CEO expressed just this strategy when he said, "At these price levels we think some of them may be terrific long-term assets to hold," during his last conference call. JP Morgan was holding about $26.4 billion in leveraged loans at the end of the fourth quarter, after selling about $16.5 billion of the commitment related debt during the period.
The fact of the matter is that in July of 2007 the music stopped and the banks were left holding the majority of the risk. However, we shouldn’t cry for banks or blame them. Why shouldn’t we cry? First of all, the fees that sponsors paid to the street when the buyout game was hot were enormous. Most of the top sponsors would easily eclipse the fees paid by Dow Jones 30 companies to Wall Street. The banks made way more money financing LBOs and providing merger advice to acquirers and targets than they are going to lose now in the current market turmoil. Not to mention all the fees that banks earned doing corporate finance work for sponsors owned businesses such as leveraged re-caps, IPOs, and private placements. Banks also made money trading LBO related debt in the secondary market and derivatives on this debt.
The truth is part of being a global investment bank is having sponsors and leveraged finance teams. In good times these groups will earn far more than they will lose in times like these. Double-digit declines in the market value of leveraged loans in the secondary market are very unusual, and a big problem for many banks, which now sit on a pipeline of $152 billion in loans that they have promised to make but have yet to sell to investors. Yet, the hit they will take on this pipeline can’t compare to the fees they earned over the last 4 years doing these kind of financings.
We also cannot blame the banks for the pause that the PE firms have been forced to take as a result of the unavailability of debt for large LBOs (even small to medium in some cases). PE shops kept pushing the envelope and showing debt with fewer covenants onto investors. Eventually, investors were going to take a walk and reassert their power. Whenever the Prince hears some private equity executive telling the press that LBOs could resume if the banks would just work through their backlog of debt he just shakes his head. Not to mention the fact the fact that committed financing with covenant lite or Pik Toggle notes are never going to be bought by investors (or maybe at a huge discount). Who pushed for these terms in the heyday of LBOs? The PE shops did. Sure, the banks took the risk but they did it because to best other banks for lucrative financing deals they had to take more risk and decrease their margin for error. The backlog in LBO debt that is still held on banks books is as much the fault of PE firms as it is bank.
We will eventually work through the bridge loans that all the banks have on their books but the financing markets are not going to open back up to the PE shops right away. With the prices of existing leveraged loans tumbling, investors have little incentive to buy new loans unless they are sold at steep discounts, something banks are reluctant to do. Another problem is that a source of investor demand for these loans has dried up. CLOs were huge consumers of corporate loans in 2006 and early 2007. CLOs hold bundles of loans and are sold to investors in slices with varying levels of risk and return. As defaults rise, demand for the riskiest pieces of these instruments is undermined. CLOs have been absent from the marketplace since the summer.
Once investors return to buying leverage loans and terms become more favorable to investors then they return. Will investors return and bring back the LBO times we say in the Spring of 2007? Only time will tell. The Prince has to hope that in 18-24 months we will beginning, to borrow Rubenstein’s language, "The Platinum Age of private equity."
http://www.princeofwallstreet.com/2008/02/06/buyout-debt-it-just-wont-go...
