Core Skills - DCM (Commercial Bank)

Hi guys,

I'm looking for some advice regarding DCM as I've got an interview for an internship next week. It's for a commercial bank in Australia, which for reference sake, have institutional/corporate banking teams, but predominantly focus on DCM though they do have involvement in ECM (Though normally not in a lead-manager role).

For M&A I'm across a lot of the technical skills (DCF, comparables etc), but I'm at a bit of a loss as to what's required for DCM. Any advice on what topics/excel skills to develop prior to this interview?

Oh, and to head off the question of "Why are you interning with DCM rather than M&A?." Essentially all internships in Aus are run over Dec-Feb whereas this will run over June/July, my logic being some experience is better than none.

Thanks very much.

Comments (11)

Jun 1, 2014 - 7:58am
yelloweat, what's your opinion? Comment below:

I'm wondering: Isn't DCM separate from commercial banking?

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Jun 2, 2014 - 5:39am
JBelfort1, what's your opinion? Comment below:

It is. I mean that banks who are traditionally known for their commercial/retail work handle most of the DCM volume in their institutional/corporate teams. I guess the best way I could equate it would be to Wells Fargo or HSBC (who don't do much ECM/M&A work?) being known for retail work, but handling the majority of DCM work.

I can't post links yet but if you google "Dealogic League Tables Australia" you'll note that your standard BB dominate ECM/M&A but DCM is covered by banks you may not have heard of. These banks are primarily known for the retail/commercial services, but they handle the bulk of DCM.

Jun 2, 2014 - 11:31pm
SSits, what's your opinion? Comment below:

This book is not a bad guide to aspects of the US DCM market: http://www.amazon.com/Leveraged-Financial-Markets-Comprehensive-Instruments/dp/0071746684/ref=sr_1_3?s=books&ie=UTF8&qid=1401766176&sr=1-3&keywords=leveraged+finance

I post this for reference rather than usefulness for your position. It's unlikely that a large amount of the information would translate to the Australian market, although some of the stuff (eg how ratings agencies interact with DCM issuers and underwriters) would.

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  • 1
Jun 2, 2014 - 11:59pm
SSits, what's your opinion? Comment below:

Take a look at the LBO models on http://www.macabacus.com. Don't worry so much about the equity returns section (although you should understand it), but instead focus on calculation of cash flow available for debt service (CFADS), DSCR, net debt/EBITDA and net debt/(EBITDA - capex). Those are the key metrics I focus on when looking at a DCM underwriting proposal.

Key questions a DCM underwriting team will have around this include: - What are drivers behind the revenue and EBITDA forecasts and what are the key risks to those - What's driving capex forecast and how fast can the company "turn off" capex if earnings are lower than expected so that it can free up enough cash to service debt (eg is capex locked in a long time in advance under contracts? required to replace existing plant? etc)

Those impact CFADS and understanding the borrower's ability to have enough cash to deleverage and meet debt service is essential for assessing the risk of default.

From the book I referred to above - see this extracted chapter on debt covenants/documentation: http://www.cravath.com/files/Uploads/Documents/Publications/3234772_1.PDF

Read that to get an idea of standard (in the US, at least) covenants and other debt terms, particularly leverage covenants and debt service covenant ratios (DSCRs).

Know that "cov-lite" means a debt deal WITHOUT these type of covenants, which means the debt is more risky than those with the covenants because the company can get closer to financial distress before breaching the loan agreement, hence lenders only have a right to step in later in the game.

Know that (in the US market at least), the high demand for high yield and leveraged debt means that debt terms are borrower-friendly, so cov-lite (including no covenant flex), small pricing flex and mid to high 300s pricing is common for USD debt in the B1/B range (typical for PE LBOs, which is what I look at 75% of the time this year). Try to find out what the common spreads are in Australia for new issues (do you have access to a Bloomberg terminal) at the credit rating range targeted by the bank you are interviewing for.

Understanding seniority of debt.

Find out what types of debt your target bank does DCM work in. For example, do they focus on high yield/leveraged finance in the B1/B space, or somewhere higher (or lower) on the scale? Once you've worked that out, see question above ie work out what the common pricing is for new issues in that type of debt via a Bloomberg terminal + some knowledge of recent debt issues.

If you haven't done DCM, a lot of this stuff may not make that much sense to you or may be information you can't access. If that's the case, focus on the Macacabus model and the PDF chapter I posted from with the Cravath link and ask your interviewers some of the other questions to demonstrate you have some awareness of the market.

Those who can, do. Those who can't, post threads about how to do it on WSO.
  • 3
Jun 4, 2014 - 8:23am
HFer_wannabe, what's your opinion? Comment below:

Though you already kind of stated your stance, what's your opinion on cov-lite vs non cov-lite when considering risk? With the huge surge in cov-lite debt recently, I've seen a few articles come out in support of lax covenants so as not to overly restrict a company when sht hits the fan. I don't have a good enough historical grasp on the sector to know if that's a realistic situation or if it's just an excuse to lend out even more $$$.

Jun 2, 2014 - 11:55pm
SSits, what's your opinion? Comment below:

A key additional link:

Standard & Poors guide to the loan market: https://www.lcdcomps.com/d/pdf/LoanMarketguide.pdf

This is for the US market, but most concepts are similar. When they talk about loan syndication, that's DCM work ie DCM underwriting bank(s) arranges the loan and syndicate/place the loan with institutions and other investors.

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  • 2
Jun 2, 2014 - 11:57pm
SSits, what's your opinion? Comment below:

If you're time poor, just look at the S&P primer I posted in my last post. This covers key topics about syndication in the right amount of detail for you - not too much, not too little.

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  • 1
Best Response
Jun 4, 2014 - 10:57am
SSits, what's your opinion? Comment below:

@HFer_wannabe - Good question.

I'll break down my thinking on some details a little more explicitly than you probably need for the benefit of some of the people reading who aren't in the industry.

In most cases, I don't like cov-lite.

Why?

When I'm looking at cov-lite deal, I'm almost always looking at it as DCM underwriting risk ie an IB that is underwriting the deal and will seek to sell the debt to investors. However, bear in mind that the underwriting banks will have to hold the revolver facility, which can be around 0 – 10% of the total debt depending on the nature of the business.

So my key concerns are: 1. How can I get debt terms which make the debt easiest to syndicate to investors, so that my underwriting commitment is never triggered? 2. How can I minimise the credit risk I am forced to take on the revolver facility that will be left sitting in my books

Both mean I need to look at the deal as a lender.

As a lender, I want to know as early as possible when the company runs into problems and I want a seat at the table, typically via covenants and consent requirements which are triggered as early as possible in financial distress and mean that the company has to come to lenders to ask for approvals. Or, more likely, lenders want liquidity – ie debt that they can sell to a distressed debt fund, which typically means debt with terms that give the fund a seat at the table (see below).

This is not in the equity owners' interests, as almost always: 1. Lenders won't have any valuable advice to give to the company on how to solve its problems 2. Notifying lenders and/or seeking waivers, amendents and other concessions increases administrative costs, distracts managers from actually solving the problem and often increases the risks of bankruptcy 3. Convincing lenders to grant waivers is typically very difficult and sometimes requires paying them fees

On the last point, lenders are typically loathe to give consents and waivers because it's work and thinking they don't want to do, often involving some credit officer having to go to his/her credit committee for approval, which means he/she gets grilled about some waiver which wasn't his/her idea and he/she doesn't know that much about. It's a hassle and hassle that doesn't pay (unless the company is paying a waiver fee).

Why do I want to know as early as possible if the company is in financial distress? So I can sell the loan or take other mitigating steps before the situation gets worse.

Why do I want a seat at the table via covenants and consent requirements? A few reasons: 1. Seat at the table gives me control and, where management and equity has got themselves in a distressed situation, I want as much control as I can as I often will have concerns about their ability to manage the situation. A seat at the table gives me more visibility, increases accountability of equity and management and gives me – at least psychologically – a sense of increased control over the situation and eventual recovery of my capital. 2. If the company is in financial distress, vanilla investors usually want to sell out. Distressed debt funds want to buy in, but distressed debts will only buy into deals where that gets them a seat at the table where they can control the situation and extract a good deal. More covenants and consents required = more leverage = easier for me to sell the debt to a distressed fund. Cov-lite deals are harder to sell, at least until the company is much closer to bankruptcy. 3. Covenant breaches themselves are an early warning sign of financial distress, which warns me to get out. While rationally an investor can read quarterly/semi-annual reporting and should be able to detect financial distress itself, a covenant breach gets a lot more attention, including the attention of higher ups (eg credit committees).

I have done equity deals where my perspective has been symmetrical to debt's. That is, while I'm confident we wouldn't be in breach even if there were covenants, I've strongly preferred cov-lite because shit could happen and, when it does, I don't want to have to deal with banks on top of the situation. I certainly don't want to ask for their consent on matters.

Coming back to your question about lax covenants gives equity more flexibility to deal with shit hitting the fan. I agree it does and, in many cases, is likely better for the firm. However, lenders look at it from the perspective that there is a misalignment of financial incentives in financial distress situations. Take a scenario where debt = $100, value of the firm = $80 only and there is a high risk deal that has 10% chance of increasing value to $150 and 90% chance of taking value to $10. Rationally: - Lenders would strongly prefer the company doesn't take the risk - Equity is entirely motivated to take the risk, as the status quo means no recovery to equity ie a 10% chance of getting $50 return vs 100% chance of getting nothing

Cov-lite gives equity freedom to take the gamble. As equity, that's what I want. Clearly, as lender, I don't like cov-lite because control on the gambling decision is in the hands of equity, outside my control.

Even outside of those situations, covenants are a hassle for equity. Going back to the waiver point I made above – I had a LBO deal pre-GFC and pre-cov-lite era, where we acquired and merged two companies with around 100 large movable assets that the merged company leased long term to third parties. Banks got security over title to each asset plus an assignment of the company's rights under the leases. That meant going through each lease (typically which were in the customer's standard form) and trying to explain to the customer that we needed to include the assignment right or they needed to consent. This was a huge hassle. Many of the customers didn't want to do this and had the bargaining power to refuse. We didn't anticipate this when we structured the LBO. We later went to the banks to get a waiver for some of the assets. They understood, they were sympathetic, but "couldn't get it past their credit committee". We ended up being in technical breach but crossing our fingers that notice of "breach with reasonable explanation" would mean no action from the banks (which ended up being the right call). Cov-lite would have avoid this hassle.

Related topic - A question around cov-lite is whether regulators (eg FDIC) will crack down on cov-lite. In the last few months, they've made noises about restricting regulated banks to max 6.0x net debt/EBITDA on LBOs and the like, although they've given not much guidance around this and deals have been done. On the other hand, I am seeing deals where regulated banks are pulling back when leverage is >6x (eg the Brickman deal – see http://www.pehub.com/2014/05/rejected-banks-deny-kkr-buyout-loan-amid-regulatory-crackdown/?utm_source=dlvr.it&utm_medium=twitter). Possibly they could also come out negative on cov-lite, although I think they'll stay focused on leverage only.

Overall, I've seen cov-lite eras twice in that part of my professional career where debt markets were part of my job. Pre-GFC over 2006 – 08 and in the last 6 – 12 months. Like the current small margins on LBO deals, cov-lite indicates we're in a hot market where the supply of money for LBO debt and B1/B+ - B2/B high yield and leveraged loans (eg from cashed up CLOs) is high, so the price/cost of that debt (interest spread, restrictiveness of covenants) is low.

Leveraged debt/high yield market sentiment can turn on a dime. The right combination of headlines could see sentiment turn 180 degrees in a week.

But until the market turns, we're doing as much DCM as we can in this space. Sensible deals only, of course. Although through ~50% of the last decade, cov-lite has not been seen as sensible.

Those who can, do. Those who can't, post threads about how to do it on WSO.
  • 4
Jun 4, 2014 - 11:13am
SSits, what's your opinion? Comment below:

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