LBO Financing and Investment Banks
Just trying to figure out the relationship between collateralized loan obligations (CLOs) and LBO financing. When an investment bank syndicates a loan, who is providing the capital? Is it the bank itself, or does it simply accumulate capital from other sources (institutional investors) and collect a fee for arranging the deal? Does the investment bank take on any risk itself? Does it hold the loans on its book for a while before it securitizes them into a CLO to be sold off (thus creating "carrying risk")?
I'm just trying to figure out how this is different from submprime mortgages that caused the financial crisis. The investment banks (e.g., Lehman) got caught with a lot of subprime mortgage debt / CDOs on their books that quickly turned to junk. Did the same thing happen with leveraged loan / buyout debt / CLOs?
In an LBO, an investment bank or a group of investment banks will commit to provide the financing (underwrite). In an ideal world, a syndicate desk will be able to get institutional guys to come in for the full amount by the commitment deadline, and they will only have their desired hold level on the books (some trading desks will take a small portion of the loan to trade around and help make markets/stay active in the name).
Other times, the syndication won't go so well. They won't get enough commitments by closing, and will either have to close the deal above their desired hold level and try to sell down in the secondary market (usually at a discount, taking a loss). Note that in an underwritten deal, the fees are going to be higher than a best-efforts because of the additional risk the bank takes on.
I can't speak much to the securitizing aspect of the CLOs, as my firm doesn't do much of that.
Thanks.
What about revolvers? Who provides the capital when a company draws upon its revolving credit facility?
Also, what about market-flex language in the loan docs. If an investment bank can't syndicate the full amount at a certain rate, can't they just alter the rate to make it more attractive to investors? It seems like this removes much of the risk associated with underwriting--if they can alter the rate, the banks would likely find investors and not have to hold it on their books.
Revolvers are generally held by the banks, not institutionals.
You are correct about market flex, but there is usually a maximum the banks can reach. Look up the Rue21 deal for an example of a deal gone bad - JP Morgan and others had to lower the OID to 81.5 to get the deal done, and were on the hook for the difference.
Revolvers are the shit the IBs have to hold and fund because few other people want them. The availability fees on revolvers typically don't/barely cover the cost of capital the IB has to holding the funding liability. While revolvers pay full interest when drawn, they are rarely drawn fully, are revolving facilities (ie money constantly in and out) and are typically drawn most when the borrower is in trouble/high risk (hence they typically have springing leverage covenants).
The higher an IB's cost of funds, the shittier it is to hold revolvers and the more the IB has to hope that the PE firm sponsors of an LBO deal will provide advisory fees in the future - ie you hope the 'relationship' pays off.
Sometimes an IB may be able to sell its RCF position to a smaller bank that wants a relationship with the company.
An IB hopes that the flex will be enough, but they can't rely on that, particularly in markets like today where there is legitimate fear that appetite for leveraged paper could shift quickly. The typical LBO debt proposal I see (as a credit analyst) shows how much we'd burn through flex, then fees, then our P&L if we had to sell at a yield matching the highest yield similar paper has sold at in the last 5 years.
There are a few factors to consider, including (not limited to):
A PE firm needs LBO debt all the time. They won't want a "hung deal" (ie deal that couldn't fully clear within the rate flex) in their track record, as it will reduce IB's willingness to underwrite in their next deal or the IBs will require more IB-friendly terms. So PEs may be willing to allow a little more interest rate flex or structural flex than the documents legally allow.
Structural flex - some LBO deals allow IBs to change the loan structure if the initial loan proposal doesn't get enough market appetite. For example, a $1b unitranche deal may not be as appealing to the market as a deal with $0.7b first lien plus $0.3b second lien sitting behind the first lien. Second lien will be priced higher, as it ranks behind first lien and so is higher risk.
Synthetic flex - Even if the debt papers don't include structural flex terms, IBs can synthetically achieve a similar outcome by splitting a unitranche deal into (i) first tranche - terms as per the original deal, but smaller size; and (ii) synthetic second tranche - do something like sell a portion at higher OID (eg sell $100 par value to investors at $90, which provides higher yield) on the condition that synthetic second tranche lenders agree to be subordinated to first tranche lenders.
These are just a few of a larger number of options/considerations when you're an IB selling LBO debt.
Are people doing unitranche deals that big in the US? Still, to my knowledge, a small product in Eur, with not a huge syndicate market.
And do you know if any precedents of enforcement / restructuring of unitranches yet? Being an ex lawyer I suppose you're pretty clued up on the docs.
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