Leveraged loans were born out of the large LBOs of the 1980s and have always been
the preferred debt instrument in leveraged buyouts. Historically, private equity would
look to acquire a company with stable cash flows, look to operate it more profitably,
cut costs and pay down debt. Given that loans have little call protection and can be
prepaid at any time – loans are the preferred debt instrument of any deleveraging
capital structure.
We have seen a tremendous amount of growth in the loan market during the last
eight years with the Credit Suisse Leveraged Loan Index (CS LLI) growing 82% since
December 2010. Clearly there has been a lot of demand for floating rate senior secured
debt. Part and parcel with loan growth has been the growth in private equity. Private
equity raised $3 trillion in capital from 2012 through 2017, posting the strongest fiveyear
stretch for fund-raising in its history. So with all this growth, one must return
to the fundamental question: If the best of loans are made in the worst of times, is
the converse true? Well, we will endeavor to take a peek at what is taking place in the
senior, secured floating-rate loan market and see if some of the pillars of what makes
a loan a loan are being eroded.
Private equity fundraising has contributed to a more competitive bidding process,
higher purchase price multiples and consequently, higher leverage.
Private Multiples Increasing
Source: S&P LCD
Given the need for private equity to pay higher acquisition multiples it is probably a safe assumption that significant multiple
expansion from purchase to sale will be difficult for sponsors to achieve. And although it might be difficult, sponsors still need
to generate a return for their investors. One creative way to create a return would be to move value from senior parts of the
capital structure to more junior parts of the capital structure. Private equity sponsors have taken a targeted approach at weakening
traditional loan terms by removing amortization and by reducing, watering down and outright removing loan covenants. Although
private equity drove the initial weakening of loan terms, these lower standards have become pervasive.
When looking at new annual institutional issuance a few items stand out. Sponsor-backed transactions have dominated the leveraged
loan landscape for the last 18 years. While LBOs as a percentage of the market hit a low of 35% in 2002, they are now responsible
of 63% of all volume.
Sponsor Backed Volume versus Total Loan Growth
Source: S&P Global Market Intelligence
Not only has private equity grown as a percentage of issuance to over 60% of transactions in 2018, it has consistently represented
50%-60% of the institutional loan market during the largest issuance period in loan market history (post the global financial crisis).
S&P LSTA Leveraged Loan Index Size
Source: S&P Global Market Intelligence
The S&P Leveraged Loan Index (S&P LLI) has doubled in size to more than $1.0 trillion since 2010, driven largely by private equity
transactions. At the same time, the number of participants buying loans has also grown in an investor base consisting of banks and
crossover investors (both investment grade and high yield accounts) as well as floating rate funds, separate accounts, hedge funds
and CLOs. S&P Global Market Intelligence has recorded nearly 300 separate institutions that committed to three or more deals
or received $10 million or more in estimated allocations. This is not a comprehensive list and would not even include term loan
B demand from banks but it does highlight the possible number of participants in any one transaction. In the early 2000s, banks
syndicating a transaction would have likely reached out to 50 or 60 institutional accounts, including banks looking to buy term loan
B paper. A private equity sponsor singularly focused on one deal has the upper hand in negotiating documents with disparate group
loan investors, which are focused on investing in hundreds of deals. Indeed, this basic logic seems to hold true when looking at the
persistent erosion of credit agreement quality.
What else is new to the market?
We need look no further than the growth in bank-loan-only capital structures to understand that there has been overwhelming demand
for bank-loan paper. JP Morgan recently highlighted that loan-only issuers have grown from 403 at the beginning of 2013 to 911 today,
representing growth of 126%. This compares to modest growth among loan-and-bond issuers from 291 to 341, a 17% increase.
Growth in Loan-Only Capital Structures
Source: JPM
A lot of press has focused on covenant-lite loans versus loans with covenants, which have grown as a percentage of the market since
the global financial crisis. This is not entirely new information but is one more piece in assembling our mosaic of credit quality.
Covenant-Lite Loan Amount, Share of Outstandings
Source: S&P/LSTA Leveraged Loan Index; LCD, an offering of S&P Global Market Intelligence
To reiterate some of the points above: The market is somewhere between 80% and100% larger than it was in 2010, loan-only capital
structures are pervasive and covenant-lite loans are ubiquitous.
Is there anything else new?
Yes, as a matter of fact senior and total leverage is up and the number of EBITDA adjustments post the global financial crisis has
grown dramatically.
Leverage for LBOs has hit the highest level since 2007 and is up nearly one-turn since 2010.
Average Debt Multiples of Large Corporate LBO Loans
(Media and telecom loans excluded prior to 2011.
EBITDA adjusted for prospective cost savings or synergies)
Source: S&P Global Market Intelligence
While EBITDA adjustments appear to be in line with historical levels, the percentage of deals using EBITDA addbacks has increased
consistently.
Transactions with EBITDA Adjustments
Source: S&P Global Market Intelligence
Percentage of Adjustments to EBITDA
Source: S&P Global Market Intelligence
Therefore, leverage is growing while EBITDA adjustments are material. The real consequence is quite simple. Some deals are overlevered
and if there is either an idiosyncratic event impacting a borrower or a more systemic event like a recession, there is little
room for error.
From our vantage point, it feels like EBITDA adjustments have grown more than the chart above would imply. We have seen several
deals in the last 12 months where we view adjustments approximately 50%-100% of the total size of the original EBITDA rather the
~10% highlighted in the chart above.
There are two examples we will highlight below on a no names basis.
Example 1
- The first deal operates in the pharmaceutical industry and completed a large acquisition last year.
- The adjusted EBITDA was 40% larger than EBITDA and the final marketed EBITDA was 90% greater than the original EBITDA.
- While we could get comfortable with some of the adjustments – we felt like the marketed EBITDA was borderline absurd.
- The use of proceeds included a significant dividend.
- The investment bank leading the transaction marketed the deal with 4.8x senior secured leveraged and 7.0x total leverage.
We viewed the deal as closer to 6.1x senior and 8.8x total.
Example 2
- The second deal operates in a health care service industry. EBITDA addbacks used in this deal were creative to say the least.
- Basically, in this business model, the company is required to open offices. When they open an office they can addback those costs.
On one hand, we understand that concept. But the sponsor doesn’t plan to have this be a one-time office opening. They intend
to grow the business and open many offices every year. So that really should not be added back to EBITDA since is normal course
of business.
- The company is also permitted to run-rate the performance a new office and addback EBITDA equivalent of a mature office’s
EBITDA. Huh? So they addback the amount to open an office and they add back the difference between actual performance and
whatever they expect future performance to be?
- Now here is the really special part. If the company opens an office and it fails; well, they can add that back too. Simply put, every
office is assumed to workout out but if it doesn’t - those expenses are added back to EBITDA.
- EBITDA to adjusted EBITDA was slightly greater than 100% but pro forma adjusted EBITDA was three times greater than EBITDA.
- We believed that adjusted leverage for the deal was 6.3x secured and 8.2x total, where the investment bank marketed the deal 4.1x
and 5.1x.
What about the credit agreements?
The quality of credit agreements has also eroded. Restricted payments covenants, which limit dividends, share buybacks, and other
returns paid to shareholders by mandating that such payments not exceed a certain level, have been loosened dramatically. The
ability of borrowers to un-restrict entities in the borrower group has become common. Cash is often not part of the collateral and
borrowers can often move cash out of the borrower group to unrestricted entities. All-in-all, there has been a very targeted approach
to weaken lenders’ ability not only to claw back the very money we have loaned to borrowers but also lay claim to the assets by which
we are supposedly secured.
Looking forward – what does this all mean?
First, we should provide some context to the generally bleak picture we have painted above. Private equity has a long history of
successful investment. Therefore, having an asset class such as loan aligned with private equity could be viewed as a positive.
Furthermore, the businesses comprising the loan index today versus the businesses we saw 18 years ago are bigger, more diverse,
more interesting and more often market share leaders versus the pool of available borrowers two decades ago. Purchase price
multiples have grown but the equity tickets during the last 3.5 years have also grown.
Equity Contribution
Source: S&P Global Market Intelligence
It should also be noted that we have operated in a period of low default rates and good earnings, which have allowed companies to
push out maturities, lower debt costs and pay down debt. Finally, managers have a far greater ability to pick and choose what they
want to own in the bank loan universe as the selection of assets is much wider than two decades prior. All these are very good facts
and underpin why one would want to invest in loans.
Unfortunately, a lot of these positives are somewhat offset by the bad fact that many companies want to metaphorically have the
right to play three-card Monte with the very assets they purchased with the loan proceeds. We believe that net-net, these actions will
result in lower recoveries. Trying to put some context around recoveries, we compare first lien loans to high yield bonds. Historically,
first-lien bank loan recoveries have been closer to 70% and high yield bond recoveries have been closer to 40%. High yield borrowers
generally are not first liens, generally don’t benefit from financial maintenance covenants and they generally have little if any debt
subordination below them. Loans do still benefit from some protections even if they are not as strong as protections the market saw
20 years ago. As a result, we would assume recoveries from this vintage of deals will be lower than 70% but much higher than 40%.
Indeed, that is how recoveries have behaved in the last sixyears, averaging something closer to a 60% recovery.
Loan Recovery Rates
Source: Credit Suisse
Recap
Private equity groups have had explosive fund raising and the loan market has had a commensurate level of robust growth. Broadly
speaking, there are not only more loan-only capital structures but also the leveraged loan market has weaker covenants and higher
leveraged multiples with more aggressive adjustments to EBITDA than at any point historically. This will create higher volatility and
ultimately lower recoveries.
Credit selection and active management will be more important than at any time in the past.