Lev Lending & Subprime: Separated At Birth?

July 2, 2007

High yield investors finally told issuers to "talk to the hand" last week, and this change in sentiment comes none too soon, according to analysis by New York-based hedge fund Pershing Square Capital Management.

The high yield markets have been debating the "Will leveraged lending go the way of subprime?" question since the subprime bubble burst in February, but many participants we talked to at that time were convinced high yield loans and bonds would be fine, short of a major catastrophe.

Pershing Square, however, lands squarely in the camp that says: What happened in subprime is likely to happen in LBO financing, the cycle is just not as far along.

To support this conclusion, the firm has analyzed individual characteristics in each market and lined them up side by side with the corresponding trait for comparison.

What they've come up with is as follows:

Subprime mortgages had high loan-to-value ratios; leveraged issuers have been coming to market with higher debt-to-Ebitda ratios.

Subprime loans saw negative amortization; leveraged issuers have embraced covenant-lite issues and PIK toggle notes.

There were cash-out refinancings in the subprime market; there have been dividend recaps from leveraged loan and bond issuers.

The subprime market avoided the truth through "liar" loans or, more politely put, limited or falsified documentation; the leverage lending market has its own version with credit for pro forma cost savings.

Subprime had its 0% down; leveraged issuers have their equity bridges.

And finally, subrime saw home appreciation; the leveraged market has seen purchase multiple expansion.

Now, it could be argued that some of these examples are not exactly the same. Handing over a 0% down mortgage to an individual who lacks the resources to make monthly payments is not quite the same as a bank providing an equity bridge to a buyout firm with the deepest of pockets. In both cases it's possible to get burned (and there have been cases of equity bridges tumbling down). However, as long as the bank doesn't make promises of squeaky tight spreads and syndication goes smoothly, it will get its money back. This is not quite like depending on individuals living on the financial edge to be able to repay their mortgage when they can't even come up with a down payment.

That said, taken all together, these comparisons are pretty compelling stuff. Which is to say that maybe it's best if the hand issuers were talking to last week keeps pushing back.

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