The Future of Leveraged Lending
July 8, 2009
The mood at the annual Association for Corporate Growth InterGrowth conference is usually a good barometer of the state of acquisition finance. Attendees at this year’s event in Las Vegas were engaged, but subdued. When one moderator cited forecasts that senior debt defaults might hit 18.5%, you could have heard a pin drop. And when the depressingly familiar charts flashed on the screen showing columns shrinking dramatically from left to right, leaving the most recent quarter’s deal activity with an empty slot and an apologetic footnote ... well, “Insufficient Data” said it all.
In panel after panel, the hottest topic was the absence of leveraged lending and how that impacted all sectors of finance—M&A, public and private equity, credit and restructuring. The “big question” remained: When will lending return, and what it will look like when it does?
The lack of deal activity isn’t all the fault of lenders. One panel offered a glimpse into the thinking of some corporate boards. Though directors demand price and certainty regarding buyouts, they are getting neither. Even strategics are handcuffed. “If you don’t have confidence in your own numbers,” one Fortune 100 executive bemoaned, “how can you have confidence in the target’s numbers?”
Uncertainty Rules
Cautious private equity firms aren’t putting many chips on the table either. One would think, with purchase price multiples off from their 2007 peaks, that buyers would be busy rummaging. But in this uncertain economy, earnings are off for issuers as well. Sponsors are long-run investors, but no one wants to start off a long run with a broken ankle.
And as sellers, PE is conditioned against getting out at the bottom. Why not wait until next year? Who knows, maybe banks will be lending by then.
But will they? The same conundrum everyone in the leveraged game faces today—lack of price and certainty— hampers loan investors. Practically every class of senior debt buyer—CLO, BDC, large bank, finance company, hedge fund—has been stymied by their own liquidity issues. With senior debt capacity shrunk for all but the smallest deals, who can come to the rescue?
The CLO model, the primary driver of the leveraged loan market for the past decade is dead, at least in its historic form. The ability to create leverage using debt tranches in structured vehicles disappeared with the flight of triple-A investors, as the meltdown of subprime vehicles raised doubts about the integrity of ratings and securitization in general.
Some tentative arbitrage CLO issuance has been made, but with the higher percent of equity being demanded in those structures, the lofty asset spreads needed to meet the CLO manager’s own returns have left corporate issuers seeking other options.
Business development companies, once efficient sources of liquidity for leveraged paper, thanks to their access to public equity, have been curtailed by their low equity valuations, limiting access to new capital.
One would think that the large investment (now commercial) banks—as recipients of all the government’s stimulus largesse—would be well-equipped to lead the charge once economic recovery begins to show itself. But all those rescue dollars merely restored capital lost in the wake of mark-to-market accounting (and some real) losses. And with stress tests still showing signs of potential vulnerability, it is far from clear that big banks are ready to play a meaningful role in a leveraged loan recovery.
Large finance companies have historically played significant roles in what is now the only active sector in leveraged loan land: the middle market. But the Treasury, despite allowing these providers to buy banks, has been slow to afford them all with the status of bank holding companies. Such licenses are required for TARP money, certainly a helpful source of supplemental liquidity. Perhaps the government doesn’t want to be seen as enabling more lenders to fill their balance sheets with assets which could be perceived, no matter how inaccurately, as “risky.”
One class of investors that showed early promise in bringing additional liquidity to the leveraged market were the loan accounts run by large hedge funds. When new CLO creation fell away last year, these managers became active buyers of heavily discounted loan paper.
But those bargains have mostly vanished and the more normalized single-digit yields of the asset class simply don’t meet hedge fund return hurdles. The staff-heavy portfolio management style that leveraged lenders typically employ, especially in cyclical downturns, is also not an ideal fit for the nimble, “small-shop” trading approach some hedge funds take to investing.
Private equity has also deployed billions during the credit crunch via “side-car” vehicles designed to take advantage of market illiquidity. But these have been used by PE mainly to plug capital holes or repurchase debt opportunistically in their own portfolio companies. That’s great in times of dislocation, but IRR targets for PE, like those of hedge funds, aren’t well-suited for plain vanilla single-B rated loan issuance.
Back in Las Vegas, one senior debt veteran on an ACG panel dug deep into his securitization handbook to offer up covered bond funds as a potential white knight. These funds, popular in Europe for centuries, are pools of loans structured similarly to CLOs. The main difference is that while the bonds themselves are sold to investors, the underlying assets remain on a bank’s balance sheet.
The covered bond concept was floated by the Fed last summer as a potential solution to the frozen mortgage market in the US. The idea never really took hold, perhaps because the reeling banks had limited capacity then to hold more leveraged assets.
So who’s left? Perhaps it’s the one investor class that has been left relatively unscathed by events of the past eighteen months: regional banks.
With continued access to cheap and dependable capital in the form of customer deposits, decades of experience in commercial lending, and equity that has maintained attractive valuations relative to their bulge-bracket brethren, regional banks could be the best candidates to bring leveraged lending back from the wilderness. Fifth Third, SunTrust, Regions, and Key Bank are participating in, and even leading, conservatively structured cash flow transactions.
It is certainly true that the traditional middle-market lender risk model would never tolerate the more aggressive structural features that came to dominate the large-cap leverage landscape until the summer of 2007. But who’s to say that lower leverage, meaningful covenants, higher amortization, fewer dividend recaps, and more contributed equity capital, might not be a good thing to see in acquisition finance, at least for a while?
To play in the buyout game for the foreseeable future, private equity may have to stay small, with both issuers and lenders. And sponsors will have to rely less on financial engineering and more on good old-fashioned growth businesses to make their returns.
Of course they can always put in all equity today and hope to take chips off the table tomorrow when the next generation of CLO’s shows up.
Durant D. Schwimmer is senior managing director and head of capital markets at Churchill Financial. He is also editor/publisher of “On The Left,” Churchill’s weekly newsletter reviewing deals and trends in the capital markets. Based in New York, Churchill is a leading middle market commercial finance and asset management business.
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