Leveraged Loan Markets - Sachin Sarnobatsachin.sarnobat.com/LEVLOAN.pdf · · 2009-05-10Leveraged...
Transcript of Leveraged Loan Markets - Sachin Sarnobatsachin.sarnobat.com/LEVLOAN.pdf · · 2009-05-10Leveraged...
Leveraged Loan Markets
Reflecting Thus Far & Themes For Investing In Debt Via Secondary Trades
by
Sachin Sarnobat
(917) 940 9793
October 2008
Preface
Over the last several years, private equity, a word that was once whispered by hushed voices has now become common parlance. The leveraged buyout
boom of the last several years made kings out of private equity players, but the king-makers in this boom were the institutional, leveraged loan investors.
Sadly, they are the ones who are ‘left holding the bag’ after the kings abdicated with the treasury.
Beginning in 2003, institutional players began dominating the leveraged loan market. Cheap liquidity raised via the CLO structures was the main driver and
eventually created excess supply. Innovations in the credit derivatives market led investors to believe that risk was truly being held by those who could
afford it. The main impact of these developments was wafer thin credit spreads and later, loose lending standards.
Concurrently with these developments, the so called decade of moderation ushered in global growth and a “decoupling” of the rest of the world from the
American growth engine. The side effect of this optimism was robust growth projections and unbridled consumer spending that supported capital spending
by corporations. Asset bubbles took over and attracted additional pools of capital from the public as well as private markets.
As the asset bubble burst, the 2007/08 credit crisis created a wide spread dislocation in the leveraged loan market because of fundamental as well as
technical reasons. This report seeks to identify some of the structural nuances and understand implications of this dislocation from a secondary debt
investors standpoint.
This report is divided into the following sections:
• Key implications of the last several years (p3)
• Broad investment themes (p9)
• How did we get here? (p13)
• Corporate Issuers vs. LBOs (p21)
• Demand & supply technical factors (p25)
• Spreads & recovery by sector (p29)
• Analysis of secondary trading data (p33)
I look forward to your comments. Thank you for this opportunity.
Sachin Sarnobat
October 2008
New York
2
Key Implications of The Last Several Years
3
1. Increase In First Lien LeverageUnder-collateralization, Decreased Visibility, Value Leakage, Over-Levered Cash Flows
Institutional Lenders Inadvertently Subverted The Practical Intent of Low Cost Leveraged Loans
4
Features Practical Intent What Changed Implications
Fully secured
on a first lien
basis
• Preserve value for investors even in a case of a downside scenario
• Depends on the lenders attestation of “asset values” and
“liquidation values”
• Usually a cushion between the liquidation value and the amount
of debt is provided
• Global asset bubble,
inflated underlying asset
values
• Under-collateralization
Maintenance
Covenants
• Provide investors comfort that the borrower is adhering to its
operating plan and is inline in achieving the business objectives
that were outlined when the money was loaned
• Incase the company deviates from operating plan, investors have
a “hammer” to force the company to “come to the table” and
adjust/compensate investors for the increased risk
• Looser covenants with
greater head room
• Fewer covenants
• Covenant-lite loans
• Decreased visibility of company operating
performance for investors
• Lower likelihood of intervention will in
advance of distress
Cash Flow
Sweeps
• Cash flow sweeps are designed to force the company to de-lever
and hence minimize the principal-agent problem by providing
debt discipline
• Creates value for junior capital as the sweeps reduce secured
claims on the underlying asset over time
• Lower cash flow sweeps
with looser step-ups
• Equity markets were
ready and willing to
provide liquidity to take
private companies public
• Management could now try to take on “Hail
Mary” projects – thus increasing the risk of
destroying capital
• Increased sponsor ownership provides
incentive to use available cash flow for
restricted payments, causing value leakage
to debt investors
• Sources of equity proceeds have dried up
Fraction of the
entire capital
structure
• Traditionally, secured first lien leverage with maintenance
covenants formed a small fraction of the capital structure
• This ensured that companies were able to meet maintenance
covenants even with significant deviations from operating plan,
but the presence of the maintenance covenants kept them on
track
• Bond heavy structure with a small first lien loan component
provided a borrower with a solid defensive structure to withstand
downturns, but at the same time, optimize cost of capital by
availing of cheap debt capital via leveraged loans
• Leveraged loans because
the dominant part of the
capital structure
• Good quality companies that are over-
levered on a first lien basis
• Companies that needed a bond-heavy
defensive, structure were now levered to
the hilt with maintenance covenants
80
70
56
24
63
44 43
0
10
20
30
40
50
60
70
80
90
Revolvers Term Loans Sr. Bonds Subordinated Bonds
Secured Unsecured
• Loan loss varies from cycle to cycle and in this cycle will depend:
– Quality of loans and intrinsic credit quality
– Under-collateralization due to overvalued assets and over-levered cash flows
– Level of subordination at the time of default
• An increased use of asset based and non-recourse debt has left highly liquid assets like inventory and receivables encumbered
– Severity of downturn
• Depth of current recession is expected to be worse than the previous ones and asset values will take longer to recover
– Expected market value of defaulted assets
• Lack of liquidity for buyers could force more liquidations versus bankruptcy reorganizations
– Maintenance covenants (or lack thereof)
• This cycle this aspect will determine how soon lenders will be able to intervene and prevent collateral and recovery value erosion
• The current loan spreads imply a average default rate of 20% at 50% recovery rates
– Room for significant upside if default rate are lower or recovery rate are higher or both
– See p37 for additional analysis
Recovery Rates Could Between 50-60 Driving Factors & Implications
2. Lower Recovery Values & Higher Default RatesRecoveries Will Be Closer to Those for Unsecured Loans because of Under-collateralization
Discounted Recovery Rates By Instrument Type (1987 – 2006)
• Historically from 1986-2006, nominal recoveries have
been 80 and discounted recoveries have been about 70
cents on the dollar for secured term loans
• The difference between nominal and discounted
recovery rates is the time value from the pre-petition
date from when the borrower halts interest payments to
the time of recovery
5Source: S&P Fixed Income Research; US Recovery Study: Liquidity Avalanche Propels Recovery Rates Into Stratosphere, February 2007Various public news sources.
Covenant Headroom Increased Lenders Will Have Negotiating Leverage
3. Lax Covenant Structures Based On Bullish ProjectionsCompanies Will Need Lender Support For Amendments / Waivers
6
Year One Debt/EBITDA Headroom as a Percentage of Covenant Level for LBOs Lender Consent Required For Waivers/Amendments
Effective Covenant Cushions Will Now Be Tighter
Illustrative Covenant Calculations
($,mm) Yr.0 Yr.1 Yr.2 Yr.3
Projected EBITDA $100 $120 $132 $139
growth 20% 10% 5%
Interest $50.0 $45.0 $40.0 $35.0
Projected Covenant 2.0x 2.7x 3.3x 4.0x
Headroom or Cushion 25% 30% 35% 35%
Threshold EBITDA (1)
25% $75.0 $84.0 $85.8 $90.1
Covenant Level 1.5x 1.9x 2.1x 2.6x
Realistic Projected EBITDA $85 $89 $98 $103
Discount 15% 26% 26% 26%
revised growth 5% 10% 5%
Realistic Covenant 1.7x 2.0x 2.5x 2.9x
Threshold EBITDA $85 $89 $98 $103
Actual Cushion 15% 26% 26% 26%
Decrease In Cushion (10%) (4%) (9%) (9%)
• Given that most of the loans have been trading well below par, any amendment/waiver request is likely to be expensive
• For transactions that actually have covenants, slightly looser covenants will probably NOT be the key issue
– Covenants were based on bullish projections, and given more sober revised outlooks the cushions will now be much tighter
• Liquidity management will be critical for companies that had planned to invest and grow sales
– Given the much greater leverage on the companies, positive cash flow and access to liquidity could be an issue
– The credit crunch will make raising new debt capital difficult
• Management will have to work with lenders to secure covenant amendments/waivers as well as secure additional external sources of financing
24%
19%
25%23%
27% 26%23%
28%
24%
17%
0%
10%
20%
30%
1999 2000 2001 2002 2003 2004 2005 2006 2007 1Q-
3Q08
(1) Minimum EBITDA required to comply with covenant requirements,
• Company proposal in return for covenant
amendment
– $100 million pay down at par as part of the
economics of the amendment.
– 50 bps spread increase that would take pricing to
L+425
– 3% LIBOR floor extension
– 150 bps fee on post-paydown outstandings
• $1.43 billion term loan was put in place in conjunction with Dana’s exit from Chapter 11 earlier this year
– The loan is currently priced at L+375 and includes a 3% LIBOR floor for two years
– The paper was issued at a 90 OID
• Dana (BB-/B1 corporate) announced significantly weak results
– Third-quarter EBITDA of $15 million was $111 million below results for the same period in 2007.
– Lower production and higher steel costs of $140 million more than account for this reduction
– Results also included higher pricing, cost savings, and unfavorable currency changes
– Dana is planning up to 10 additional plant closures in 2009 and 2010, and it has expanded its targeted 2008 workforce reduction to 5,000 from 3,000
– YTD EBITDA of $290 million vs. $373 million for the same period in 2007
– Full-year sales of $8.2 billion and EBITDA of $300 million expected
• Dana maintaining large cash reserves to preserve access to liquidity
– The auto supplier had a $1.0 billion cash balance at Sept. 30, including $180 million that it drew during October from its $650 million revolving credit
• Free cash flow of negative $151 million for the third quarter was about the same as that during the same period in 2007
Lenders Can Extract Value + Readjust Terms Company Situation
Case Study: Dana Corp. – Value of CovenantsThe Auto Supplier Completed an Expensive Amendment Seeking Covenant Relief
Par paydown + coupon +upfront fees + LIBOR Floor Weak earnings indicative of sector underperformance
• The automotive supplier is projecting year-end non-compliance with the covenants on its term loan
– The company was in compliance with the 3.1x total-leverage test as of Sept. 30
– However, the leverage covenant is due to step down to 2.9x on March 31, 2009, with additional step-downs in subsequent quarters
• The term loan is quoted at 63.5/65.5 with the entire auto sector is under pressure
Having Covenants Is Critical For Value Capture
Term Loan trading under 70 / Total Leverage Covenant of 2.9x Breached
7
Asset Values Increased… Other Peoples Money
4. Thin Equity Cushions With No Sponsor SupportPrivate Equity Sponsors Will Act In Their Self Interest, Often To The Detriment of Lenders
Average Purchase Price Multiples Of LBO Transactions Sponsor Ownership Will Act Against Debt Holder Interest
…With Lower Equity Cushions
Average Equity Contributed As % of Total Purchase Price
8
28%30% 32% 31% 31%
27%30% 31% 31%
38%
20%
30%
40%
50%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1Q-
3Q08
Public-to-Private All Other
• Unprecedented availability of cheap liquidity led
tight equity cushions in recent LBO transactions
– Eq. In the Tribune transaction, the present value of the
tax savings was presented to the debt investors as part
of the equity cushion
• The tax savings were only important as long as
Tribune was earning positive taxable income
• As the business performance has gone south, the
present value of the tax savings has diminished
• Sponsors acting to maximize returns to their
limited partner investors, do not have enough “skin-
in-the-game”
• Equity investors can usually intervene in troubled
companies and support the going concern value by
providing liquidity and recapitalizing the business
– The main motivation is to preserve the residual value
of the equity holders
• Sponsors have taken the opposite path by going
down the dividend-recapitalization route
– Companies that have been over-levered because of
sponsor dividends will face challenges in terms of
raising additional equity capital
2.4 2.4 2.6 2.2 2.3 2.5 2.6 2.3 2.6 2.9 3.5 4.2
7.9 8.1 7.7
6.3 6.1 6.57.1 7.4
8.2 8.6
9.8 9.7
0.0x
2.0x
4.0x
6.0x
8.0x
10.0x
12.0x
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1Q-
3Q08Equity/EBITDA Others Sub Debt/EBITDA Senior Debt/EBITDA Total
Source: S&P LCD Comps
5. Access to Take-Out Capital Determines Returns TodayTake-Out Capital Supply is Lower Than Initially Invested, But Will Grow Over Time With GDP
9
Type Source Requirements for Target Investment
Internal Organic Cash Flows
- Strong franchise values that sustain
through the cycle
- Access to liquidity
Desirable(Higher Rated)
Equity Markets - Franchise value can support growth
Debt Markets- Well known issuer that has good
relationships with debt investors
Ch-7 Liquidation- Easily separable assets
- Readily identifiable buyerLess Desirable
(Lower Rated)
Limited Access None Ch-7 Liquidation
- No access to incremental liquidity
- Excess capacity in industry
- Weak competitive position
- Fundamental industry restructuring
?
Ch-11 Reorganization
- Availability of DIP Financing
- Customer lock-in and influence over
suppliers that preserves value through the
reorganization
- Access to public/private capital markets
for bankruptcy exit
External
Take-Out
Capital
Available
Broad Investment Themes
10
Investment Themes Relevant In Current Environment
11
Theme Sector Related Issues Company Related Issues
Discretionary
Consumer
Spending
• Discretionary consumer spending that
drives almost 70% of the US GDP was
significantly over estimated
• Capital expenditures that were
committed to before the crisis could
cause significant over-supply
• Avoid sectors that were levered for robust
consumer spending cash flows
• Avoid sectors that have fixed costs and high
capital expenditures
• Commodity vs. differentiated value proposition
• Differentiated value proposition needs to be
sustained, quality driven, non-discretionary and
important to customer’s competitive advantage
Recession • The recession trough could be much
deeper than past recessions and last
much longer
• Pick defensive sectors that serve a core
customer base that provide critical services
• Even if margins decline, ability of companies
to avoid negative cash flows will determine
survivors
• Pick companies with high degree of variable costs
that can be cut as sales decline
• Capital structures will need to be defensive
Liquidity • Banks are undercapitalized and access
to liquidity will be severely constrained
• Pick sectors that are not capital intensive
• Additionally, because of asset-light nature,
these sectors should have strong brands,
proprietary intangible assets, value-added
service oriented components
• Company should have revolving credit facilities as
well as room under its credit
agreements/indentures that offer flexibility to
execute asset based lending agreements
Capital Spending • Capital spending will be deferred
because of lack of financing
• Pick sectors that need capital expenditures
based on replacement cycles
• Pick companies with access to liquidity over the
next several years with reliable counterparties
• Backlog driven industries with strong credit
worthy customers
Marginal
Producers
• Marginal producers will be
disproportionately hit
• Sectors where capacity utilization affects
pricing will favor level utilization companies
even if they are not the lowest cost
producers
• Producers that supply the last x% of demand at
premium pricing will be affected
Obsolescence of
Business Models
• Sectors like Auto, Residential Homes,
that relied heavily on availability of
financing will have to be restructured
• Complementary industries will suffer
• Too much uncertainty for non-investment
grade, highly levered borrower
• Need to look to collateral values of the market
leader in these sectors
• Smaller players could be squeezed from not being
able to re-write the rules of the game to their
favor
Investment Themes Relevant In Current Environment
12
Theme Sector Related Issues Company Related Issues
Sponsors • In a distressed scenario, sponsors
should be able to provide equity
injections to keep the business solvent
• Certain sectors such as retail,
chemicals saw dividend
recapitalizations mere months after
the companies were taken private
• Sponsors should have enough “skin-in-the-game” to care,
else if the sponsor has taken a dividend off the table then
solvency in a distressed scenario could lead to bankruptcy
fairly quickly
US vs. Non-US
Revenues
• Exposure to fast growing Asian markets • Sectors that are regionally
serviced/supplied via a local
franchise
• Market leadership in fast growing markets and access to
liquidity to support market share growth
Bankruptcy • Even if bankruptcy is the optimal
answer to keep going-concern value,
current downturn might depress asset
values, and not provide liquidity to
potential buyers
• If entire sector is distressed, then
bankruptcy reorganization could
lead to liquidation versus a sale and
might not maximize value
• Company need to be in jurisdictions that are friendly to
enforcing on liens and where bankruptcy reorganization
does not cause value leakage to junior capital
Size • Mega-LBOs like TXU and HCA would not
have happened without the level of
cheap liquidity
• Great companies with premium
franchise value even if leverage is a
concern
• Mega-LBOs in “toxic” sectors like
Autos, Financials will be challenging
to execute successfully and exit
• Any governmental intervention
increases uncertainty
• Need to verify underlying collateral value and structure
that will enable lenders to capture that value for par
payback on the secured loan
• Mega-LBO candidates were market leaders in their space
and provided strong, stable cash flows
• Need to verify that sponsors have “skin-in-game” and are
pre-dividend recapitalization
• These companies will make excellent IPO candidates when
the equity markets open again
Structure • Covenant-lite, PIK Toggles, Incurrence
Term Loans
• Need strong understanding of the sector as well as
company to understand the level of distress
• Lack of covenants will add a level of complexity to
negotiate with borrower
Working Capital • Working capital management will be
focus of most management teams
• Sectors that traditionally involved
supplier financing will get squeezed
because suppliers lines of credit will
no longer be able to support them
• Strong customer power will require suppliers to finance
inventories at their own expense
What Makes An Ideal Target for Debt Investments?Strategic Analysis of Company vis-à-vis Buyers, Suppliers & End-Consumers
13
Suppliers Ideal TargetCo Buyers or Customers End-Consumer
• Large number of smaller
suppliers that are
commodity pricing driven
• Excess capacity in supplier
industry
• Specialized suppliers
dependent on specific
industry demand
• Suppliers that have access
to vendor financing
facilities to provide credit
lines to TargetCo
• Located close to TargetCo
and provides lock-in
In a recession scenario, the ideal TargetCo will have:
• Customer lock-in via contracts in the “right” industries
• Customer switching costs that need cash expenditure
• Companies that help their customers achieve and sustain cost competitiveness
• Ability to assume a greater number of buyer activities more efficiently and cross sell
additional services to enhance revenue
• Ability to find new, alternative product markets
• Constant utilization companies will have lower costs even though smaller competitor s
grow faster during the upturn
• Strong regional franchise
• Industries that do not have a need for extensive marketing/advertising
• Low working capital needs because of well capitalized buyers
• Lean operations with non-critical operating activities outsources to lowest cost producer
• Experienced management team that has seen a previous downturn
• No adverse regulatory pressures
• Defensive capital structure with presence of bonds to minimize maintenance covenants
• Smaller than Company
• Profitable, well capitalized
• Replacement cycle driven
• Depends on TargetCo to
provide goods or services
critical to its competitive
advantage with end-
consumer
• Quality driven needs
• Customization driven with
heavy interaction between
respective teams
• Small portion of end
product costs
• Ability to out-source
additional services to
TargetCo
• Avoid customers that could
demand specific
performance and
potentially renegotiate
contracts in a bankruptcy
scenario
• Demands differentiated
product based on sustained
value proposition
• Cost of low-quality is high
• Few substitutes
• Not discretionary buyer
• Stable base of necessity
driven buying behavior
• Replacement need or
maintenance driven buying
pattern
• In case of service industries,
recession resistant needs
like healthcare services
• Geography of end-
consumer will play a factor
Product Focus Industry Focus
Product focused companies specialize in
an application of their technology across
various industries
Industry specialists provide a broad range of
services for a tailored to a particular industry
and depend on the health of that industry
and related industries that support it
Ideal players would have:
• Quasi-monopolistic markets
• Proprietary technology
• Complex product or patents
• Some economies of scale that prevent
industry specialists from competing
with them and allow them to be lowest
cost producers
• If product is simple, cost focused
customer
• If product is complicated, quality
focused customer, but without need
for extensive customization
• Variable costs that can be cut at short
notice with decreased revenues
Ideal players would have:
• Industry leadership, market share, brand
• Customer demanding specialization,
customization
• Complex assets like factories that need
significant investments
• Oligopolistic markets that understand the
dynamics of capacity driven pricing because
fixed costs create penalty for
underutilization
• Should not be marginal producer
How Did We Get Here?
14
201 168 101 117 121
233 286 277
465 527
114
209 184
139 105 81
74
112 112
159 149
59
$0B
$100B
$200B
$300B
$400B
$500B
$600B
$700B
$800B
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 YTD 7/08
Institutional Bank
2 1 0 2
72
229
409
261 251 220
00
100
200
300
400
500
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 3Q08
Leveraged Loan & High-Yield Bond VolumesInstitutional Ownership Fueled Leveraged Loan Issuance and The Subsequent Debt Boom
75 100 126 130 136 147 184 235 376
522 554
0 1 9 12
24
35 32
16 14 16 19 39 66 71
63
66
71 81
159 182 231 260
335 374
396 461
495
531 551
71 79
91 94
121 121
121
119
113
107 121
$0B
$200B
$400B
$600B
$800B
$1000B
$1200B
$1400B
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007YTD 7/08
First Lien Second Lien Sr Secured Sr Unsecured Subordinated
Pre-2003 Banks Dominated The Leveraged Loan Market, But Institutional Demand Took Over And Multiplied from 2004-2007
The Demand/Supply Mismatch and Increased % Institutional Ownership, Led To Looser Lending Standards
# Transactions Without Upfront Fees Institutional Volume Outstanding: $1,338bn
% Institutional Ownership of Leveraged Paper# Transactions Without Upfront Fees Is an Indicator of Demand Vs. Supply
15
41
%
3%
6%
41
%
9%
44%
0%
10%
20%
30%
40%
50%
60%
Jun-96 Oct-97 Mar-99 Jul-00 Nov-01 Apr-03 Aug-04 Jan-06 May-07 Oct-08
Institutions
Banks
0% 0% 0% 1%
36%
67%86% 93% 86%
40%
0%0%
25%
50%
75%
100%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 3Q08
6 15 17 15 13
29 33 47 52
93 98 90
23 4 7 2 13
1217
22
4655
44
111
46
14
21
14
4
4
7
4
0
50
100
150
200
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1Q-3Q07 1Q-3Q08
$500 million-$1 billion $1-2 Billion $2-5 billion $5 billion or more
The Top 10 Accounts Got Larger Increased Number of Institutional Investors
Mega-Accounts Lead To Mega-LBOsAs The Market Was Overrun by Cheap Liquidity, Deals Grew Increasingly Ambitious & Issuer Friendly
…resulting In Mega-LBOs i.e. Companies That Would Not Have Experienced Those Levels of Debt
16
Top 10, 10-20, 20-30 Account By Size ($,mm) Investor Groups that Made 10 or More Primary Commitments Each Year
22 2948 54
42
6476
98116
168
218
261
79
0
50
100
150
200
250
300
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 3Q08
Number Of LBOs (#)
23 36 48 25 26 41 64 65 82 110
277
128
58 74
151
43 39 69
91 122 130
232
357
237
--
100
200
300
400
500
600
700
800
900
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 3Q08
Top 10 Accounts By Size 11-20th Account by Size 21-30th Account By Size
Source: S&P LCD Comps
8.8
7.16.7
5.35.0 5.1 5.3 5.2
5.8 5.6 5.24.5
4.0 3.7 3.8 3.9 4.2 4.3 4.44.9 4.7
4.33.6
3.9
0.0x
2.0x
4.0x
6.0x
8.0x
10.0x
1987 1988 1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 4Q07 1Q08 2Q08 3Q08
Sub Debt/EBITDA Other Sr Debt/EBITDA SLD/EBITDA FLD/EBITDA
4% 6% 5% 6% 10% 13% 11% 17%28% 33%
57%44%
14%18% 18% 19%
20%24% 23%
37%
39%42%
28%41%
82% 75% 77% 75% 69%62% 66%
46%33%
25%15% 15%
0%
25%
50%
75%
100%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1Q-3Q08
2 or less 3 4 or more
2.32.6
0
1
2
3
4
5
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1Q-
3Q08
FirstLien
Total Debt
Number of Covenants Dropped Below Three… …and 60% had Two or Fewer Covenants
Debt Multiples & Covenants Over TimeIncrease In First Lien Leverage With Loose Covenants Incurred In A Bullish Market
First Lien Leverage Increased To Levels Only Second to 1987
Note: For years 1987-1996 Sub Debt/EBITDA reflects all Non Bank Debt/EBITDACriteria: Pre-1996: L+250 and Higher; 1996 to Date: L+225 and Higher; Media Loans Excluded; There were too few deals in 1991 to form a meaningful sample
Number of Covenants (Excludes Covenant-Lite Transactions) % of Covenants (Excludes Covenant-Lite Transactions)
17
Leverage & Coverage MultiplesAs The Market Was Overrun by Liquidity, Deals Grew Increasingly Ambitious & Issuer Friendly
18 27 55 70 74 71 1072715 20
51 52 52121
141
2624 22
3856 61
13688
2222 19
3236 43
51 78
1513 10
1933 16
3539
926 23
3938 32
5173
16
$0B
$100B
$200B
$300B
$400B
$500B
Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Jun-08
<3.0x 3.0x-3.99x 4.0x - 4.99x 5.0x - 5.99x 6.0x - 6.99x >7.0x
26 20 33 23 24 55 49 9 64 58
106 136 111
175 219
43
14 19
35 36 46
115 137
25 13 24
58 92 96
120
122
37
$0B
$100B
$200B
$300B
$400B
$500B
Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Jun-08
<1.5x 1.5x - 2.99x 3.0x - 3.99x >4.0x
Leverage Multiples Increased As Companies Levered Themselves With Tighter Interest Coverage
18 46 79
146 158
349
500
73 94 76
145
132 111
102
11
41
$0B
$100B
$200B
$300B
$400B
$500B
$600B
2001 2002 2003 2004 2005 2006 2007 3Q08
0% Sweep 50% Sweep 75% Sweep 100% Sweep
..But At The Same Time Relied On IPO Proceeds From Equity Markets To Pay Down Debt
Total Leverage Interest Coverage
Equity Issuance RecaptureExcess Cash Flow Sweeps
74 75
198 197 213 302
369
85 13 18
--37
8
125 --
--30 28
35 46 28
37 158
28
$0B
$100B
$200B
$300B
$400B
$500B
$600B
2001 2002 2003 2004 2005 2006 2007 3Q08
0% Sweep 50% Sweep 75% Sweep 100% Sweep
18Source: S&P LCD Comps
L+225bps
L+257bps
175
200
225
250
275
Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08
Covenant-Lite All Other First-Lien
Debt Innovations Like Cov-Lite & PIK Toggle LoansCompetition To Deploy Capital Led To Sponsors To Push The Envelope on Structure
Approximately $90billion of Covenant-Lite Loans Are Currently Outstanding
Covenant-Lite Term Loans Trade at a Discount To Comparable Credits
19
Par Volume of Covenant Loans Currently Outstanding
Average Nominal Spread (bps)
67.43
73.12
65
70
75
80
85
90
95
100
105
Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08
Covenant-Lite All Other First-Lien
Average Bid
32bps
570bps
92
--
$25bn
$50bn
$75bn
$100bn
De
c-0
4
De
c-0
5
Jan
-06
Feb
-06
Ma
r-0
6
Ap
r-0
6
Ma
y-0
6
Jun
-06
Jul-
06
Au
g-0
6
Sep
-06
Oct
-06
No
v-0
6
De
c-0
6
Jan
-07
Feb
-07
Ma
r-0
7
Ap
r-0
7
Ma
y-0
7
Jun
-07
Jul-
07
Au
g-0
7
Sep
-07
Oct
-07
No
v-0
7
De
c-0
7
Jan
-08
Feb
-08
Ma
r-0
8
Ap
r-0
8
Ma
y-0
8
Jun
-08
Jul-
08
Au
g-0
8
Sep
-08
Oct
-08
Source: S&P LCD Comps & Markit.
164
0bps
50bps
100bps
150bps
200bps
250bps
Why Do Cove-Lites/PIK-Toggles Trade At A Discount?Lenders Dislike Lack of Visibility, Cannot Capture Waiver/Amendment Fees or Adjust Terms
• Lack of covenants are adverse to debt value because they complicate the principal-agent problem and
delay identifying potential issues to lenders
1. Delay extracting value from the borrower as consent fees because of technical amendments
2. Prevent renegotiating the terms of the debt structure to adjusted for the revised risk profile
3. Since secured loan covenants tend to be breached first, prevents the lenders from intervening and helping the
management correct course
4. Borrower may decide to stay the course and cause value leakage from the collateral until a point of no-return
5. Lack of visibility of when default will hit, adds to lender apprehension as lenders cannot manage their risk and exit
position before the borrower is in a serious default
Approximately $100billion of Covenant-Lite Loans Are Currently Outstanding
Covenant-Lite Loans Preclude The Lender From Capturing Amendment & Covenant Relief Fees
Average Covenant Relief Amendment Fee (bps)
20
Average Covenant Relief Spread Increase (bps)
63
0bps
10bps20bps
30bps40bps
50bps60bps
70bps80bps
Source: S&P LCD Comps & Markit.
Lastly, Ratings Were Issued In A Bull MarketLoans Are “Notched Up” Based On Historical Recovery Rates
• LBOs were structured to a single B corporate rating and a BB loan rating
• Ratings considered should be corporate ratings rather than facility ratings
– Due to the recent trend of highly levered LBOs, debt service and access to liquidity will be important
• Loan ratings incorporate the positive effects of the security and liens on recovery value in case of bankruptcy
• Borrower default is tightly correlated to corporate ratings
1 518
43
92
134117
56
32
165
2 2 013
61
$0B
$50B
$100B
$150B
BBB+BBB BBB- BB+ BB BB- B+ B B- CCC+CCC CCC- CC C D NR
All BB Loans Are Not Born Equal Loan Or Facility Based Ratings Are Higher…
Loan/Facility Ratings & Spreads ..But Corporate Ratings Will Also Be Important
21
Loan Ratings Could Overestimate Recovery Value Loan / Facility Based Ratings
Corporate Credit RatingsAverage Secondary Spread Based On Loan Ratings
Note: Includes loans that are priced and those that are not priced. Vast majority are institutional tranches.Secondary Spread calculations assume discount from par is amortized evenly over a three-year life.
1 3 10
31
69
157
116103
17
3 115
70
$0B
$50B
$100B
$150B
$200B
BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CC D NR
80%20%
50%50%
1,0881,265
1,4561,728
2,6533,176
L+200bps
L+700bps
L+1,200bps
L+1,700bps
L+2,200bps
L+2,700bps
L+3,200bps
BB+ BB BB- B+ B B-
Corporate Issuers vs. LBOs
22
• As the large Mega-LBOs were being structured,
large corporate opportunistic refinancings
peaked in 2007
• These transactions structured similar to LBO
transactions, but had lower leverage and higher
coverage ratios
• The current environment allows for investing in
a select pool of corporate loans that are direct
competitors of the companies that were LBOed,
but have much more flexibility from a capital
structure standpoint
$130 billion of Volume in 2007 Commentary
Large Corporate Issuances Peaked In 2007The LBO Boom Also Allowed Corporate Issuers To Avail The Same Loose Covenants
$,Bn of Corporate Transactions that Were Opportunistic Refinancings
Average of $780mm Per Transaction in 2007
#Corporate Transactions that Were Opportunistic Refinancings
23
13
38
7665
55
131
0$0B
$20B
$40B
$60B
$80B
$100B
$120B
$140B
$160B
40
93
231 207
141 166
00
50
100
150
200
250
300
Source: S&P LCD Comps & Markit.
Corporate Vs. LBO Corporate Transactions Have Been 1.1x Turns Less Levered With 0.8x Increased Coverage
24
Total Debt/EBITDA Senior Secured Debt/EBITDA EBITDA/Cash Interest EBITDA - Capex/Cash Interest
LBO Corporate ∆ LBO Corporate ∆ LBO Corporate ∆ LBO Corporate ∆
1Q-3Q08 4.9x 3.7x 1.2x 4.2x 2.9x 1.3x 3.0x 4.4x (1.4x) 2.3x 3.0x (0.8x)
2007 6.2x 4.9x 1.3x 5.5x 4.4x 1.1x 2.1x 3.0x (0.8x) 1.6x 2.4x (0.8x)
2006 5.4x 4.4x 1.0x 4.6x 3.9x 0.7x 2.3x 3.1x (0.8x) 1.9x 2.4x (0.5x)
2005 5.3x 4.3x 1.0x 4.0x 3.6x 0.4x 2.7x 3.6x (0.9x) 2.1x 2.7x (0.6x)
2005-07 Avg. 5.6x 4.5x 1.1x 4.7x 3.9x 0.7x 2.4x 3.2x (0.8x) 1.9x 2.5x (0.6x)
2004 4.8x 4.3x 0.6x 3.3x 3.1x 0.2x 3.4x 4.0x (0.6x) 2.6x 2.8x (0.2x)
2003 4.6x 4.1x 0.6x 2.8x 2.7x 0.1x 3.1x 3.7x (0.6x) 2.5x 2.5x 0.0x
2002 4.0x 4.0x 0.0x 2.5x 2.7x (0.2x) 3.2x 3.6x (0.4x) 2.4x 2.4x (0.0x)
2001 4.1x 4.0x 0.0x 2.7x 2.6x 0.1x 2.7x 3.2x (0.5x) 2.0x 1.8x 0.2x
2000 4.2x 4.2x (0.0x) 3.2x 2.8x 0.4x 2.3x 3.0x (0.7x) 1.6x 1.8x (0.2x)
1999 4.7x 4.6x 0.1x 3.2x 3.2x (0.0x) 2.3x 2.9x (0.6x) 1.7x 1.5x 0.1x
1998 5.4x 5.0x 0.4x 3.2x 3.4x (0.1x) 2.1x 2.6x (0.5x) 1.2x 1.3x (0.1x)
1997 5.7x 5.4x 0.3x 4.0x 3.6x 0.5x 2.0x 2.3x (0.3x) 1.2x 1.2x 0.1x
Lenders Need To Be Careful About Hidden Traps Citadel Capitalized On Absence of Buyers
Dangerous Precedent or New Buyer Base?Citadel Broadcasting Redeems Loan At Below Than Par Value via a Modified Dutch Auction
Win-Win versus Giving Away Upside
Transaction Overview
$1.5Bn Covenant-Lite Term Loan
25
• Corporate borrowers who do not have onerous cash flow sweeps like LBO buyers have the ability to use the excess cash flow to request an amendment for a buy-back below par
• As the secondary market gets weaker and liquidity is drying up, a greater number of lenders could be tempted
• This is a dangerous precedent because it not only changes the dynamics of the leveraged loan institutional structure, but also creates incentive for the borrower to be opportunistic about redeeming debt below par
• Loans generally have no provision for the borrower or any of the affiliates of the borrower to redeem the loan at less than par value via a Dutch auction tender
• The concept of tendering for a debt instrument by the borrower below par is not new and is used extensively by issuers of unsecured and subordinated bonds when the bonds are trading below par
– This provides liquidity to existing debt holders who are willing to give up value in exchange for the ability to exit their respective positions
• Citadel Broadcasting sought an amendment that allowed the borrower to purchase its loans at a price below par as part of a modified Dutch auction
• Under terms of that amendment, the issuer had the ability to approach investors up to three times over 90 days to repurchase as much as $200 million of its TLA and TLB
– Citadel Broadcasting bought back just over $149 million of senior debt after completing an amendment in March that allowed the company to purchase up to $200 million of its loans at a price below par as part of a modified Dutch auction
– Citadel paid an average of just under 81 to repurchase paper whereas Citadel’s TLB was quoted at 45/47 recently
– Citadel’s lenders do not have an excess cash flow recapture provision, and the company’s covenants were flexible
– Lenders would not be entitled to the pay down and the issuer could easily dividend out its cash on hand
Purpose
Merger; Along with an RC and TLa, backs the merger of
the Citadel Broadcasting with Disney's ABC Radio
Holdings.
Industry Radio; Domestic mid-market radio franchise.
Deal Size $1535mm
Corporate Rating (at
close)B+/Ba3
Loan Rating (at close) B+/Ba3
TLB (Flex) $1535M/L+162.5 (-12.5 bps)
Institutional Break Price 100.25%
Demand & Supply Technical Factors
26
Demand & Supply Technical FactorsLack of Capital Has Severely Curtailed Demand For Leveraged Loans
• The four main pillars of loan market technicals
have crumbled over the past year, in the face of
the ongoing bear market
1. CLOs: Year to date, managers have priced $13.5
billion of new vehicles, down from $83 billion
during the same period last year
• Many TRS and market value CLOs because of
structure mandates, are hitting selling trigger
points as asset values fall further depressing
valuations
2. Prime Funds: Withdrawal of assets by retail
investors are bleeding the prime funds.
• Through September investors withdrew $6.4
billion, versus $1.8 billion of net inflows during
the first nine months of last year.
3. Repayments: Repayment rates have slowed to all-
time lows
• Repayments for the year to date totaled $43.9
billion, down 67% from the same period in
2007, when issuers repaid $133 billion.
4. Institutional fund raising: Year-to-date fundings
total $85 billion, down 70% from the same period
last year, versus an increase of $144 billion during
the same period in 2007
Demand Supply
Prices Will Continue to Have Downward Pressure Demand/Supply Mismatch
27
$420bn
• About $150 billion has been withdrawn from the institutional loan market and unless this amount is replenished, prices will not return to par
• The marginal seller of loans has been the mark-to-market account (market value CLOs, TRS line, hedge funds) that remain vulnerable to redemptions
Repayment Rates Have Slowed To a TrickleCompanies Are Conserving Cash To Ride The Downturn And Are Only Delaying Default
Repayment Rates Dropped from $160bn to about $60bn per year as of October, 2008
28
Monthly & Rolling12-month repayment amounts ($,billions)
$0B
$50B
$100B
$150B
$200B
$0B
$3B
$6B
$9B
$12B
$15B
$18B
$21B
$24B
$27B
$30B
Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08
Repayment amount Rolling-12mo
• Majority of the companies that raised debt capital especially via LBOs over the last few years, were over levered with fixed charges being a strong demand on cash flow
– Deleveraging is the key attribute that will keep the companies from default since growth in EBITDA will be difficult to achieve because of the global slowdown and rationalization of both GDP and sector growth projections
• Looser maintenance covenants and lower cash flow sweep requirements are allowing the companies to avoid triggering default
• A lack of ongoing repayments indicates that when “fate catches up” and performance erodes to a thin cushion to default
1. the deviations from projected operating plan will be significant and,
2. there will be a greater amount of claims on assets of lower value
Decrease In Repayments Highlights the Severity of Potential Underlying Issues
Companies need to deleverage to avoid default
Source: S&P LCD Comps & Markit.
2008 Has Been A Year Of Net Capital WithdrawalCLOs Were the Overwhelming Driver of Institutional Demand from 2005-2008
Estimated Cash Inflows into Institutional Accounts By Account Type
Institutional Net Cash Flows less Change in Outstandings
29
9.1 12.116.2
25.5
52.6
97.088.9
13.5
-0.5
1.0 0.2 2.1 0.7 2.6 2.8
-5.6-5.2 -5.7
0.19.0
4.2 5.5
-1.0-5.9-$20.0B
$0.0B
$20.0B
$40.0B
$60.0B
$80.0B
$100.0B
2001 2002 2003 2004 2005 2006 2007 YTD08
CLO Issuance CLO Pipeline Change Prime Funds
-$12B
-$10B
-$8B
-$6B
-$4B
-$2B
$0B
$2B
$4B
$6B
$8B
$10B
$12B
Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08
Source: S&P LCD Comps & Markit.
Spreads & Recovery by Sector
30
Discretionary Consumer + RE Exposure
Even though historical recovery
values are high for Gaming &
Lodging, recent real estate boom
could lower these values.
Secondary Spreads & Recovery Values On DefaultFood Products, Healthcare, Industrials, Chemicals, Utilities Will Be Defensive Sectors
BB & B Rated Loan Secondary Spreads
Recovery Values On Default
31
Significant risks in light of government
intervention
����
Source: S&P LCD Comps & Markit.
Weak Consumer
Spending
+
Low Collateral
Value
�
79.5
62.6 62.370.3
65.376.1
82.8
55.1 53.9
70.379.9
55.0
79.5
53.9
0
20
40
60
80
100
Foo
d P
rdts
He
alt
hca
re
Co
nta
ine
rs/G
lass
Uti
litie
s
Ind
ust
ria
ls
Leis
ure
Ch
em
ica
ls
Re
taile
rs
Ele
ctri
cal
Bro
ad
cast
ing
Ga
min
g &
Lo
dg
ing
Pu
blis
hin
g
Au
to
Ho
me
Bu
ildin
g
832 1016 945 1009 1077 1267
18731611 1762
1353
1963 2088 2260 2032290 130 367 314 440 650
89 380 273 859 444
731 642 893
1,122 1,146 1,312 1,323 1,5171,917 1,962 1,991 2,035 2,212
2,4072,819 2,902 2,925
--
L+750bps
L+1,500bps
L+2,250bps
L+3,000bps
Foo
d P
rdts
He
alt
hca
re
Co
nta
ine
rs/G
lass
Uti
litie
s
Ind
ust
ria
ls
Leis
ure
Ch
em
ica
ls
Re
taile
rs
Ele
ctri
cal
Bro
ad
cast
ing
Ga
min
g &
Lo
dg
ing
Pu
blis
hin
g
Au
to
Ho
me
Bu
ildin
g
B
32
• Criteria relevant to debt investors:
– Risk/return ratio measured by Sharpe Ratio
– Recovery values in even of downturn
– Liquidity provided by secondary market as
measured by the par amount outstanding
– Size of company within sector as measured by
the average size of loan
• The Sharpe Ratio and Standard Deviation were
calculated based on trading data over from January
2002 – YTD October
Sector Number Par (mm) Bid Avg. Size Stdev Sharpe Recovery
Clothing - Textiles 13 $3,000 76.7 $230 5.2% 80% 62.3
Nonferrous Metals - Minerals 13 4,300 75.5 330 4.8% 69% 59.0
Oil And Gas 50 22,550 77.0 450 3.1% 63%
Aerospace and Defense 30 9,600 76.1 320 3.0% 59%
Industrial Equipment 30 8,850 75.1 295 3.1% 55% 65.3
Chemicals And Plastics 52 27,050 70.1 520 4.6% 52% 82.8
Electronics - Electrical 41 17,750 68.1 435 5.5% 49% 53.9
Telecom 43 34,850 83.6 810 5.6% 46% 45.3
Food And Drug Retailers 11 5,350 76.6 485 3.3% 35% 79.7
Utilities 54 40,100 77.6 745 5.8% 34% 70.3
Conglomerates 17 5,350 75.9 315 4.3% 34%
Financial Intermediaries 30 25,050 72.0 835 3.4% 32%
Business Equipment and Services 61 30,300 72.0 495 4.6% 32%
Industrials 196 93,500 68.7 475 4.3% 29% 70.3
Healthcare 97 55,450 78.6 570 3.5% 25% 62.6
Containers and Glass Products 21 9,100 76.0 435 3.9% 25% 62.3
Forest Products 14 11,950 81.3 855 4.2% 23%
Food Products 33 13,500 79.5 410 3.9% 20% 79.5
Leisure Goods-Activities -Movies 41 18,650 67.4 455 3.7% 19% 76.1
Surface Transport 18 6,450 63.7 360 5.0% 12% 62.6
Retailers (Not Food And Drug) 34 19,600 66.8 575 4.0% 12% 55.1
Lodging And Casinos 44 26,100 62.6 595 5.3% 11% 81.1
Home Furnishings 23 5,450 60.7 235 5.4% 11% 53.9
Cable and Satellite TV 24 23,200 75.2 965 5.9% 1% 85.3
Food Service 30 10,750 73.5 360 4.5% 0% 76.1
Automotive 53 38,350 61.1 725 6.1% (3%) 79.5
Building And Development 60 22,450 58.2 375 4.3% (5%) 53.9
Beverage & Tobacco 11 3,700 76.7 335 3.7% (7%) 76.1
Publishing 63 40,750 57.4 645 5.8% (7%) 55.0
Cosmetics - Toiletries 15 4,600 69.0 305 5.0% (10%)
Radio And Television 41 24,700 64.6 600 5.3% (10%) 85.3
Media 115 83,850 63.4 730 5.6% (20%)
Sub-Sectors Sorted By Sharpe RatioAttractive Sectors Are Highlighted In Grey
What Sectors Will Have Access To Liquidity?Asset Based Lending Is A Source of Capital That Can Be Raised During A Downturn
Lenders Look To Value of Specific, Easily Liquidated Collateral And Can Provide Liquidity
The Asset Based Lending Market is Used More By Some Industries Than Others
Asset Based Loans As a % of Total Leveraged Loan Volume
($ in millions)
5.0%3.3%
7.7%
5.1%6.2%
13.3%
8.6%9.7%
4.8%3.6%
7.2% 6.2%4.6% 4.1%
8.5%
11.3%
7.9%
17.7%
14.1%
0%
5%
10%
15%
20%
25%
1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 YTD3Q08
465 476 500 590 610 700 790 1,216 1,294 1,676 1,961 2,1363,192
6,5907,632 7,883 8,416
11,655
0
2,500
5,000
7,500
10,000
12,500
15,000
33Source: S&P LCD Comps & Markit.
Analysis of Secondary Trading Data
34
Average Bid Based On Ratings Shows The Gap Widening, But Technical Reasons Have Dominated
Performance & Ratings Based PricingDefaults & Non-Performance Haven’t Hit Secondary Pricing of Loans
Average Bid Based On Performing Vs. Non-Performing(1) Loans
35
70
75
80
85
90
95
100
105
12/96 6/97 12/97 6/98 12/98 6/99 12/99 6/00 12/00 6/01 12/01 6/02 12/02 6/03 12/03 6/04 12/04 6/05 12/05 6/06 12/06 6/07 12/07 6/08
Performing Loans Index All Loans Index
65
70
75
80
85
90
95
100
105
12/96 6/97 12/97 6/98 12/98 6/99 12/99 6/00 12/00 6/01 12/01 6/02 12/02 6/03 12/03 6/04 12/04 6/05 12/05 6/06 12/06 6/07 12/07 6/08
Current BB Index Current B Index
Source S&P/LSTA Leveraged Loan Index and Merrill Lynch High-Yield Index (H0A0)
0.89
0.00
0.20
0.40
0.60
0.80
1.00
De
c-9
8
Jun
-99
De
c-9
9
Jun
-00
De
c-0
0
Jun
-01
De
c-0
1
Jun
-02
De
c-0
2
Jun
-03
De
c-0
3
Jun
-04
De
c-0
4
Jun
-05
De
c-0
5
Jun
-06
De
c-0
6
Jun
-07
De
c-0
7
Jun
-08
82.44
77.0075
80
85
90
95
100
105
De
c-9
8
Jun
-99
De
c-9
9
Jun
-00
De
c-0
0
Jun
-01
De
c-0
1
Jun
-02
De
c-0
2
Jun
-03
De
c-0
3
Jun
-04
De
c-0
4
Jun
-05
De
c-0
5
Jun
-06
De
c-0
6
Jun
-07
De
c-0
7
Jun
-08
Loans Bonds
Relative Value: Bonds Vs LoansFrom a Relative Value Perspective, Secured Loans Seem To Undervalued
Unsecured Bonds Traded Below Secured Loans In the Last Cycle…
…But This Cycle Has Seen Tight Correlated Moves That Imply Technical Selling Pressure
Weighted Average Bid Price For Leveraged Loans & High Yield Bonds
Correlation Between Price Movements of Leveraged Loans & High Yield Bonds
36Source S&P/LSTA Leveraged Loan Index and Merrill Lynch High-Yield Index (H0A0)
Relative Value: Bonds Vs LoansLeveraged Loans Are Yielding Spreads That Exceed Those Seen In The Last Cycle
L+790bps
L+1,111bps
L+150
L+350
L+550
L+750
L+950
L+1150
L+1350
L+1550
Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08
Loan Spread to Maturity Bond Swapped to Worst
Differential Between Unsecured & Secured Paper is ~320bps at Absolute Rates Well Above 10.00%
• The spread between secured loans and bonds accounts for:
– Security package, priority and liens
– Tighter maintenance covenants
– Ongoing compliance and reporting covenants
– Cash flow sweeps
– Recovery values on default or credit loss given default
• Historically, spreads between secured versus unsecured paper have been around 218bps
– A 320bps spread between secured vs. unsecured either implies much lower recovery values or under pricing of
unsecured bonds on a relative value basis
Source S&P/LSTA Leveraged Loan Index and Merrill Lynch High-Yield Index (H0A0) Note: Loan Spreads are spreads to 18-month call if average bid is par or higher, 2 years if average bid is 98 but less than par and 3 years if the average bid is less than 98 but greater than 92 and 4
years if the average bid is less than 92
320bps
37
Average Nominal Spread of the S&P/LSTA Index L+280bps
Historical Average Default Rate 3.0%
Historical Loss Given Default 30.0%
Average Credit Loss 90bps
Average Effective Spread 190
Historical Return from 1997-2008 4.11%
Spread to Maturity of the LSTA 1,166
Less: Effective Spread (190)
Risk Premium 976
Average Recovery Secured Loans 70%
Loss Rate 30%
Implied Default Rate = Risk Premium/Loss Rate 33%
3.27%
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07
Recovery Rates
LSTA Spread 25% 50% 70% 90%
L+500 4% 6% 10% 31%
750 7% 11% 19% 56%
1,166 13% 20% 33% 98%
1,250 14% 21% 35% 106%
Current Default Rate is 3.27% Implied Default Rates
Higher Default Rates and Lower Recovery RatesThe Spread of 1,166bps on the LSTA Index Implies that Recovery Values Will Be Lower Than 70%
Recovery Rates of 50% Are More Likely
Lagging 12-months Default Rate by Number of Issuers
Lagging 12-months Default Rate by Number of Issuers
Implied Default Rates Vs. Recovery Rates (RR)
33%
20%
17%
3.3%
0%
5%
10%
15%
20%
25%
30%
35%
Oct-98 May-99 Dec-99 Jul-00 Feb-01 Sep-01 Apr-02 Nov-02 Jun-03 Jan-04 Aug-04 Mar-05 Oct-05 May-06 Dec-06 Jul-07 Feb-08 Sep-08
70%RR 50%RR 50%RR+125bps Actual Rate
Current Trading Levels Imply a 20% Default Rate Assuming a 50% Recovery Rate
39
Imputed Default Rate and Lagging 12-Month Default Rate
As the liquidity boom took off, several LBOs that were structured in early part of the cycle were good quality credit with well structured covenant and reasonable leverage – reflected in trading behavior in loans of that vintage
0% 3
%
2% 2%
2%
1%
0%
0%
0% 0%
20
%
-- 0 0
0
0
0
0
0
-- 0
0
0 0 0
0 0
0
0
-- 0 0
0
6%
4%
7% 1
1%
12
%
2%
0% 0%
0%
7%
24
%
91
%
67
%
64
% 66
%
61
%
20
%
9% 1
2%
24
%
91
%
7%
3%
24
%
21
%
13
%
18
%
76
%
90
%
87
%
75
%
1%
0%
0%
25%
50%
75%
100%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 10/31/2008
Less Than 60 60 - 69.9 70 - 79.9 80 - 89.9 90 - 99.9 100 or More
As With Fine Wine, Vintage Of Loans Matters2007 Vintage Loans Were Mostly Trading Below Par
40
Distribution of Secondary Loan Bid Price By Vintage Of Loan
The loans issued earlier than 2003 trade at a discount because probability of default increases with the age of the loan instrument
Several Mega-LBOs were structured in 2006 but never hit the
market until 2007
These were deals that were over-levered and pushed the
envelope with covenant-lite structures
Source: S&P LCD Comps.
DISCLAIMERThese discussion materials are presented solely for the purpose of demonstrating analytical and critical thinking abilities. Data used this in these materials was based on trial
subscriptions provided by Capital IQ, S&P LCD Comps, Bloomberg, Markit and other public data sources that need a fully paid subscription and are used in good faith. These
materials may not be reproduced without the written permission of the author.
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