CHAPTER
THIRTEEN
LEVERAGED LOANS

STEPHEN J. ANTCZAK, CFA*

Consultant

FRANK J. FABOZZI, PH.D., CFA, CPA
Professor of Finance
EDHEC Business School

JUNG LEE*

Consultant

A leveraged loan is a loan made to a company whose credit rating is speculative grade. That is, the borrower has a below investment-grade rating (below BBB–/Baa3). When a reference is made to “loans” by market participants, typically it means (1) loans that are broadly syndicated (to 10 or more bank and nonbank investors), (2) senior secured loans that are at the top-most rank in the borrower’s capital structure, and (3) large loans to large companies. In terms of total par amount outstanding, the leveraged loan market was comparably very small back in 1996 (under $15 billion of leveraged loans versus about $975 billion of corporate bonds). The market steadily grew to about $250 billion by 2005. In the next three years, however, the market more than doubled to over $550 billion par amount outstanding. While there was a downward trend in the size in 2009 and 2010 due to the financial crisis that began in 2008, the market size remains significantly greater than its long-term average.

For below investment-grade companies, leveraged loans are a key component of their capital structure. Although there are significant variations, for a typical leveraged loan borrower the debt capitalization is about 65% to 70% loans and 30% to 35% bonds. Broadly speaking, corporate borrowers utilize the proceeds from a leveraged loan for various purposes. In the first quarter of 2011, 64% of new-issue loans were used to refinance existing debt, 11% for shareholder-friendly activities away from leveraged re-capitalizations (e.g., special dividends), 10% for corporate acquisitions, and 10% to fund (at least partially) leveraged buyouts, and the remaining 5% on other activities such as working capital.

Leveraged loans have been syndicated and sold to nonbank institutional investors since the late 1980s, but institutional investors only became a significant factor in the market beginning in 1995. We describe various facets of the leveraged loan market in this chapter.

SYNDICATED BANK LOANS

A leveraged loan is one form of a syndicated loan. A syndicated loan is a single loan with a single set of terms, but multiple lenders, each providing a portion of the funds. The advantage of the syndication of a loan from a borrower’s perspective is that (1) it allows a corporation to negotiate loan terms once, while at the same time having access to multiple lenders; and (2) it avoids conflicts in priority from arising that might otherwise occur if the borrower serially negotiated loans. All lenders in the syndicate share equally in rights under the credit agreement.

Typically, a syndicated loan is arranged by a commercial or investment bank—referred to as the arranger, also called the mandated lead arranger¹—and that entity advises the borrower on the type of facility (as described later, a revolving line of credit and/or term loan), negotiates the terms of the loan, including pricing, and manages the structuring of the credit agreement. The arranger prepares an information memo or bank book. The document, which is confidential and made available to qualified banks and accredited investors only, provides information about the borrower, the borrower’s industry, loan terms, and the borrower’s financial projections. For administering the loan on a daily basis, an agent is appointed. It is the agent, which is one of the banks, that is responsible for monitoring the borrower to assure compliance with the terms of the loan.

After the credit agreement and a security agreement are finalized, the required documents are filed with the relevant legal jurisdictions. However, the credit agreement may be amended for a variety of reasons. It could be for a minor change such as a waiver of a specific covenant. Such changes may merely require a majority vote to do so. At the other extreme, it could involve more complex changes such as changes in the interest rate, term of the loan, or the security for the loan. More complex changes may require unanimous consent.

Worth noting, one amendment that has become more frequent is the “amend-and-extend.” The bankruptcy process often tends to be expensive for lenders—the cost of Lehman Brothers’ bankruptcy surpassed $1 billion by the end of 2010, about two years after its filing for Chapter 11 in mid-September 2008—and in part for that reason from a lender’s perspective modifying the terms of a loan may be a more beneficial option than the bankruptcy process. Exhibit 13–1 shows that the number of amend-and-extend and covenant relief amendments spiked in 2008 to 100, and then more than tripled to about 350 in 2009. While the number fell by about 50% in 2010, the number of amendments still remains significantly higher than the historical average.

EXHIBIT 13–1
Number of Covenant Relief and Amend-and-Extend Amendments

Loans may be underwritten or done on a best-effort basis. In an underwritten deal, for any portion of the loan that is not subscribed for by other banks or investors the arranger must take onto its books (and thus fund). In contrast, in a best-efforts deal the arranger does not guarantee the placement of the entire amount to other banks or investors. Instead, the pricing or the size may be adjusted. A variant of the best-effort arrangement involves the use of market flex language wherein borrowers typically give arrangers the flexibility to adjust loan terms and loan pricing to ensure that the loan would be fully subscribed. Typically in such an arrangement there is an upper limit on what the borrower will accept and that often involves increasing the loan’s spread above its reference benchmark. A reverse market flex, in contrast, tightens the spread in response to over-subscription or other market conditions.

LOAN STRUCTURE

In practice, there is typically not just one loan that is arranged. Instead, a credit agreement often calls for a revolving line of credit and one or more term loans with increasing maturities, term loan A, term loan B, and so on. In some credit agreements, the revolving line of credit can be drawn upon by the borrower who is then permitted to convert the amount drawn upon into a term loan.

Leveraged loans can be classified under the credit agreement as pro rata loans and institutional loans. Pro rata loans are distributed to banks, and usually include the revolving line of credit and term loans that mature from three to five years. As the name suggests, institutional loans are distributed to nonbank institutional investors and typically include term loans maturing in five to seven years. Newly issued leveraged loans were mostly pro rata in the late 1990s (average of 81% of the new issues from 1997 to 1999, for example) but institutional loans have grown progressively and are now the significant component of new loan issues (average of 60% of new issues from 2006 to 2010).

LOAN TERMS

The loan credit agreement sets forth the loan’s terms. There are three forms: (1) representations and warranties made by the borrower, (2) affirmative covenants, and (3) negative covenants.

Leveraged loans commonly contain covenants or requirements that must be satisfied by borrowers. The two most common are maintenance requirements and incurrence requirements. These requirements are specified in the form of tests. Basically, maintenance requirements are regular reviews of various operating performance measures, such as leverage, interest coverage, and so on. It is not necessary for there to be any particular corporate action in order to “trigger” a review of these operating measures. An incurrence requirement is a review of specific operating measures relative to predetermined levels after an issuer has taken an action that triggers a review. Examples of such typical actions that can trigger a review are share repurchases, divestitures, and special dividends. There are five purposes served by this process:²

1. Preservation of collateral: The borrower represents that the lenders have a legal, valid, and enforceable security interest in the pledged collateral. Typically, this means not only the borrower’s existing assets at the time of the loan’s closing, but also assets subsequently acquired by the borrower. There are loans where only specific assets are pledged as collateral.

2. Appropriation of excess cash flow: In the absence of restrictions, a borrower could take out a loan, sell its assets, distribute the proceeds from the sale of the assets and the proceeds of the loans to the equity holders, and thereby create an empty corporate shell with no assets for the lenders. To prevent this, excess cash flow from the borrower’s ordinary and extraordinary business activities—defined as cash flow minus cash expenses, required dividends, debt repayments, capital expenditures, and changes in working capital—is required to be used to prepay loans.

3. Control of business risk: Lenders become disadvantaged when a borrower’s business becomes riskier and the risk that borrowers will make business decisions to benefit equity holders at the expense of lenders increases.³ Management of the borrowing firm can increase risk by taking on riskier investment projects, taking on more debt, or acquiring other firms. Loan terms are imposed to prevent this practice. In the case of taking on more debt, this may be prohibited even if the priority of the new debt ranking is subordinate to the loan.

4. Performance requirements: Performance measures used by lenders include ratios such as coverage ratios, leverage ratios, and liquidity ratios, as well as dollar amounts such as tangible net worth, maximum capital expenditures, and cash flow/net worth requirements. These measures can be calculated based on financial statement items (prepared under generally accepted accounting principles) or lender-specified calculations. If these measures are violated, the loan becomes due and payable immediately.

5. Reporting requirements: For purposes of monitoring the borrower, the lender will require that the borrower periodically furnish specified documents and reports. These include not only documents required by government regulatory agencies but also internal reports such as budgets and projections and accounts receivable analysis, as well as third-party nonfiling reports such as appraisals for certain assets.

The pricing of a loan (i.e., the loan’s spread) depends on three factors: (1) the credit quality/rating of the borrower, (2) the size of the loans, and (3) the supply of and demand for new issues.⁴ Obviously, the lower the borrower’s credit rating, the greater the loan’s spread all other factors equal. The second factor relates to the balance or imbalance between the amount of loans that are being brought to market and the credit appetite of buyers (i.e., banks and institutional lenders). The size of the loan can result in a higher or lower spread. On the one hand, the larger the loan size, the higher the spread needed to clear the market. On the other hand, for trading purposes, a larger loan size can work to decrease the spread because investors believe that larger loans tend to trade better in the secondary market due to greater familiarity with the issuer.⁵

RECOVERY RATES

The textbook description of the position of a creditor in the case of a bankruptcy is that the priority of creditors as set forth in the original lending agreements will be respected by the courts. However, a good number of empirical studies have clearly demonstrated that in the case of a Chapter 11 bankruptcy, the absolute priority rule is typically violated. That is, senior creditors may not be paid in full before junior creditors and even equity owners receive some form of payment. There are a good number of economic reasons as to why the absolute priority rule may be violated. These reasons relate to the direct and indirect costs associated with the negotiations among the creditors and equity claimants. The bottom line, however, is that the recovery rates for the various levels of creditors is an empirical issue.

Fortunately, studies of recovery rates confirm that despite the high risk of a violation of the absolute priority rule in practice, the senior claim of bank loan lenders on the assets of the borrower, as measured by recovery rates, is higher than that for other creditors. In a comprehensive study by Moody’s of about 3,500 defaulted loans and bonds issued since 1987 by 720 nonfinancial U.S. corporations, the ultimate recovery rates were higher for loans in comparison to bonds.⁶ More specifically Moody’s found that the average recovery rate for defaulted loans was 81% of par value; the average recovery rate for defaulted bonds was only 39% of par value. Of course, the recovery rate for bonds did vary by the seniority of bonds in the capital structure, with the most senior bonds (i.e., senior secured bonds) recovering 67% of par value. Moreover, the Moody’s study reported that loan recovery rates have a right-skewed distribution, while bond recovery rates have a left-skewed distribution.

Another way to look at the recovery rates is using the post-default trading prices as a proxy for recovery rather than the ultimate recovery levels. Based on the issuer-weighted, post-default trading prices, the 1990–2009 average recovery for first lien loans is about 70% of par value. In comparison, Moody’s found that the average recovery rate for the same time period is about 41% of par value for corporate bonds.

It is important to keep in mind that the previously mentioned recovery rates are all expressed in percentage terms of par value. As such, loans trading at par are exposed to greater loss than those trading under par in the event of a default. For example, Exhibit 13–2 shows that the average bid price of leveraged loans in the secondary market fell to as low as $62 in December 2008. If we assume 82% ultimate recovery rate of par value and that an investor had bought an average loan at $62 in 2008, he would not have any loss even if a default occurred. Also worth noting is that the recovery rates tend to vary meaningfully by year. For example, while the recovery rate for loans in 2004 was almost 90% of par value, it was only about 55% in 2009.

EXHIBIT 13–2
Average Bid Price for Leveraged Loans

SECONDARY MARKET

Leveraged loans are private contracts and, as a result, prior to 1987, little public information was available about leveraged loans. This stifled secondary market trading. In 1987, the Loan Pricing Corporation (LPC) began publishing information on global syndicated loans. Its flagship product, Gold Sheets, is a weekly publication that provides information on pricing, structure, tenor, and industry segments.

In 1995, the Loan Syndications and Trading Association (LSTA) was created as an industry association whose goal was to foster the development of a more liquid and transparent secondary market. It has done so by establishing market practices and procedures for settlement and operations. For example, the LSTA publishes model credit agreement provisions and a document covering the principles for the communications and use of confidential information by loan market participants.

LSTA and LPC started gathering mark-to-market pricing data. LoanX (now part of Markit Partners) began offering loan pricing in 1999.

LSTA and Standard & Poor’s (S&P) joined forces to create secondary market indexes. Market indexes play an important role for all asset classes for several reasons, such as measuring the performance of an asset class for purposes of making asset allocation decisions and evaluating the performance of active managers. In the leveraged loan market, the S&P/LSTA U.S. Leveraged Loan 100 is the primary index.⁷ This index measures the performance of the 100 largest institutional leveraged loans (on a market-weighted basis) drawn from the approximately 1,000 term loans included in the S&P/LSTA Leveraged Loan Index (LLI). To be eligible to be included in the LLI itself, the term loan must be a senior secured first lien, have a minimum initial term of one year, have a minimum initial spread of 125 basis points over LIBOR, have a minimum par amount of U.S. $50 million, and be dominated in U.S. dollars. The loans included in the index are selected by a set of rules specified by S&P’s index committee.

According to the LSTA, quarterly secondary trading volume grew from $50 billion in the first quarter of 2005 to $142 billion in second quarter 2008, falling to $107 billion in the fourth quarter of 2010. The annual secondary trade volume was slightly above $400 billion by end of 2010, a decline since peaking in 2007 at over $500 billion, yet still more than about $350 billion in 2006.

There are two methods by which loans in the secondary market change hands: by assignment or by participation. In the case of an assignment, the buyer becomes the lender of record with all related rights and powers. An assignment typically requires the borrower’s consent for the exchange to take place. In contrast, if the exchange is accomplished via participation, although the buyer receives the right to repayment, the original lender remains the lender of record. It is therefore the responsibility of the lender of record to collect the amount due from the borrower and then pay that amount to the participant. The borrower’s consent is usually not required in the case of a participation. However, the buyer bears a greater credit risk in the case of a participation because there is no contractual link between the borrower and the participant. As a result, if the original lender becomes insolvent, the participant may have no recourse.

In Exhibit 13–3, we see that the secondary market for leveraged loans has historically been less volatile, with the average bidding price hovering around par value and the spread (to maturity) staying in the LIBOR plus 400 basis points range, until the beginning of the financial crisis in 2007.

EXHIBIT 13–3
Spread to Maturity in the Secondary Market

KEY POINTS

• A leveraged loan is a loan made to a company whose credit rating is below investment-grade (below BBB–/Baa3). When a reference is made to “loans” by market participants, it typically means (1) loans that are broadly syndicated (to 10 or more bank and nonbank investors) leveraged loans, (2) senior secured loans that are at the top-most rank in the borrower’s capital structure, and (3) larger loans to larger companies.

• A leveraged loan is a syndicated loan with a single set of terms, but multiple lenders, each providing a portion of the funds. The advantage of the syndication of a loan from a borrower’s perspective is that it (1) allows a corporation to negotiate loan terms only once yet gain access to multiple lenders, and (2) avoids possible conflicts in priority if the borrower serially negotiated loans; all lenders in the syndicate share equal rights under the credit agreement.

• Leveraged loans can be classified as (1) pro rata loans that are distributed to banks and usually include the revolving line of credit and shorter maturity term loans, and (2) institutional loans that are distributed to nonbank institutional investors and typically include longer-maturity term loans.

• Leveraged loans commonly contain covenants or requirements that must be satisfied by borrowers. The two most common are (1) maintenance requirements, or regular reviews of operating measures, and (2) incurrence requirements, a review of specific operating measures after an issuer has taken an action to trigger a review. Purposes of such loan terms include: (1) preservation of collateral, (2) appropriation of excess cash flow, (3) control of business risk, (4) performance requirements, and (5) reporting requirements.

• Studies of recovery rates confirm that the senior claim of bank loan lenders on the assets of the borrower, as measured by recovery rates as percentage of par value, is higher than that for other creditors. It is important to keep in mind that such recovery rates are expressed in percentage terms of par value so that loans trading at par are exposed to greater loss than those trading under par in the event of a default. Also worth noting is that recovery rates tend to vary meaningfully by year.

• There are two methods by which loans in the secondary market change hands: (1) by assignment, in which the buyer becomes the lender of record with all related rights and powers, and (2) by participation, in which the buyer receives the right to repayment but the original lender remains the lender of record. In the case of a participation, the buyer bears a greater credit risk since there is no contractual link between the borrower and the participant.