Monday, June 8, 2015

Leveraged Finance Market Developments

Leveraged finance involves an ecosystem of parties funding leveraged buyouts and acquisitions resulting in noninvestment entities. It includes originators like private equity firms. Also includes financial sources such as bank arrangers like JP Morgan Chase, Collateralized Loan Obligation (CLO) Funds, the end takers of bank arranged leveraged loans (they hold > 2/3rds of the term loans), and high yield bonds. The market is highly cyclical. Thus, it expected to benefit from the sharp surge in deal activity.

Leveraged finance activity so far, however, has been disappointing. The crowding out of PE by strategic acquirers has been previously discussed.  Leveraged activity is down almost 50% from prior year. Additionally, regulatory developments impacting banks (e.g. GECC) and CLOs has made traditional participant reluctant to bring new deals to market. Some of the major changes include the following:

1)     Basel III: new higher capital requirements for higher risk transactions may “spook” some capital sensitive banks like Deutsche.
2)     U.S. Regulatory Guidelines: joint agencies directive frowns upon transaction leveraged more than 6X FD/EBITDA. This concern is understandable given banks are using subsidized government guaranteed short term deposits to fund long term highly leveraged borrowers. Leverage levels seem to be behaving by hovering around the 6X limit. This makes it difficult to match the high price bids by strategic acquirers.
3)     CLOs: the Dodd Frank Act retained interest rules (effectively requiring more capital) are forcing CLO to restructure and possibly raise new capital.

Hard to tell how this all is going to play out. It is a work in process and it is still on-going. Nonetheless, some preliminary observations are:

1)     High Yield Bonds (HYB): HYBs are substituting for bank loans in the capital structure. Issuers can swap back from fixed to floating. HYBs are, however, less flexible than loans on matters such as early repayment.
2)     New Non Bank Lenders (AKA Shadow Banks): include brokerage firms like Jefferies, which is in the top 10 of leveraged loan arrangers. Jefferies is less leveraged than a bank. Additionally, it is much smaller than the major bank arrangers. Finally, it has suffered some setbacks like the Rue21 transaction. So the jury is still out.
3)     Business Development Corporations (BDC): another specialized non bank lender. BDCs have special tax and leverage traits which may limit their application for large deals. Traditionally, they focused on smaller higher risk middle markets deals where they can get the extra spread needed to compensate for their lower leverage. The irony is both brokerage houses like Jefferies and BDC are funded by banks via warehouse lines. So the banks may still be exposed to highly leverage deals.

Some serious unresolved issues:
1)     Revolving Credit Facilities: banks are needed to provide revolvers. Less desirable alternatives include prefunding a liquidity reserve (expensive) and bank revolver carve-outs (messy inter-creditor issues).
2)     Securitization: still going to need warehouse facilities probably funded by banks.
3)     Non Banks: need larger participants to achieve scale to fund larger deals. May need to return to Drexel  (the firm not the school) style Highly Confident Letter  in lieu of firm bank type underwritings
4)     PE Accept Lower leverage: impact their bidding ability to compete against strategic acquirers.

These changes represent the third act of leveraged finance. The first being the entry of large arrangers like Bankers Trust in the 1980s. The second being the shift towards capital market style instruments to facilitate the entry of non bank investors. The current regulatory induce changes will take time and result in new winners and losers as this dynamic market continues to change.


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