Change of Seasons

I have always believed markets have seasons. The seasons themselves are not as interesting as the change among seasons. We appear to be currently undergoing one of the more interesting changes in years. The June Federal Reserve (Fed) announcement concerning the beginning of the end of its QE3 (quantitative easing) bond buying program this September promises to have major corporate finance implications. The Fed seems concerned that QE was creating market distortions, and was no longer needed.

The market response to the announcement was dramatic. It triggered a substantial stock market correction. More importantly, however, it produced a major bond market rout. The bell-weather 10 year Treasury (T10) jumped by 80bps almost overnight to 2.5% a level not seen since 2011. Credit spreads on other private debt instruments jumped even more. For example BB bonds credit spreads widened by almost 140bps. As a rough rule of thumb, bond prices drop by 1% for each year of a bond’s duration for every 1% increase in rates. Duration (Duration) is in effect a bond’s beta. Investors had been reaching for yield by going further out on the yield curve (i.e. taking increased duration exposure) for the past year to offset artificially low interest rates due to the QE3. Hence,  duration for many investors and bond funds exceeded 5 years. Thus they suffered massive June market value losses of more than 4% - even more for leveraged bond funds. Investor withdrawals from bond funds were large. PIMCO, a major bond fund sponsor for example, suffered billions of withdrawals in June as the market re-priced. The severity of this re-pricing rivaled the 1994 Fed surprise rate adjustment. Furthermore, the expectation for rates is a continued rise as markets adjust to a world without QE. Rates could increase to a more normal 3.5-4% pre-crisis level over the next year.

Consequently, investor bond appetite has declined, and issuers are curtailing bond offerings as the market adjusts. Some implications of these developments are as follows:

1)    Debt financed stock repurchases and recaps will slow as the relative cost of debt rises compared to equity. The impact on pending deals like Dell should be interesting.

2)    Decline in use of aggressive debt features such as PIK, covenant lite and second lien. Issuers will focus on more investor friendly straight debt instruments.

3)    Increased funding risk for debt-financed cash acquisitions involving non investment grade buyers. This will favor better financed strategic buyers over financial buyers.

4)    Debt capacity will decline as rates increase. This will depress purchase price and funded debt multiples.

5)    PE fund raising and exits will decline from near record 2Q13 levels.

6)    IPO and M&A volumes will suffer.

The abrupt market change highlights again the value of financial slack -“excess” capital and liquidity. Firms with slack will weather the adjustment process without any major disruptions. Additionally, they will have the capacity to engage in opportunistic transactions to capitalize on market mispricing.

Firms need to recognize the end of the multiyear QE based bond bull market. The means adjusting to new investor demands when designing instruments and transactions. It was great while it lasted, but he bull market bond summer season is over. This is not necessarily bad - it just means things will be different. These changes are what good corporate finance professionals are paid to recognize, improvise on, adapt to and overcome.

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The Regulatory Shot across the Bow

Leveraged loans (LL) are a key funding source for buyouts. They are similar to high yield bonds. They both involve credit to highly leveraged non investment obligors. LL differ from high yield bonds as they are higher up in the capital structure, senior and secured, and usually lack call protection. Currently, LL yields, although down from the prior year, still exceed 5%, which has attracted investor and bank attention.

Even though banks remain important, the LL investor market has evolved into a largely non bank institutional market. The majority of funding is provided by collateralized loan obligation funds (CLOs). CLOs are structured vehicles designed to buy loans. Loans are structured for bank orientated investors include revolvers and shorter term amortizing term loan As. Institutional investors focus on the longer term loan Bs which have minimal amortization.

CLOs went dormant following the financial crisis, but have returned in the second half of 2012. CLO fund raising volume increased from $ 28B in 2011 to over $ 62B last year. This growth is a major factor supporting the return of large buyout transactions like Dell ($24B) and Heinz ($28B) in the first quarter of 2013.These larger deals underlie the expansion of  1Q13 buyout volume to $78B from $19B in the prior year same period. This represents the highest volume since the boom years of 2006 and 2007.

Regulators are rightly concerned that LL’s high nominal yields may cause an inappropriate growth in bank loans in this area. This is especially true for yield hungry community banks. They are increasing their LL exposure through organizations such as BancAlliance, which now counts more than 100 community bank participants. Consequently, they issued revised regulations last month to control the activity LL GuidanceMarch,2013 .

 Current LL debt levels, as a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA), have increased to over 5 times from around 4 times last year. This increase, while aggressive, appears sustainable given the current low level of interest rates and credit spreads. These developments have reduced yields from 7% to 5% in the past year.

Equally concerning to the regulators is the return of boom era structures like covenant lite and payment in kind (PIK) securities. Covenant lite as its name suggests are loans with minimal or no covenant features. PIK securities are negative amortization instruments in which interest is “paid” by issuing new securities, which is added to the principal balance. Structures like these are usually employed to expand debt capacity reflecting weakening underwriting standards.

The likely consequence of this regulatory shot across the bow, along with possible higher capital charges for LL, is to slow bank LL activity relative to CLOs. Transaction originators will likely respond by increasing non bank orientated term loan Bs at the expense of bank focused revolvers and term loan As. Something to keep an eye on as this is implemented.

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