Driven by the current merger wave, leveraged lending has become a major profit engine for banks. Volumes are at their highest level of the decade. Margins, although under pressure, are still attractive. Banks are eager to consider these credits compared to unattractively priced investment-grade loans.
The leveraged lending renaissance is in stark contrast to declining capital markets activity. Hampered by higher interest rates, competing high yield bonds, and 144A private placements, issuance has declined.
The reversal of fortunes has not gone unnoticed by the investment banks. Several of them, including Goldman, Sachs & Co. and Merrill Lynch & Co., have entered the leveraged lending market. This article analyzes the forces at work in the market and ways banks can capitalize on the opportunities.
In the 198Os, leveraged loans were made primarily to financial buyers.
Currently, the loan market caters to strategic buyers. Merger and acquisition volume, near a record level for 1994, continues strong this year. This is a predictable development as the business cycle matures and industries like defense and health care consolidate. Firms now find it easier to buy, rather than grow, earnings.
Banks are satisfying the demand for acquisition funding. Profits from playing the yield curve, formerly a major profit generator for banks, disappeared when interest rates began rising last year. Credit is again the chief source of revenue growth.
Competition for loan volume is reducing pricing. Reaching for yield, banks have pushed investment-grade type pricing into the BB category with spreads at the London interbank offered rate plus about 100 basis points. Single-B pricing still exceeds Libor plus 200 basis points as the universe of banks prepared to enter this higher-risk class is, for now, limited. Borrowers, recognizing this relative pricing shift, are replacing bonds with loans in their capital structure.
Amortization schedules have become more back-ended. Also, terms are lengthening, with seven-year term loans returning. These changes are needed to moderate the fixed-charge burden from increased interest expenses flowing from higher interest rates.
Total debt levels appear deceptively moderate. Funded debt as a multiple of earnings before interest, taxes, depreciation, and amortization - or EBITDA - remains at 5 to 6 times, with equity levels exceeding 20 percent of total capitalization. This is in contrast to the 8 to 10 times multiples and 5% to 10% equity levels in the late 1980s.
A more revealing debt-level measure is free operating cash flow, defined as EBITDA less taxes, investment for working capital, and capital expenditure growth. This reflects the debtor's ability to internally generate enough cash to service debt. The current transactions are more growth-oriented.
Thus, they consume more cash for investment purposes, Therefore, debt- servicing ability is lower than a simple EBITDA multiple suggests. Also, the composition of debt in the capital structure is changing.
Junior or subordinated debt has been replaced with less costly tranche B, C, and D term loans sold to nonbank institutional investors. These loans usually begin amortizing after the bank-held loans are retired. They share equally with the bank loans in most other respects, including collateral and seniority. This complicates workouts by reducing senior debt asset coverage levels.
Covenants are fewer in number and permit wide variances in fixed-charge, leverage, and net worth coverage.
Particularly disturbing are the weakening cash flow controls. Excess cash flow recapture clauses, limits on capital expenditures and dividends have been reduced, if not eliminated. This diversion of cash flow formerly available for debt service effectively lengthens the average life of the loan.
Bridge loans are also returning. Commercial and investment banks are using bridge loans to gain market share. These loans are either provided directly by the institution or through a bridge loan fund like Chase's Roebling Fund. Examples include transaction by Chemical Bank's for UCAR and Chase's loans for Dominicks and Associated Stationers. An interesting development is the joint venture arrangement between Chemical Bank and Goldman Sachs to provide bridge facilities to their clients.
High stock prices have limited financial buyer activity. The distinction, however, between financial and strategic acquirers is blurring. Many financial buyers, including Clayton Dubilier, are growth- oriented, focusing on add-on or leveraged buildup acquisitions in consolidating industries. Strategic buyers are becoming increasingly hostile following the GE-Kemper bid last year. Hostile bids, like Ingersoll Rand-Clark, are at their highest level in the decade, representing over 1% of total M&A activity.
Some predictions:
Capital market activity will increase once interest rates stabilize. This will pressure loan margins as public bonds and rule-144A private placements begin replacing term loans. Banks with capital market powers and capabilities should be less sensitive to this development
Investment bank entries into the loan market will continue. Lead roles in recent transactions such as Goldman's co-agency in the Santa Fe Pacific facility illustrate their continuing success in this effort. They recognize the competitive necessity of servicing the entire right-hand side of their clients' balance sheets to combat commercial bank Section 20 securities activities. This highlights the convergence of the loan and bond segments of the leveraged transaction market. The market is moving beyond borrowers and lenders to issuers and investors.
Robust volume levels should continue throughout the year, based on the following factors.
First, the weak U.S. dollar is attracting foreign buyers, as illustrated by the Grand Metropolitan-Pet and Luxottica-U.S. Shoe acquisitions.
Second, industry consolidation forces, including excess capacity and slow growth, underlying the current M&A movement continue unabated.
Third, LBO funds are flush with cash following record fund-raising activity of over $19.5 billion last year. They are finding innovative ways to employ these funds when competing against strategic buyers.
The previously mentioned leveraged buildup or platform investments are effectively used in consolidating industries. Other techniques include the Six Flags joint venture leveraged buyin, where an LBO sponsor joins with a strategic business partner to purchase a share in an existing business. Evidence of increased LBO activity is reflected by the strong current-year deal volume
Credit quality is, however, declining.
The decade began with severe credit problems, leading to a credit crunch. A small group of institutions continued lending to well-structured and richly priced transactions during the 1992-1993 refinancing boom.
Emboldened by this experience and driven by the need for revenue growth, banks began accepting declining spreads, longer maturities, and weaker transactions. Problems like the London Fog and G. Heilman transactions are beginning to surface.
Although cause for concern, the situation appears manageable. Recent studies on bank-leveraged lending experiences over the last cycle show an acceptable performance. Agent banks managing for league-table status typically suffer more than other institutions. The activity is cyclical and should be managed with a long-term view versus a short-term market share focus.
Maintaining objective credit standards rather than following market cycles is critical. Leveraged lending remains a credit- and not a distribution-driven business line.
Leveraged lending is at a high point due to the demand for financing caused by the M&A boom and the decline in competing capital market alternatives.
This current set of favorable circumstance is not, however, maintainable. While credit quality will undoubtedly slip, the results are unlikely to exceed those of the 1991-1992 period, given the lessons learned from that painful experience. The activity remains an attractive line of business for institutions capable of managing the risk.
Mr. Rizzi is a senior vice president at ABN Amro North America Inc.
