Comment: Investors Driving Trend to More Liquid Market

After working with more than a dozen investor groups, it has become overwhelmingly clear to us that institutional investors are emphasizing liquidity in choosing new investments.

There are two primary drivers of this trend. First, spreads of large, rated deals have risen faster than those of smaller, middle-market executions. As a result, the economics of smaller, less liquid credits have become less compelling.

Second, investors are focused on the ability to rebalance their portfolios through secondary trades. Large, rated deals are more conducive to secondary liquidity.

That leveraged lending has-seemingly overnight-switched gears from an issuers' market to an investors' market is clear. Those investors are exercising their influence by demanding better pricing, favorable structures and improved leverage ratios.

The most striking example of investor clout is that secondary prices have bottomed out-at least for now-to their lowest levels in recent years.

During December, the average secondary bid for par term loans-those bid at 95% of par or higher as tracked in Donaldson, Lufkin & Jenrette's leveraged loan index-ticked up to 98.1% of par, from 97.9% in November. Before precipitous drops in September and October, the average stood at 99.34%.

Another astonishing illustration of slack investor demand: In November, tor the first time since December 1994, not one loan in the index was bid over par. (The market recovered somewhat last month, when one facility topped par.) Just a year ago, nearly half of the index loans were bid above par.

Investors also have made their presence felt in the new-issue market. Since Labor Day, spreads and fees jumped to the highest level of the current cycle, from the lowest. The increases have come both in the pro rata segment (revolving credit and traditional amortizing term loans) and the institutional segment (longer-dated term loans syndicated primarily to nonbanks).

That's because in the five years leading up to the August disruption, institutional investors flooded into the leveraged loan market. Portfolio Management Data tracked 63 institutional investor groups in the leveraged loan market at the end of the third quarter, up from just 14 in 1993.

These investors have been faced with a severe slowdown in portfolio turnover in recent months, and therefore have little dry powder to invest. At the same time many opportunistic institutional loan investors- particularly hedge funds and high-yield investors-have refocused on the wide spreads available in the high-yield sector.

As a result, when the market turned, institutional demand was harder hit than demand for pro rata, or bank-loan, tranches. Hence, institutional spreads have increased more aggressively and, on average, new-issue fees paid on institutional loans came into line with those paid on pro rata loans for the first time in recent memory.

Since Labor Day, the average pro forma leverage ratio-debt over earnings-of new leveraged loans declined one full turn, from an average of 5.6 times to 4.7 times. It took the market five years of steadily increasing liquidity to ratchet up the average ratio one turn to 5.6 times. In the space of several weeks in September, the average was reset to 1992 levels.

Averages can be misleading, but not in this case. Taking the analysis a step further, we also looked at how many loans are syndicated with a pro forma leverage ratio of 6.0 times or higher for the largest, most liquid leveraged loans, those loans $250 million or more. We concluded that during the past month, 15% of these loans had leverage exceeding 6.0 times. This compares to 32% of such loans during the third quarter and 42% during the first half.

Increases in spreads and fees are not the only symptom of the new investor's market. Institutional investors are also demanding more favorable structuring terms.

For instance, investors wanted prepayment fees on institutional tranches. Those fees protect returns when issuers refinancing when the loan and high-yield markets become more issuer-friendly.

In December, fully 35% of institutional term loans had prepayment fees, up from just 5% in the first half. Prepayment fees even have shown up on large, BB rated institutional loans. These loans rarely, if ever, carried prepayment fees before Labor Day.

Grid pricing on institutional term loans has become another victim of slack investor demand.

During the first half, three in four institutional term loans tracked by Portfolio Management Data had pricing step-downs tied to issuer performance. During the past month, just one in 10 of these loans had pricing step-downs.

Our firm has also observed an increase in mandatory prepayments from cash flow and equity and more stringent security packages. u

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