The leveraged transaction market continues to evolve after collapsing in the wake of credit problems of the late 1980s.
Improving capital markets permitted the rescue of many transactions during 1991 and 1992 through needed refinancings. The market is now poised for transaction growth.
The deal market produced its first volume gain in several years during 1993. According to Mergerstat, announced merger and acquisition transactions for the nine months ended Sept. 30 jumped by more than 60% from the same period of 1992. Full-year activity is approaching the record 1989 level.
The reasons for this development are as follows:
* Low interest rates. Treasury rates are at their lowest in more than 10 years, which softens the impact of high transaction prices.
* An improving economy. Buyers' operating expectations are improving.
* Liquidity. Financing in both the public and private markets is plentiful.
Most transactions are divestment- and consolidation-related, with strategic buyers predominating. Active industries are financial services, health care, and telecommunications.
Financial Buyers Come Back
Leveraged buyout activity, while improving, still lags the general M&A market. Financial buyers are, however, returning to the market. The Remington, G. Heileman Brewing and Allison Gas Turbine transactions are recent examples of significant purchases by financial buyers.
A return to the late 1980s, when financial buyers dominated the market, is unlikely. A normalized 20% to 25% participation level for financial buyers is more likely. This translates into a $20 billion to $25 billion LBO level, up from 1992's depressed total of $7 billion.
Third-quarter volume of more than $4 billion, the best quarterly volume of the 1990s, confirms this trend. Purchase multiples also reflect the increased activity. Earlier price multiples of four- to five-times earnings before interest, taxes, depreciation, and amortization are now more like six- to eight-times such earnings.
The strong stock market may fuel deal activity. Strategic buyers are increasingly using their appreciated stock to fund acquisitions - as in the Bell Atlantic-TCI acquisition.
Financial buyers are also benefiting from high stock prices received during last year's equity refinancing boom. Additionally, buyout funds are raising new equity at a record rate. Consequently, financial buyers have the financial capacity to fund significant transactions.
The $1 billion purchase of Payless Drugs from K mart by Leonard Green exemplifies this development.
Pushing for Yield
Low interest rates and a steep yield curve have investors searching for yield in the long-term and high-risk segments. The high-yield bond market tallied more than $49 billion in new issues through October. This compares to the former record of $42 billion for all of 1992. Other developments are as follows:
* Maturities: extending beyond 10 years.
* Ratings: increasing acceptance of single-B issues.
* Covenants: becoming less restrictive.
* Deferred-interest securities: Payment-in-kind and other forms of deferred-interest securities are reappearing.
Pricing: Spreads for BB-rated credits have fallen below 300 basis points for senior subordinated debt. Spreads of less than 200 basis points are possible for privately placed senior notes.
Leveraged loan activity was depressed during the first nine months of 1993 for two reasons.
Fewer Reverse LBOs
First, prior-year results had been distorted by a strong reverse-LBO refinancing market. For example, 55 reverse LBOs closed during the first half of 1992, compared with just 28 this year. Reverse LBOs involve the refinancing of expensive high-yield debt through issuance of equity by companies that had previously undergone leveraged buyouts.
Second, strong capital markets have crowded out loans.
Non-investment-grade borrowers can raise long-term capital with bullet maturities and minimal covenants at attractive rates, This imposes a competitive disadvantage on shorter-term, amortizing loans with restrictive covenants and rates of 250 basis points above the London interbank offered rate. Thus, the portion of bank debt in new transactions is falling.
Two new transaction types have developed.
The first is exit financing for firms leaving bankruptcy. Examples include P.A. Bergner, Zale, Hills, LTV, Gaylord, and Best.
Transaction volume is declining as the number of bankruptcies decreases.
A second development is anticipatory investment-grade transactions. These involve companies that, although still non-investment-grade, anticipate a rating improvement within one year. Examples include General Instruments, Sybron, AMI, HCA, and Burlington.
Typically, these companies have completed an equity-financed reverse LBO and are enjoying improved operating performance. Loan pricing for these companies is in the range of 125 to 150 basis points over Libor for unsecured facilities with weak covenants.
The credit cycle turned again during the second quarter as bank and capital market credit standards fell due to competitive and yield pressures.
Bank loans are competing against aggressively priced and structured capital market instruments, particularly privately placed senior notes. These pressures are leading to higher-risk and lower-priced transactions. This is reflected as follows:
* Lower equity levels: Equity requirements have fallen below 20% in newer transactions. Increased use of subordinated debt makes up the difference, with ratios of funded debt to earnings before interest, taxes, depreciation, and amortization more commonly exceeding five.
* Maturities: increasing to seven years.
* Amortization: development of so-called bullet-tranche term loan structures designed to compete against privately placed senior notes and sold to nonbank institutional investors.
* Covenants: weak financial tests and loose cash-flow control concerning excess cash-flow recapture and capital expenditure limits.
* Pricing: Pricing has declined to Libor plus 125 to 150 basis points. Prices below a 100-basis-point spread over Libor for BB-rated refinancing transactions like Caldor are becoming more common.
* Bridge loans: Bridge-loan volume this year increased by almost 40% from the 1992 level, reaching its highest point since 1990.
A Maturing Market
The leveraged lending market is maturing. The rapid growth of the late 1980s is unlikely to return. Also, a fundamental structural and cyclical shift toward higher risk and lower return has changed the competitive dynamics. Banks can no longer rely on loan growth or holding larger loan participations for volume increases.
Competing in this environment depends on whether an institution adopts a lead agent or participant strategy.
Lead agent strategies require providing both loans and securities to fund the entire right-hand side of the client's balance sheet. When loans become overpriced compared to securities, loans are deemphasized relative to bonds.
Leveraged lending remains attractive as a lead-in product allowing these institutions to capitalize on followup financing opportunities.
First, there is the leverage-increasing acquisition transaction. These companies usually refinance within two years to reduce debt costs and to increase financial flexibility. Typically, this involves an equity or high-yield-bond offering combined with a new loan facility.
Additionally, these companies are likely candidates to use debt again to capitalize on market opportunities, including leveraged acquisitions.
Banks unable to adopt a lead strategy can adopt a participant investor approach.
The first participant option is an invest-and-hold strategy. This involves investing in loans originated by others. The current risk-return dynamics, however, place loans at a disadvantage as an attractive investment alternative. Consequently, loan investment activities should be curtailed until market opportunities again become favorable.
An alternative trading and distribution participation strategy lets institutions capitalize on the growing loan trading market to take shorter-term positions in loans. The positions are liquidated over six to 12 months. The bank benefits from price appreciation or the ability to skim a portion of the interest spread or fee on resale of the loan.
Banks adopting this strategy underwrite larger portions in the primary syndication to achieve a coagent's status. Their exposure is reduced to a final hold level through a controlled sell-down to both bank and nonbank institutional investors.