HLT Market, Its Wounds Healing, Seems on the Verge of Recovery
Recent developments in the highly leveraged transactions market have been dismal. The list of nonperforming HLTs such as Interco, Insilco, Hills, and Best Products is growing.
The number and size of new transactions has declined through 1990 and into the first half of 1991. Also, the stalled syndication of the high-profile Lexmark transaction this year illustrates the underwriting risks associated with larger HLTs.
Understandably, many domestic banks are reluctant to be known as pro-HLT under these circumstances. Consequently, they have curtailed such lending activities to satisfy both investor and regulatory concerns.
But recent events indicate an increased number of new transactions. The transactions are being arranged and funded by a group of institutions that are expanding their deal efforts as transaction structures and pricing have improved.
According to the Securities Data Co., leveraged buyout activity, a key HLT component, fell from $74 billion in 1989 to $16 billion in 1990, the lowest level since 1985. The market actually peaked in 1988 at $52.6 billion, as the 1989 results were distorted by the $25 billion RJR/Nabisco transaction.
Pricing, defined as an earnings before interest and taxes multiple, declined from 12.5 times in 1989 to 7.8 times in 1990, again the lowest level since 1985. Deal size and type shifted from larger transactions involving firms going private, such as Southland in 1987, to smaller, divestment-type transactions like the Butrey Foods spinoff from American Stores in 1990.
Although current transactions have more affordable earnings before interest and taxes pricing multiples, the uncertain financing environment, primarily in the senior-debt bank market segment, has curtailed activity. The abrupt decline in HLT financing is due to credit and regulatory factors.
When the Bubble Burst
Credit problems began surfacing in late 1989, reflecting the decline in underwriting standards of poorer-quality transactions completed at the end of the 1980s restructuring boom. Transaction prices rose faster than underlying values as investors expected the price increases to continue. Once the speculative bubble burst, prices fell in line with intrinsic values.
Unfortunately, the drop did not occur until after many late cycle-investors discovered that they had overpaid and were unable to meet their debt-service payments.
Recessionary pressures and the international uncertainty following Iraq's invasion of Kuwait in August 1990 exacerbated the strain on many of these poorly conceived transactions, leading to increased defaults which dampened bank demand for HLT financing.
Regulations Disrupt Lending
The second major market change was a regulatory shift. HLTs represent a financial technique and not an industry concentration. Therefore, loan problems are less concentrated, and reflect individual bank underwriting problems rather than a systemic flaw affecting the entire loan category.
Nonetheless, regulators became concerned with the growth in restructuring related debt, and issued HLT regulations in late 1989. The regulators failed, however, to distinguish acceptable HLTs from badly leveraged transactions. Thus, a stigma is attached to all such transactions.
Predictably, the regulations disrupted lending for corporate restructurings, leading to a 7.7% decline in HLT exposure at major institutions in 1990 compared to 1989.
Using the Right Comparison
Corporate restructuring and related HLT-lending is cyclical and follows the general stock and mergers and acquisition markets. During 1990, the stock market fell and the mergers and acquisitions market declined to its lowest level since the early 1980s.
These factors, plus credit and regulatory concerns, made 1990 a nonrepresentative transition year.
Rather, the better comparison is with the more representative mid-1980s results, which suggest a $15 billion to $25 billion per annum deal flow with transaction sizes under $750 million.
Short-term recession and international uncertainty are becoming resolved as reflected in the rebounding stock market. Long-term fundamentals also support this belief with declining deal prices and interest rates making transactions more affordable.
Recent events in the deal market signify a growing level of confidence. A number of previously troubled transactions, such as RJR, have been stabilized or resolved. Also, an increased flow of equity capital has been raised by buyout firms including Kohlberg Kravis Roberts & Co. and Forstmann Little.
Finally, the pipeline of new or completed transactions, including Healthco and Alpha Beta, is growing.
These HLTs will not be structured as regulatory HLTs to broaden their syndication appeal. Nonetheless, they are either priced as HLTs or contain pricing step-up clauses if they are subsequently classified as HLTs. The weak link in this early recovery is the uncertain senior debt bank market.
Bank involvement is primarily limited to larger money-center and regional institutions, and the scale is far less than real estate lending.
According to study of 35 banks by Salomon Brothers, HLTs represent 5.7% of total loans in 1990 compared to the 14.0% commercial real estate concentration for the same banks.
The study also indicated that nonperforming HLTs increased from 3.0% of total HLT loan outstandings in 1989 to 8.2% in 1990. Nonetheless, this still compares favorably with the 1990 nonperforming real estate-loan rate of 14.6%. Clearly, HLTs are less of a concern to banks than real estate loans.
Furthermore, interesting concentration patterns in the nonperforming results exist. The HLT nonperforming rate among banks varies widely, ranging from the upper teens to the low single digits. This reflects differing underwriting standards, and illustrates that HLTs are not inherently flawed as an asset class.
Dangers of Lead Strategy
The banks with the highest levels and largest increases of nonperforming HLTs are those institutions that pursued aggressive lead strategies at the end of the HLT boom. This highlights the perils of a lead strategy, whereby origination infrastructure costs force banks to lower underwriting standards, to match changing market conditions to maintain volume.
The nonperforming rates are skewed by the number and size of retail defaults such as Interco, Federated, Ames, Southland, and Allied. According to Loan Pricing Corp., over 35% of the retail HLTs originated in 1988 have defaulted. Extracting retail nonperforming transactions substantially reduces the 1990 nonperforming rate.
Finally, HLT activity peaked in 1988, when a number of questionable transactions were completed. This is reflected in the disproportionate number of 1988 transactions that defaulted in 1990 representing over 36% of the total 1990 nonperforming loans. Portfolio quality should stabilize as the number of these lower-quality transactions begins to decline.
On the positive side, the recovery rates on recent nonperforming HLTs are encouraging. Recoveries exceeding 80% are common, according to Loan Pricing Corp. research. This reflects the senior secured status of many HLTs and the stability of the underlying collateral values.
The combination of high interest rates and recoveries makes HLT portfolios resilient. For example, assuming a net interest margin of 250 basis points, an 8% nonperforming rate and a 20% loss rate, a significant remaining net interest cushion still remains. The cushion can be further supplemented by fees and equity interests.
Bank participants in the market are changing. Lead banks, which had created an origination structure to service an expected $75 billion market, are cutting their origination infrastructure to fit the smaller market environment.
Institutions unable to manage the high levels of credit risk, as reflected by double-digit nonperforming rates, are also curtailing activities. Foreign institutions, which are less impacted by regulatory concerns and enjoyed relatively low nonperforming-HLT results, are becoming more active participants in recent transactions, such as Oryx and Lexmark, and the trend is expected to continue.
Focus on Return on Assets
Once stripped of its financial hysteria, the HLT market becomes a less forbidding environment in which specialists, who can distinguish badly leveraged transactions from HLTs, can still earn favorable returns. The key to successful HLT operations is to manage for return on assets and not growth.
This requires a disciplined underwriting process that keeps nonperforming assets below 5% and losses at 100 basis points or less within the context of a widely diversified portfolio.
Undoubtedly, the market has experienced a structural and cyclical correction, but preliminary indications are that a recovery has begun. A return to the overheated 1988-1989 levels is not suggested.
Rather, the market will return to a more rational state similar to the mid-1980s. Sound transactions meeting conservative underwriting standards will be completed by a reliable group of professional funding sources, illustrating that the reality of the HLT market differs from its popular perception.
Mr. Rizzi is vice president, structured finance unit, at ABN-Amro North America Inc. in Chicago.