The leveraged buyout community is increasingly relying on institutional term loans to finance its deals.
These loans-which are tranches of syndicated bank loans designed for insurance companies, retail mutual funds, hedge funds, derivative structures, collateralized loan obligations, and other nonbank investors- have emerged as a major source of funding for LBOs in recent years.
Last year institutional investors plowed $11 billion into term loans to finance larger leveraged buyouts-those valued at $250 million or more- according to Portfolio Management Data, a subsidiary of Standard & Poor's.
That represented 23% of the financing for these buyouts, up from 18% in 1995.
"Institutional investors have exploded in this market," said Michael H. Rushmore, managing director of loan research for BancAmerica Robertson Stephens. "They have a voracious appetite for floating-rate, high-yield term loans."
Mr. Rushmore predicted that the leveraged buyout community would develop an even greater dependence on institutional term loans.
Bank debt as a portion of LBO financing has remained pretty steady at about 45% throughout the 1990s. But the size of the average bank revolver and bank-financed term loan for LBOs has been decreasing, even as the total volume of leveraged lending to the LBO market has increased.
The commitment of bank capital for buyouts valued at $250 million or more has dropped from 27% of the total deal value in 1995 to 15% in 1997, according to Portfolio Management Data.
Institutional investors are also taking on larger roles in individual LBO loans. This year 25% of LBO loans traced more than half of their capital to institutional investors. This was true for just 16% of last year's LBO loans, 6% of 1996's, and none of 1995's.
Howard Tiffen, senior vice president and portfolio manager of Pilgrim America's Prime Rate Trust fund in Phoenix, said banks have shifted more of their loan risk to other investors in recent years to make better use of their balance sheets.
"Banks have much higher costs of operations, and their profits are shared between depositors and shareholders. But we only have one set of mouths to feed, and so we don't have to cut the pie quite as fine," he said.
Market observers say institutional investors have filled a gap created by the exit from the U.S. loan market of foreign banks, particularly Japanese banks who were major players in the 1980s.
"You can almost trace the decline of foreign bank participation directly in opposition to the growth of institutional investors in this market," Mr. Tiffen said.
But competition on the buy side is leading to price compression. The number of institutional investors interested in senior secured high-yield paper has soared from 14 in 1993-when this type of facility was created-to 78 last year.
This demand has driven down point spreads. Since 1995, when spreads on institutional term loans for larger buyouts averaged 313 basis points above the London interbank offered rate, average spreads have dropped to 246 above Libor for the 12 months ended in March. The figures were computed on a value-weighted average by Portfolio Management Data.
"It's totally supply and demand," said Babak Varzandeh, an analyst with Portfolio Management Data. "Competition is hotter for the larger deals, because you know if you get into trouble you can sell the paper on the secondary market."
Mr. Varzandeh said most people tend to think of the market for LBO loans as a whole, but "smaller deals have a liquidity premium to them," he said.
Therefore, fewer institutional investors are willing to commit to buyouts valued at $100 million or less. Price compression has been minimal in this segment, with these institutional term loans dropping just 23 basis points since 1995, from 331 to 308.