Take One Down and Pass It Around

A bull market for syndicated bank loans lets lenders transfer risk.

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A bull market for high-yield bank loans is giving commercial bankers a chance to do something they’ve been itching to do since digging themselves out of the last crisis: lower their standards. Amid investors’ soaring demand for a portion of the bank loan business, experts report that credit quality is slipping, covenants are loosening, and prepayment penalties, for savvy issuers, are history.

In the past five years, the syndicated bank loan market has come of age. Volume in the first half of 1997 was a record $509 billion, 28 percent ahead of the pace in 1996, when total loan volume was $888 billion, according to Loan Pricing Corp./Gold Sheets, which tracks the bank loan market. No longer chiefly a means to refinance existing debt, syndicated borrowing is catching on in mergers and acquisitions, often as bridge loans until a company taps public equity or bond markets.

Meantime, credit quality is in an accelerating decline. Typical non-investment-grade syndicated loans in 1992 featured interest rates in excess of 275 basis points over LIBOR. The benchmark earlier this year was 225 basis points, and, moreover, covenants governing fixed costs and debt ratios are weaker.

“In pricing, terms, and flexibility to corporate issuers, I think the bank credit market is at an all-time low–or high– depending on your perspective,” complains Joe Thomas, manager of corporate finance at Wachovia Capital Markets, in Atlanta. “That’s good news for corporate issuers and not necessarily for corporate lenders.” Wachovia alone has originated syndicated deals worth $20 billion in just 24 months.

WILD AND WOOLLY

Thanks to a wild and woolly syndicated market, bankers can afford to loosen up lending requirements. Effectively, their loans are unlisted securities, and investors are gobbling them up. Buyers tend to be other banks and institutional investors, such as mutual funds, drawn to long maturities and hefty returns. It’s lucrative for banks that collect a fee for processing the loans but bear as little of the risk as they want to.

“Banks are falling all over themselves to find borrowers,” says Loan Pricing Corp. president Jim Davis, noting an abrupt shift in the climate. “The market is very different today. Banks are a lot more aggressive in selling down their exposure. But the exposure they’re selling down has a lot less juice or pricing to it than it did several years ago. It’s a question of the pendulum having swung 180 degrees since the credit crunch ended in late 1992 or early 1993, when banks could dictate terms and conditions. Today, it’s most definitely the borrower [calling the shots].”

A recent recapitalization of Packard BioScience, in Meriden, Connecticut, hinged on a $115 million bank loan with very attractive characteristics. “We were able to restructure the facility to the point where the company had almost no amortization requirements for the first five years,” crows Jay Allen, senior managing director of leveraged finance at Bank of America. The initial plan called for a $90 million loan subject to amortization, with quarterly payments. After some negotiation, it became a $40 million loan with scheduled payments of a modest $100,000 each quarter. Boosting the revolving credit facility to $75 million, from $40 million, supplied an ample supplement to cash flow.

“On principal negotiation, we clearly did better,” says CFO Ben Kaplan. What’s more, the bank loans came cheaper than the other part of the financing package, $150 million in 10-year bonds fetching a fixed 9.375 percent. Interest on the bank loans floats at 275 basis points over LIBOR, or around 8 percent, in mid- August. Rising interest rates over the debt period prevented Packard from taking on even more bank debt. “We could borrow more cheaply from Bank of America,” Kaplan concedes, “but one rate is fixed and the other floats.”

PRESSURE ON FEES

Driven by fierce competition, commercial banks also are under pressure to cut underwriting fees in order to compete in a field dominated by investment banks. “Now you’re seeing [fees] in the 1 to 2 percent range instead of 2 to 4 percent [of face value],” Bank of America’s Allen observes. “All the investment banks have senior lending groups. They don’t care about the [above]-investment-grade business, because they don’t have the same relationships commercial banks have. And we’re trying to do high-yield, which is traditionally their business.”

In this bountiful climate for issuers, one sacrifice is called for–control over distribution. Because secondary distribution is critical, banks sometimes dig in their heels over who participates in the syndicate. “Your CFOs don’t necessarily like that, but it’s a fact of life,” warns Allen. “There was a time, not long ago, when companies wanted strong control over who was in their bank groups and who held their paper.” Nowadays, only investment-grade borrowers still can exercise control. And that’s because there is no meaningful secondary market for their low-risk, low- return bonds. “In weak BB and B ratings, typically the borrower has no say at all,” says David Nass, co-head of loan syndication at J.P. Morgan. “Banks can trade paper freely and assign risk to whomever they want.”

Such trading has given rise to plenty of talk in the credit business about a “convergence” of the bank loan and bond markets. And with the larger commercial banks underwriting public bond offerings and investment banks originating commercial loans, “there are 10 or 12 players all trying to do the same thing,” says Bank of America’s Allen. Now the markets are converging in actual debt structures, in the form of “hybrid” loans that combine bond and bank-loan characteristics in a single facility.

The innovator here was Huntsman Specialty Chemicals, a producer of propylene oxide and MTBE, and a subsidiary of $4.5 billion Huntsman Corp., based in Salt Lake City. Earlier this year, Huntsman set out to raise $135 million to finance a plant acquisition and, says CFO J. Kimo Esplin, “the only market available to us at the time was the public high-yield market. We needed a 10-year bullet maturity, junior to our bank debt.” But Huntsman is a private company, and what Esplin really wanted was a way to do a public bond offering without the disclosure requirements of registration. “We were on the road for a week, talking to funds, asking if they were interested in a private piece of paper that is not typical of the high-yield market.” Esplin and his colleagues got some positive responses, so together with Bankers Trust, the agent bank, they made it work.

Maybe it helped that Esplin is a former Bankers Trust employee– maybe not–but Huntsman ended up with a 10-year bullet loan [no principal is due until maturity] at LIBOR plus 350. Huntsman got the long maturity and high-yield covenant package, but with the floating rate and prepayment flexibility of a bank loan (it is callable at par in 3 years, or sooner at a premium).

“Most important, we were able to do it without registration rights,” says Esplin. “In fact, we’ve recently gone back to the market and done a $400 million high-yield offering for [parent company] Huntsman Corp. And we did it all on the private market, because of the strength of our track record and the fact that the market is so strong.”

SAFETY VALVE

Is the market too strong? So far, at least, there’s no evidence of the recklessness that burned so many lenders in the LBO binge of the 1980s. For one thing, this time around there’s a safety valve in the secondary market. And while some lower-rated companies have gotten terms previously reserved for their investment- grade brethren, overall the banks are more cautious than they were a decade ago. Recently, for example, several banks have declined offers from Chase Manhattan and Bankers Trust to join a syndicate for the $1.8 billion they’ve underwritten for Portland, Oregon-based retailer Fred Meyer’s attempt to acquire Smith’s Food and Drug Centers. The price, at 30 basis points over LIBOR, was said to be too low for a not-quite-investment-grade deal.

Of course, an economic downturn could slow market activity and force some consolidation in the business, which would also shift the emphasis away from price. After all, what the banks are really bidding for are relationships.

“Our clients tell us they don’t expect us to compete solely on price or structure, but on idea generation and creativity,” says Allen. “It’s going to be banks that can bring other services to CFOs that the CFOs are going to be interested in.”

Meantime, the secondary market for high-yield bank debt is fostering a fine party for issuers. But if bankers get tipsy again, someone else might wake up with the hangover.

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