According to both Washington and Wall Street, the credit crunch that resulted from last year’s global financial crisis is history.
But tell that to Main Street. Before the crisis, banks were stumbling over one another to get corporate business, offering cheap loans in exchange for the right to offer services with higher profit margins, including cash management and foreign exchange. But those days have gone. Many banks have withdrawn from the market, while those still lending have raised their rates and imposed stiff new fees for drawing down credit facilities.
Nowhere is that more apparent than in the syndicated lending market, which has become the primary source of corporate capital from banks. In a typical syndication, one or two banks serve as agents, committing to arrange the participation of other banks and even institutional lenders. In effect, those agent banks exchange the interest payments they would have received under a bilateral agreement for underwriting fees in the syndication.
Starting in the late 1980s, banks under regulatory pressure to move assets off their balance sheets developed a secondary market for their pieces of loan packages. This secondary market’s annual trading volume grew from about $600 million in 1990 to about $67 billion in 1998, according to New Yorkbased Loan Pricing Corp., which tracks the syndicated lending market. Today’s downstream investors in these loans range from stodgy insurance companies and mutual funds to the most aggressive hedge funds. More recently, investors from the secondary market for bank loans have started to step up to the plate for the first round of syndications.
The market’s development clearly has provided much greater liquidity than existed before, though not all CFOs may appreciate its benefits. “My general impression is that CFOs don’t particularly like that liquidity,” says Scott Page, coportfolio manager of the Eaton Vance Prime Rate Reserves, in Boston, which, with $8.5 billion in assets, is one of the largest institutional holders of bank loans. That’s because CFOs end up with what amounts to an unfamiliar lender. In the most extreme cases–and a real stumbling block to the market’s growth in the early 1990s, when bankruptcies were more common than today–CFOs were forced to negotiate loan workouts involving these downstream investors, a changeable cast of characters.
However, a growing number of finance executives have grasped the benefit of the loan market’s increasing liquidity. “We have mutual funds owning tranches of our bank loans that then come back to buy our public debt and notes,” says Robert Krause, treasurer and acting CFO of American Axle & Manufacturing Holdings, a Detroit auto-parts supplier with $2-plus billion in revenues. Meanwhile, Krause says, insurance companies that buy pieces of its bank loans often later invest in the company’s private placements. “They know your business,” he adds.
Because of this, and because of competition among banks, rates for companies with AA or AA credit ratings on multiyear loans they drew down slid from an average of 46.9 basis points over the benchmark LIBOR during the third quarter of 1992 to only 15.5 points over LIBOR by the first quarter of 1998.
Since then, however, the spread over LIBOR on AA/AA credit has risen to 20.3 points, and the trend has been similar on loans to companies with lower ratings. What’s more, annual fees charged by banks on such credit increased between the first quarters of 1998 and 1999 by 32 percent for AA-rated borrowers and by 70 percent for BBB borrowers. And the amount of credit available from this source dwindled, as syndicated lending volume fell by 22 percent last year.
To be sure, the global financial crisis that climaxed during the third quarter of 1998 spooked bond investors and banks alike. And the crisis does seem over. Loan volume, in turn, has increased slightly since then. But such companies as American Axle have felt the pinch. Krause closed a $750 million senior secured credit facility in October 1997, with tranches that were priced at rates starting at LIBOR plus 75 basis points–or roughly 5.9 percent. By December 1998, the bottom end of the range of rates on that facility had risen to 9 percent.
Other companies are considering abandoning banks for the public markets. And while this source is relatively easy to tap at the moment, if the bond market turns south, finance executives in need of debt capital may have to raise their hurdle rates.
RAROC and a Hard Place
That risk would be far less worrisome if the credit crunch at banks were temporary. But that is not likely to be the case, say many analysts. One reason: Consolidation has put banks under pressure to improve profit margins, so more now insist that loans pass a profitability test based on their risk- adjusted return on capital (RAROC, for short). What RAROC analysis has shown is that while returns on loans to lower-rated companies have been high enough to justify the risk involved, that hasn’t been true at the higher end of the credit scale.
“Banks are adopting the RAROC model, and investment-grade loans don’t fit the bill,” reports Meredith Coffey, an analyst with Loan Pricing. As a result, banks are either pulling out of that end of the market or charging much more than they once did.
And loan pricing isn’t the whole story. Otherwise, banks might have found that they made enough money on cash management and foreign exchange to justify the use of loans as virtual loss leaders. But Coffey says they’ve come to the opposite conclusion. “Bankers were overestimating the ancillary business that would come out of a syndicated loan,” says the analyst. So much for relationship banking.
Bankers themselves say the new climate isn’t subject to the business cycle, but rather reflects several fundamental changes. For one thing, overcapacity in lending has finally begun to disappear. Some of that is due to the M&A activity that has swept U.S. banking in recent years. It also reflects a dramatic pullback by Japanese banks. In early 1998, many Japanese banks exited the U.S. lending markets “full force,” says Arrington Mixon, managing director and the head of corporate structuring for the syndicated loan department of Banc of America Securities LLC. With a 20 percent market share, the Japanese banks had contributed significantly to the declining prices on lending of the mid-1990s, both by their sheer market weight and by their aggressive pursuit of that market share. “The Japanese bought market share, and the U.S. and European banks simply had to meet their pricing,” says Mixon.
No longer. “A financing has to have an economic return that is specifically accretive to shareholders’ equity,” insists Peter Gleysteen, the managing director who heads up the global syndicated lending department of The Chase Manhattan Corp., a product itself of the mergers of three New York money-center banks within the past eight years–Chase Manhattan and Chemical Bank in 1996 and Chemical and Manufacturer’s Hanover in 1991. Chase now dominates the syndicated lending market, having served as the lead underwriter on 34.5 percent of the deals in the first quarter of 1999, followed by Banc of America with 17 percent and Citibank/Salomon Smith Barney with 9 percent. “This [requirement of economic returns on loans] represents a structural shift,” says Gleysteen.
The shift has not been lost on customers. “Banks are far more conscious of their return profiles,” reports Roy Guthrie, CFO of Associates First Capital Corp., an $86.8 billion (in assets) finance company spun off by Ford Motor Co. in a two-stage initial public offering in 1996 and 1998. Associates nonetheless closed a $2.5 billion loan facility last December, primarily to finance its acquisition of Avco, a consumer finance company, announced earlier in the year.
But the financing did not come cheap. Despite its AA credit rating, Associates had to agree to pay 30 basis points over LIBOR for the facility, as yet undrawn. Granted, the circumstances were somewhat unusual. Not only was the financing arranged at a time of great market turmoil, but it was also intended to be drawn down, rather than serve as a backup facility for commercial paper, which is what Associates usually looks for in the syndicated market. But Associates has been paying more for its customary credit facilities as well. Guthrie says its “all-in” pricing (including fees) on its syndicated loans has climbed from about 7 to 8 basis points over LIBOR in 1997 to about 12 to 13 points in 1998.
Use It and You Will Pay
Other corporate borrowers can now expect to pay stiff premiums to draw down loan facilities. Like Associates, many companies until recently used these facilities primarily to back up commercial-paper programs, so the funds were rarely drawn upon. Last fall, however, prices of much commercial paper spiked so dramatically that borrowers had difficulty obtaining funds from that market. With loan facilities momentarily cheaper, companies started drawing on them instead. But the banks responded by imposing premiums on that portion of funds drawn above a certain threshold. These so-called utilization premiums have persisted, even though commercial-paper rates have come down.
“Bankers had simply assumed that these facilities would not be used, and we needed to readjust,” explains Mixon of Banc of America.
For borrowers rated BBB+, utilization premiums added an average of 8 basis points to the cost of drawn funds on a multiyear loan in mid- June, bringing the total to LIBOR plus 75.5 basis points.
Utilization premiums, to be sure, are not universal. But while CFOs of companies with weaker balance sheets will find their premiums and thresholds higher, even finance chiefs of more creditworthy companies have cause for concern. In the first quarter of 1999, fully half the A-rated companies that closed a loan paid a utilization premium ranging from 2.5 basis points to 10 basis points when outstandings exceeded 25 percent to 33 percent of the total commitment, according to Banc of America.
For BBB companies, utilization premiums were much more common, and ranged from 10 basis points to 15 basis points when the amount outstanding exceeded 33 percent to 50 percent of the total commitment.
“Utilization premiums used to be few and far between, but now these are becoming relatively standard,” says Mixon.
Should this persist, companies like Associates will most likely turn away from banks. As Roy Guthrie says, “There’s lots of dry powder out there,” referring to the public debt market. “Banks are the platform this company was built on, starting in 1918,” he concedes. “But with prices rising, we will migrate to the capital markets. You won’t see our bank credit lines, now about $22 billion, growing at the 17 percent rate at which the company is growing.” For Associates at least, turning away from new opportunities is not an option. “We’re not going to retreat or discontinue [our bank borrowings],” Guthrie insists. But for funding the company’s incremental growth, Guthrie will look to other sources of capital.
Not all the news on the banking front is bleak. In fact, lower-rated borrowers may not necessarily pay more under RAROC. While the rule of thumb that banks use to separate investment-grade borrowers from lower- rated, “leveraged” borrowers in the syndicated markets has been a debt ratio of four or more times earnings before interest, taxes, depreciation, and amortization (EBITDA), much depends on a borrower’s industry and particular circumstances.
Look, for example, at Hercules Inc., the Wilmington, Delaware-based specialty-chemicals concern with $3.4 billion in pro-forma sales. Hercules closed on a $3.65 billion loan facility at the end of the fourth quarter of 1998 for its purchase of BetzDearborn Inc., a water-treatment specialty-chemicals company, among other things. The acquirer came to its banks, led by Banc of America, with a debt/EBITDA ratio of 4.8. Nonetheless, Hercules senior vice president and CFO George MacKenzie and his bankers were able to convince the credit rating agencies to maintain the company’s investment-grade rating on its public debt (BBB/Baa3) going into the deal. The initial pricing on the loan was LIBOR plus 200 basis points, with the deal divided into four tranches. But once one of those tranches was repaid last April, the price came down to LIBOR plus 75, in line with what investment-grade companies pay. All in all, Hercules didn’t fare too badly.
Also, fears initially expressed over yet another new wrinkle in the lending markets–a feature called market flex–may be overblown. This term, introduced about 18 months ago by Chase into lending memoranda, leaves bankers some flexibility on pricing up to the last minute before the loan closes. Absent market- flex language, borrowers receive a commitment to a certain level of funding at a given price before the loan is syndicated, or divided up among all the participating banks and lenders. Chase now includes market-flex language in all its lending memos, for both investment-grade and leveraged loans.
“It’s a break-the-glass-only feature,” says Chase’s Gleysteen, pointing out that the market-flex language has rarely been exercised. All but one of the 10 instances in which banks exercised the privilege occurred in October 1998, he continues, noting that both investment-grade and leveraged borrowers had this experience.
Consider the experience of IXC Communications Inc., a $669 million Internet and telecom services provider in Austin, Texas, that had been extremely eager to get a $600 million loan facility set up last fall to finance the “lighting up” of its networks.
“We definitely needed term loans to build our networks,” explains James Guthrie, CFO of IXC. “But if we had to go to the capital markets for every surge in customer demand, it would be simply unworkable,” he says, highlighting the utility of revolving credit facilities. Given that eagerness, Guthrie was willing to accept market-flex language to get his loan at LIBOR plus 250 basis points for drawn-down funds. And he preferred that to the alternative of paying interest immediately on a conventional loan. “It’s useful not to have to pay for monies that you are not going to use in the short-term,” says Guthrie.
As for the market-flex language that was exercised in putting IXC’s facility in place, Guthrie recounts, “The bankers gave us ranges and the market fell apart in October. We are satisfied with the facility as it stands.”
More Hype than Hope?
In addition, some experts contend that the Internet has the potential to far outweigh any tightening in bank lending. Electronic services that enable investors to access loan information over the Internet “will save money and help speed up the transaction by widening the circle of investors,” contends Jim Davis, president and CEO of Loan Pricing, which has offered such a service for the past three years. On the leveraged side of the loan market, Davis predicts “a new breed of fixed- income investors, who are looking for yields and will now find analytical tools on a par with what they are used to in the bond markets.”
At this point, however, the Internet’s ability to push the evolution of market transparency and efficiencies to a new stage is still unrealized (see “Running in Circles,” June). And until the Web lives up to its billing, finance executives who want bank financing are likely to face a tough environment.