The launch of a $5 billion chunk of First Data’s LBO financing on September 17 brought some sense of normality back to the loan market in mid-September – albeit a very different normality to that previously experienced.
The $26 billion buyout of First Data by Kohlberg Kravis Roberts had been stymied by the seizing up of the loan market in the summer, and was part of the massive deal overhang that has subsequently been such a headache for underwriting banks in this market. Arrangers Credit Suisse and Citi had to chop the planned $16 billion First Data loan into chunks that were digestible in new market conditions and launched a $5 billion seven-year term loan B paying 275 basis points. This is probably 50bp wider than where the loan would have priced before the disruption, and the issue is also being offered at a 4% discount and includes a leverage ratio covenant (it had originally been structured as covenant-lite). Observers suggest that the changed terms alone could costs the banks nearly $200 million.
The deal is just the latest example of underwriters having to offer sizeable original issuer discounts in order to get their blocked loan pipelines moving again. They are also having to offer most-favoured nation (MFN) provisions, whereby underwriters commit themselves not to sell any outstanding loan balances at more generous levels after the terms of the deals have been struck.
Chunks of the Alliance Boots and Allison Transmission deals were also sold at a discount in September. Citi, Lehman, Merrill Lynch and SMBC underwrote the Allison Transmission LBO (which involves the sale of the GM unit to Carlyle Group and Onex for $5.6 billion), and sold a $1 billion chunk of the $3.5 billion senior loan, also at 96, in the same month. And the mezzanine portion of KKR’s Alliance Boots acquisition has also been placed at 95. But the LBO overhang is $300 billion, and questions remain as to exactly how much pain will have to be taken for that to be cleared.
"Arranging and underwriting banks are substantially adjusting and renegotiating terms in order to make loans more appealing and to try to lock up investors for as long as possible," says William Healey, chief executive officer at Picus Capital Management in London. But in return for reintroducing covenants, improving terms and offering MFN provisions, some banks have been looking to tie up investors by asking them to agree to fixed period lock-ups (whereby they agree not to sell the loan for, say, 60 days).
It is difficult to see what incentive there is for investors to agree to this, as they know how much paper the banks need to shift and are in a pretty comfortable position. Having had their position gradually undermined over several years through ever-tighter spreads and the erosion of covenant protection, investors will relish finally being in a strong bargaining position. "There are plenty of people willing to buy paper," says one. "There are large numbers of firms standing by to put cash to work. But if a loan is out there at 95/96 there will be people looking to pick it up at, say, 92. The market wants the banks to mark this stuff down – this is the intermediaries’ problem and we are not going to solve it for them."
But the underwriting banks themselves are unlikely to roll over and take that kind of hit without a fight. There is just too much at stake: Deutsche Bank, for example, revealed on September 20 that it had outstanding leveraged loan commitments of nearly €30 billion. "We have a problem on our hands," says a source at an underwriting bank (in something of an understatement). "We have to figure out exactly how the overhang will work its way through the system. The banks are trying to ascertain what the sponsors will agree to."
It will indeed be interesting to see how the relationship between the private equity sponsors and their underwriting banks plays out if the loan overhang persists. Observers made much of KKR being forced to add a leverage ratio covenant on the First Data deal – something seen as a significant climbdown by the sponsor.
Avoiding commitments
But the banks will need more than that to fix this problem. They will likely wriggle out of any commitments that they can (documentation permitting). For example, in late September, JPMorgan and Lehman Brothers walked away from a $750 million lending commitment to the buyout of mortgage lender PHH Corp by General Electric and Blackstone, saying that they had "revised interpretations" as to the availability of the funding.
What remains is something of a Mexican stand-off between buyers and sellers, each trying not to blink first.
"Banks that made a lot of money earlier in the year have a decent cushion to sit this out," says Healey at Picus Capital Management. "But they have a lot of other problems to think about and there is no penalty for investors to be sitting on cash at the moment."
Figures released by Morgan Stanley and Lehman Brothers in late September indicated the impact that taking down leveraged loans that have not been sold can have on the balance sheet. Morgan Stanley took a $726 million loss on its leveraged lending business and Lehman a gross loss of more than $1 billion.