Debt products: Hybrids take root

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The development of the simple syndicated loan into a more liquid security advanced a stage further this summer with two groundbreaking financings which arranger Donaldson Lufkin & Jenrette (DLJ) describes as bond/loan hybrids.

In leveraged loans for American companies, non-bank institutional investors now account for roughly 50% of lending, bankers estimate. Institutional investors - including prime-rate mutual funds, insurance companies and pension funds, special purpose vehicles for collateralized loan obligations and even cross-over junk-bond buyers - are all attracted to leveraged bank loans. As an asset class they offer high yields, the potential for some very modest price performance, low loss rates and strong security, with illiquidity the only traditional drawback. Even that is changing. Nearly $40 billion of leveraged loans are now traded, with dealers making markets in $5 million chunks and investors actively managing their portfolios.

European corporate treasurers, who have mixed feelings about the development of a secondary market in their bank loans, should take note of how American borrowers have embraced developments there. "Issuers are comfortable that the more new investors participate in loans, the better terms they will get," points out Harold Philipps, co-head of the senior debt group at DLJ. "They want us to maximize non-bank participation, not constrain it." He recalls that, three or four years ago, American treasurers were just as suspicious of attempts to distribute and trade their loans like bonds as Europeans are today.

The new hybrid instrument blends the attractions of bonds and loans for an issuer. It offers a long maturity and lax covenant restrictions, like a bond, but also the flexibility to pre-pay, like a loan.

In June the firm arranged a $335 million financing package to fund chemical company Pioneer America's acquisition of a chemical plant and to refinance some existing debt. The package included two conventional elements for a B+ rated issuer in a cyclical industry: a $35 million asset-backed revolving credit and a $200 million 10-year high-yield bond issue. It also unveiled an innovatively structured hybrid term loan with a 9.5 year maturity, priced at 250 basis points over Libor. The loan and bond, each ranking as senior secured debt, were marketed in tandem to institutions. There was price talk for the loan, ranging from 250bp to 300bp over Libor and a book-building with a price demand curve. DLJ, which entirely underwrote and distributed the hybrid loan, made no attempt to syndicate it to commercial banks because of its long maturity and lack of covenants.

The key attraction for the issuer is that the bank loan is repayable early - although with some financial penalties - whereas high-yield bonds invariably carry hard non-call protection for, say, five years. During that time the issuer cannot pre-pay at any price and may be stuck servicing high-cost debt even while generating the profits to repay it, which would enhance its credit rating and lower its funding cost for new debt.

The hybrid loans can be repaid at 103% of par in year one, 102% in year two and 101% in year three. "Cyclical companies like Pioneer, which typically fund with an asset-backed revolver and high-yield bonds, tend to sit on excess capital when they generate it, which is not particularly efficient," points out Philipps.

DLJ's rivals downplay the hybrid loan as clever marketing and nothing new. They point out that Bankers Trust launched a series of hybrid loan instruments last year for American companies. These were essentially subordinated floating-rate notes, offered to a narrow investor base. Many institutional investors are forbidden by their charters from buying subordinated debt.

There is indeed an element of marketing frippery in the hybrid loan. The 9.5-year maturity is deliberately designed to contrive a distinction with high-yield bonds. As the bonds and loan were marketed to the same investors, DLJ did not want investors to run a simple relative-value analysis and submit orders entirely for the bonds or for the loans. The slight maturity difference makes such an analysis more difficult.

As another minor twist, the hybrid loan carried a modified cross-default clause to the asset-backed revolving credit thus providing slightly stronger security than on the bonds. Some investors, whose performance is measured against a floating-rate benchmark, would have a natural inclination towards the loan rather than the bond.

The powerful attraction of the hybrid loan became evident when DLJ launched the second deal in July, this time for Playtex Products. The $300 million deal, split equally between bond and hybrid-loan tranches was designed as a refinancing for bank debt taken on in the leveraged buyout of the company by Haas Wheat & Partners in 1995. The issuer wanted to replace bank debt with longer-term bonds but was persuaded to refinance partly with a hybrid loan. In this case, the hybrid loan counted as senior secured debt rated BB minus and the bonds as senior unsecured rated B+. This deal raised more controversy as the company was a long-standing client of Chase. Chase had arranged its previous $360 million credit facility which the new deal refinanced.

DLJ spent six months devising its long-term callable "covenant-lite" debt and hopes to bring out several more such deals in the next few months. It is already marketing a $200 million 10-year hybrid loan as part of a $1 billion financing package for its client, Total Renal Care.

If such hybrid products catch on - and other banks are rumoured to be marketing similar structures - they will squeeze commercial banks from two directions. As arrangers of leveraged loans, the likes of Chase face growing competition from investment banks with their culture of securities research and trading, as well as their ties to institutional investors in the bond and equity markets - commercial banking giants won't welcome many more defections like that of Playtex. Meanwhile institutional investors are now competing with banks as lenders, seeking leveraged loan assets as part of the diversified loan portfolios they carry on their books. Peter Lee