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By WinstonWolf
January 13, 2005

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Since I am entering a new star class, I figured I'd pontificate a bit to show my worth (or lack there of). In all seriousness, I wanted to discuss some thoughts that have been on my mind and came closer to conclusions after reading the excellent OID interview from MDCigan's post. Be warned that this is long...

The thoughts relate to the current state of the corporate banking industry and how we could be in for a dramatic downturn, probably more pronounced than the recent downturn that followed the deemed 'bubble' burst. I say deemed because I am not certain we are out of the woods yet. We are in the midst of a game of credit musical chairs that is in hyper mode and when the music stops there may not be many chairs remaining. I work in corporate bank debt, primarily for mid corporate companies with $100MM-$2B in annual revenues (large private corporations/small-to-mid public corporations). The recent market can only be described as a mania from my perspective.

Credit expansion and contraction obviously has a powerful effect on the overall economy. The more credit available, the more a corporation can leverage its equity base - - and visa versa. As most people know, in the mid-to-late 1990's we had a dramatic expansion, which was followed by a dramatic contraction. This corresponded with Fed Funds in the mid 4% range to mid 5% range through most of the mid-to-late 1990's, it peaking at 6.5% in mid 2000, and then falling dramatically to 1% in mid 2003 - - rates not seen since the early 60's.

Bank loan demand and utilization rates (actual borrowings versus total amount available to borrow) dropped dramatically during the contraction. Some of this was expected, as weaker firms could not borrow as much as they could before. Additionally, acceptable cash flow leverage ratios (senior debt to EBITDA) were extremely conservative during the contraction, often at best 3.0x and usually in the 2.0x range. This is even hindered some of the good firms that wanted to borrow; however, many of the 'good' firms did not want to borrow. After an unprecedented economic expansion, combined with the doomsayers and the ability to be more efficient (through new technologies, strategies, etc.), many good companies took the inventories to historic lows. Working capital is one of the prime generators of bank debt and with lower working capital requirements, companies required less debt. Banks resorted to all kinds of measures to 'stream-line' their own structures in order to be able to withstand declined borrowings.

At the same time, two other things were happening:

(1) A new form of debt was beginning to take hold of the banking industry - - 2nd lien financing (also called Term Loan B's and other names). This is a form of senior debt that has a 2nd lien on assets. [Though supporting different assets, it is probably easiest to compare it to a home equity loan. Your mortgage has a first position on your house and thus you get a lower rate. The home equity loan has a 2nd lien on your house and cannot get paid until the first mortgage is paid; therefore, it is lending against the residual value of your home and will charge a higher interest rate.] 2nd lien financing originated in asset based lending deals. Generally speaking, asset based lenders historically advanced a line of credit to companies against a conservative collateral pool with a reasonable loan-to-value. More generally, they lend against A/R and inventory primarily, subtract any ineligible collateral (slow moving inventory, slow paying receivables, etc.) and then advance debt against, say, 75% of the value of the eligible A/R and 40% against the value of the eligible inventory.

Life began to flow into this form of debt when some ingenious banker thought to him (her)self, "Hmmm. Those asset-based guys are too conservative. I bet there is another 10% or so of true value in the assets. If we can only convince them to allow us to make a senior loan with a 2nd lien position, we could offer the company real value and make the bank a lot of money." That person's thoughts became reality. The initial loans were smaller term loans (versus lines of credit from asset based lenders) and more focused on more 'storied' companies. The was substantial language written in to the contracts ensuring that the debt was as close to true sub-debt as possible, while keeping the senior status in a bankruptcy scenario.

Though 2nd lien facilities may sound simple, logical and almost inconsequential, these facilities did not arise until the late 90s. Consider these lines from an article appearing in the ABF Journal:

for the first 250 years of asset based-lending in the U.S. (dating back to the factoring of textile shipments between England and the colonies), senior secured lenders always required a first, perfected and exclusive lien on a borrower's assets. The exclusive lien was standard practice and, until recently, a credit officer would never consider allowing a 2nd lien holder to enter the capital structure.

Not so dramatic when you consider that the market was still very small and unknown. But changing a 250-year practice is dramatic and the market activity since has made this a very dramatic change.

During the credit contraction, many companies could not refinance their debt. Another banker (maybe the same) thought that 2nd lien financing could be morphed into 'rescue capital' with support from residual assets and intangible asset value. Senior lenders often found it difficult to lend against brands, patents, etc.; but this succeeded and the market for and the knowledge of 2nd lien financing began to increase. In fact, institutional investors (hedge funds, CDO funds, etc.) began to embrace this paper because the yields were extremely attractive relative to the current treasury rates. The demand for the paper created its own secondary market, as banks began to sell the paper to these investors (speculators?).

(2) Money flowed into private equity funds/VCs and hedge funds. The former because of the unprecedented success in the 1990's followed by substantial funds raised just prior to the downturn. With little market activity, these funds were flush with cash going into the early 2000's. The latter is because of their recent successes. The money flowing into hedge funds today is simply astonishing. One highly prominent Goldman Sachs trader recently raised $5B to start up his own hedge fund. Think about that - - $5B.

So where are we in time? We are now at the beginning of 2003.

What's the demand situation? Interest rates are at all-time lows. The economy has apparently stabilized - - almost miraculously considering that 9/11 occurred only 1.5 years ago. People are actually thinking we are at the bottom and possibly poised for at least stability. The war in Iraq causes some apparent caution, though it does not last long. Most firms are 'cleansed' and business surveys suggest that they may actually increase inventory levels somewhat and even invest in capital equipment. Demand for cash begins its increase.

What's the supply situation? As mentioned previously, banks have cash; institutional groups (specifically hedge funds) have cash; and private equity houses have cash. With loads of cash and several years of nominal activity, the supply of cash is abundant and participants are anxious to put it to use.

The result? Banks have cash and are willing to loosen standards a bit to utilize it. Private equity firms have cash and with the new debt structures are anxious to put as much cash to use as possible before their investment timeline expires for funds raised just before and during the market downturn. Institutions are sitting on cash and looking for more attractive yields, which is satiated somewhat by the 2nd lien loan market. The result is quite simply a frenzied debt and buyout market that takes off mid 2003.

The market feeds on itself. Companies go in acquisition/buyout mode. Lenders have already loosened standards, so what's a little more going to hurt? Institutions are absorbing the 2nd lien debt with ease and facilities are now starting to become oversubscribed. With the oversubscriptions, banks start increasing the size of the 2nd lien portion. 2nd lien debt now morphs into the high-yield debt for mid corporate companies (high yield is generally only for larger issuers), all but replacing traditional mezzanine financing because of its market acceptance, ease to syndicate, document and most importantly, aggressive pricing and lack of warrants/equity linked returns. Once a small piece of the transaction, it is now grow in size and represents a large amount of the total transaction. Private equity firms see the demand and are either selling their portfolio companies or (better yet) recapitalizing their portfolio companies to return initially invested capital.

The market has been on an astonishing pace since mid 2003 and a lot of it can be attributable to 2nd lien loans becoming a mainstream product. Think about this: Prior to 2001, 2nd lien loans rarely [exceeded] $300MM in annual volume. The market for 2nd lien facilities was $600MM in 2002, $3.3B in 2003 and through the first half of 2004 stood at $7.4B. From my actual experience, I would be shocked if the second half of 2004 was not at least as robust, if not more robust. And almost all of the recent deals involve recapitalizations, stock repurchases, leveraged buyouts or acquisitions - - inherently risky transactions. [Note that the traditional high yield market is similarly robust, so this new form of debt is adding fuel to the fire.]

Over the past year, purchase multiplies have increased because of competition between buyout firms, while credit structures and the cost of credit (interest rate spread) have actually deteriorated due to the number of banks/institutions looking to put their funds to use. Some anecdotal comments:

(1) On product demand => I was involved with a transaction in the first quarter of 2004 that had an initial debt structure with a 1st lien line of credit (~35% of debt), 1st lien term loan (~25% of debt) and a 2nd lien term loan (remaining ~40% of debt). The entire 1st lien term loan was priced approximately 50 BPS higher than the 1st lien line of credit and the 2nd lien term loan approximately 100 BPS higher than the 1st lien term loan. The pricing was relatively attractive at first. This resulted in a 250% oversubscription in the 2nd lien facility and close to a 100% subscription in the 1st lien facilities. With market flexibility language, the lead bank shifts much of the 1st lien term debt into the 2nd lien term debt and then lowered the pricing on all facilities. Basically making the debt structure more risky, but lowering the overall return. The transaction went through with lenders and institutions complaining that they did not get a big enough piece.

(2) On deteriorating structures/pricing => I have looked at two transactions this month, which have absolutely amazed me with their weak structures. Both were for acquisitions and both are near completion and for all intensive purposes are finalized and waiting to fund. (i) The first is actually a strong company that has had a lot of success expanding its moat and growing its cash flow year-to-year. Nevertheless, the deal came to market at nearly 5x senior bank debt to EBITDA and nearly 8x total bank debt to EBITDA. Spreads were ridiculously low in aggregate and especially low when considering the 2nd lien loans were priced within 50 BPS of the 1st lien loans. This was also one of the larger 2nd lien facilities that I have seen at nearly $1B. (ii) The second is a combination of an average company with a slightly below average company. Both are in a highly cyclical industry and neither made money on an income statement basis until last year (though they had plenty of EBITDA to throw around!). The deal came to market at nearly 4x senior bank debt to EBITDA and nearly 5x total bank debt to EBITDA. Spreads were low and the 2nd lien loan had the exact same pricing as the 1st lien loan. The size of the 2nd lien loan was over $500MM.

Think about this. We still have tremendous demand. In fact, many buyouts that occurred in early 2004 and prior are now coming back to do recapitalizations. I read an article that mentioned a private equity firm closed a deal one month and then two months later came back to market to fund a dividend (and give itself bank nearly a third of its original investment). The banks are bringing average companies to market at absurd leverage levels and good companies to market at even more absurd leverage levels. My dad used to say, "you can't polish a turd". My dad was wrong - - it's amazing how good bankers are at polishing turds.

I truly believe that we are at, or near the peak of this game. With the current environment, the activity should continue through mid 2005 and then begin to slow at the end of 2005/beginning of 2006. The banks will continue to push weakly structured debt; the institutions will continue to purchase the ever-increasing debt; and the private equity firms will continue to buy/refinance companies - - until the music stops.

Interest rates are creeping up and the economy will eventually slow (if it already hasn't). Historically, when credit is loosened as it has been recently, defaults eventually rise and bankruptcies begin. The leveraged history is young though, as LBOs were introduced in the 1970's and high yield debt was introduced in the 1980's. We've had two major fall-outs since the introduction of high yield debt, one in the early 1990's and one in the early 2000's. Both followed dramatically enhanced credit markets that suddenly stopped; and while each fall-out was substantial, both were followed by a rebound - - the 90's bull market and our present market today.

I fear that when the music stops this time (i.e. bank loan defaults begin), we have the potential to be in for a doozy! The reason is that I think the recent run-up is a bit different. We've obviously had ebbs and flows historically, but there are a couple of characteristics that were not present in the past in their current form and abundance: 2nd lien loans, hedge funds and derivatives.

(1) Relatively speaking, 2nd lien loans appear harmless at first glance. You may think that they have just allowed smaller companies access to high-yield type debt and we will probably have a result similar to the downturn following the introduction and boom of high yield debt in the 1980's. They have, but they have also introduced a LOT of uncertainty in bankruptcy scenarios. There is a reason why for 250 years senior bank debt required a 1st and exclusive lien on assets: treatment in bankruptcy. This put them at the top of the line, no questions. No one really knows what will happen this time around. Many presume (and pray) that the courts will view them as having a position similar to past positions; however, the language in the 2nd lien loan agreements has gotten fuzzier and fuzzier. With the recent increase in size of the facilities, the tail could very likely be wagging the dog in a bankruptcy scenario.

(2) Hedge funds are to 2003/2004 what new venture capital was to the late 1990's. They are raising funds and hiring individual at a blazing pace. I am not too confident that many of these new folks have been through downturns or have the ability to function through workout scenarios, which is a critical and not very abundant skill. While most take reasonable sized pieces in 2nd lien transactions (say 10%), some are taking larger pieces in these facilities. Additionally, if defaults are wide spread, transaction sizes may be mute because all of the transactions could be 'blowing' up. This is not uncommon, but what is uncommon is these funds are leveraged to begin with. When people begin to experience losses and realize that the risks in hedge funds are much greater than presently hinted, you can be sure that funds will start to flow out. What will happen is certain hedge funds will begin to implode because of a liquidity crunch.

(3) The derivative thought actually became more crystallized during my read of the OID article. We know that hedge funds utilize derivatives, so if they are failing, their corresponding derivatives will also fail. What I did not think of initially is that second lien financing (and high-yield issues) are mostly based upon LIBOR rates and banks usually require at least a 50% hedge on term debt. The exposure to these hedges if out-of-market can be very large. If the debt defaults, these large swaps will be defaulting as well.

The combination of 1+2+3 (and everything else I left out - - consumer debt, housing market bubbles, government debt, etc.) could lead to a dramatic decline and push our financial markets to a crisis scenario. Think about it. Banks will have to absorb the loan defaults and the possibility of a not-so-senior position if in bankruptcy. They'll also have to absorb the interest rate derivatives employed by the failing companies and the derivatives and other leverage employed by the hedge funds. It could get very, very ugly.

Then again, know one knows what will happen and we are America - - land of the free, home of the brave and unbelievably resilient (I hope so!).

Thanks for listening.

- The Wolf

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