Buy now, while stocks last

From the moment the credit crunch started in August 2007, secondary prices of leveraged loans started to trade lower offering, at first, perceived buying opportunities for leverage loan funds. Despite this initial demand, greater negative forces meant that the leveraged loan market was impacted by an unprecedented technical correction. There was a sudden halt of CDO issuance and the liquidation of a number of CDO warehouses. With the supply of leveraged loans far exceeding the demand for the paper, loans in the secondary market started to trade down, slowly at first and then rapidly, until in March 2008, the European Leverage Loan Index reached an average price of 85.

Some market participants observed that this represented compelling value, with many of the marked down loans backed by companies actually achieving their business plan whilst also de-leveraging. For example, assuming a Libor rate of 6%, a coupon of 2.25% and a three or a four year refinancing of the debt, the implied yield on senior debt equated to between 12.00% and 13.25%.

So, the question being asked in many company and private equity board rooms was how to take advantage of this once-in-a-cycle opportunity to purchase senior debt risk that was yielding mezzanine returns.

There are three ways in which a company and by extension its private equity owners can buy back discounted debt: the company can buy back its own debt; the private equity firm can buy back its portfolio company’s debt from an external fund; the company and private equity sponsor can purchase its own hung loan at a discount, repackage the loan and then syndicate the new debt package.

The first option involves a company using its own cash resources to purchase its debt at a discount to par. There are a number of legal issues which need to be considered if a Borrower were to undertake this route, inter alia: is the proposed buyer of debt an eligible transferee? Is the buy-back prohibited by the restriction on acquisitions? Is the buy-back prohibited by the restriction on Extending Credit? Is there a breach of the pro-rata sharing provisions? Whilst there are arguments for the first three issues being acceptable under current loan documentation, the prevailing view is that the vast majority of borrowers would fail the pro-rata sharing provisions. The syndicated facility pro-rata sharing clause would require, upon cancellation of the par-amount claim, that the borrower / purchaser share the benefit of the cancellation rateably with all other lenders, which in effect cancels any benefit of the purchase.

The second option is where a private equity house buys back the debt of one of its portfolio companies or buys back the debt of any company where its debt is trading at a significant discount to par. From a legal perspective there are no prohibitions (although some lenders are concerned that sponsors are able to vote in their own transactions), as the transaction can be deemed to be an outside investor purchasing leveraged loans for its running yield.

Whilst a 12.00% to 13.25% yield may be considered attractive, the return can be boosted by using modest leverage. For example, assuming an average transaction price of c.89 and assuming leverage of c.3x is used on the equity stake, it is possible to achieve IRR’s of c.30% and a money multiple of almost 2x, based on a three year exit. It was this strategy that the large US private equity firms used when buying up significant swathes of hung loans from arranging banks in early 2008. In this case the leverage was provided by the arranging banks themselves, enabling them to move the hung loan to a different part of their balance sheet, with a marked-to-market price of par.

The final debt buyback opportunity is only achievable where the loan is “hung”, i.e. where an arranging bank has been unable to syndicate its exposure. In this scenario, which is illustrated graphically below, the Company sets up an SPV (FinCo) as a subsidiary of TopCo (preferably outside the existing Obligor Group and therefore not regulated by the facility documentation). FinCo would purchase all the existing senior and subordinated bank debt from the arranging bank at a discount to par, funded by new equity from the private equity house in addition to new senior and mezzanine debt. The new senior and mezzanine debt is secured on FinCo’s asset (i.e. the loan to BidCo) and is provided by a club of lenders with on market pricing and terms and conditions. FinCo equity would receive a substantial IRR and money multiple return and can be viewed as investing in a portfolio business at a lower multiple as the private equity house has captured the loan discount.

The credit crunch has caused the largest technical correction ever witnessed in leveraged finance. Although, certain credits are trading at a discount to par for fundamental reasons, the majority of loans are trading at a discount to par due to the mismatch of supply and demand of leveraged loans. In this article I have highlighted three ways in which private equity houses can purchase leveraged loans. To be able to achieve a 12% - 15% unlevered return on senior debt, choosing to invest in the senior debt of market-leading, recession-resistant businesses is a once-in-a-cycle opportunity. Despite the upcoming economic slow down, the best advice is surely, buy now whilst stocks last.

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• Topics
• Financing
• UK / Ireland