September 2011

ABL & Capital Markets Issuances — The State of Things

When it comes to capital markets issuance, ABF Journal turned to Wells Fargo Capital Finance’s Dorothy M. Killeen to explain where asset-based loans fit in the grand scheme of things. In the following Q&A, Killeen explains the differentiating characteristics of various ABL combinations.

A Conversation With Dorothy M. Killeen, Managing Director, Wells Fargo Capital Finance

ABF Journal:What types of capital markets issuances are most typical in conjunction with asset-based loans?

Dorothy M. Killeen: Prior to the 2008 market disruption, the prevalent combination was an asset-based loan and an institutional term loan (TLB). The most popular concurrent issuance in recent years has been high-yield bonds. Since the beginning of the economic recovery in 2009, there have been substantially more asset-based deals combined with high yield (112 transactions) than with institutional term loans (58) or equity.

In the spring of 2011, the institutional loan market embraced the re-emergence of covenant-lite term loans for certain borrowers, whereby TLBs are structured with incurrence covenants (similar to a high-yield bond) as opposed to the standard maintenance covenants. As a result, we had hoped to see more ABL/TLB combinations in the second half of 2011. However, recent market volatility makes that less likely for all but the highest quality borrowers, repeat issuers, and large, liquid deals backed by financial sponsors.

There have been very few asset-based loans executed simultaneously with an equity offering. This is driven largely by the timing requirements of the equity market, which generally compel borrowers to complete any related financings well in advance of their initial or follow-on equity offerings.

ABFJ: How extensively are asset-based loans combined with other capital markets issuances?

DK: Year-to-date through mid-August 2011, we’ve seen 36 syndicated asset-based deals paired with concurrent high-yield offerings, representing 16% of the asset-based transactions closed this year (as tracked by Thompson Reuters). Twelve of these 36 asset-based borrowers tapped both the high-yield and institutional term loan markets. Most of the ABL/TLB/HY financing packages totaled at least $1 billion and were used to support acquisition activity and LBOs. Only five issuers have launched broadly syndicated ABL/TLB-only deals in 2011, with the bulk of these deals coming in Q2/11 as covenant-lite structures.

ABFJ: What type of ABL borrower has access to the high-yield market and the institutional loan market?

DK: Most high-yield issuers have EBITDA of at least $45 million to $50 million, need to raise at least $150 million, achieve a corporate/family rating of at least Caa1/CCC+ from Moody’s and Standard & Poor’s and will become public filers (if they aren’t already). These borrowers typically provide three years of historical financial statements audited by a reputable accounting firm. While asset-based lenders focus on collateral value and availability, bond investors are focused on cash flow, leverage, capital structure, industry dynamics and enterprise value, among other things. As such, high-yield issuers must have a “story” to sell to investors.

Institutional term loan holders are more flexible on certain points than bondholders. For example, institutional term loans for non-rated borrowers with EBITDA of $30 million to $45 million are commonplace, although they attract a smaller set of potential buyers than liquid, rated term loans. Public filings are not required; quarterly financial and covenant reporting requirements are similar to asset-based loans.

To create value for bondholders or term loan holders, many asset-based borrowers are able to carve out fixed assets or real estate to secure the high yield or TLB. Leveraged term loan holders nearly always require a security interest and prefer the bifurcated security package described above. Additionally, bondholders and term loan holders often take a second lien on the collateral securing the asset-based facility. Depending on leverage and enterprise value, bondholders are willing to go unsecured if they perceive they are “covered” by the value of the company and are appropriately rewarded for the risk they’re taking.

ABFJ: What are major advantages to issuers of these structures?

DK: The distinct structural advantage of an ABL/HY capital structure is the lack of amortization and maintenance financial covenants. This is also generally the case for ABL deals paired with covenant-lite term loans. Syndicated asset-based deals typically only require a borrower to meet financial covenants if they fall below a minimum availability threshold. Although covenant thresholds have come under pressure in recent months, most new deals are structured such that covenants are not tested unless a borrower’s excess availability falls below 10% to 15% of the revolver amount (or another liquidity measure). High-yield covenant packages typically include only an incurrence-based leverage and/or fixed charge coverage test.

ABFJ: How do asset-based borrowers decide whether to pursue an ABL/HY structure versus an ABL/TLB structure?

DK: There are several structural differences between a high-yield bond and an institutional term loan that will influence a borrower’s decision-making process. High yield is generally longer term money (typically seven to ten years) paying a fixed rate on a semi-annual basis. Broadly syndicated term loans are floating rate debt with interest paid quarterly over a five- to seven-year tenor.

Given the longer tenor and often lower ranking in the capital structure, high-yield bonds typically pay a higher rate, even when swap-adjusted to a floating rate basis. Initial issuance costs, including legal, accounting and underwriting fees, are also higher for high-yield bonds than term loans. These bonds nearly always have a non-call period of three to five years, followed by a period during which call premiums step down annually. Conversely, very few term loans include non-call provisions and most recent deals include only one year of minimal prepayment penalties.

Despite higher initial and ongoing costs for high yield, these bonds can provide substantially greater flexibility than terms loans given the lack of amortization and maintenance covenants described above, less restrictive baskets for distributions and investments, equity clawback provisions and optional PIK interest periods for certain issuers. However, one of the long-term keys to success for issuers tapping the high-yield market is negotiating a thoughtful indenture, which contemplates the borrower’s likely financial and operational evolution; a high-yield indenture may be more flexible than an institutional loan agreement, but is much more difficult and expensive to amend post closing.

ABFJ: Are there timing differences for issuing a high-yield bond versus an institutional term loan?

DK: High-yield bonds are issued either as registered securities or as 144A private placements, with the latter method representing the vast majority of high-yield issuance. The 144A timeline from engagement to issuance is typically seven to eight weeks, consistent with the timeline for an institutional term loan. Timing from start to finish on a registered high-yield bond can run substantially longer and is dependent on SEC interactions. Most 144A issuers ultimately register their bonds with the SEC, although certain issuers choose to go “144A for life” in order to avoid filing public statements (note that this option impacts pricing and execution).

Market timing (or gauging market conditions to determine optimal launch date) is typically associated more frequently with the high-yield market than with the institutional loan market. Although both markets are impacted by equity market sentiment, corporate earnings and economic indicators, the high-yield market tends to react more quickly and with more volatility than the loan market.

ABFJ: Are there any special considerations for a privately held issuer versus a publicly held issuer?

DK: Regardless of whether a borrower is tapping the high-yield or term loan market, the business, legal, and accounting due diligence process (and related management time commitment) is typically much more intensive for private companies than for companies that are public filers. Post-closing, private companies that become public filers incur increased legal and accounting costs and must also consider the competitive implications of publicly disclosing their financial statements and other quantitative and qualitative information about their business.

ABFJ: Are there synergies gained by simultaneous issuance?

DK: Definitely. The most notable is cost for the asset-based facility, which can often be minimized if asset-based arrangers and lenders are rewarded with underwriting economics across the capital structure. Running a concurrent process also creates efficiencies on marketing materials, legal documentation and diligence processes. For an ABL/TLB execution, management can limit travel by conducting a single investor meeting for both sets of lenders.

ABFJ: How do issuers manage the need to reward multiple banks and investment banks?

DK: Asset-based lending is a relationship-based business for lead banks. The most active lead arrangers of asset-based loans are also top tier players in high-yield and leveraged loans and expect their clients to utilize their capital and expertise across markets. Concurrent issuances present an opportunity for borrowers to both reward their top banks and investment banks financially via a larger fee pot than would be created for a standalone issuance and to divide up lead roles across products. It also creates an environment where capital is as much a part of the equation as distribution capabilities. While banks and investment banks will consider each role and economic offer on a particular product (ABL versus TLB versus HY) as a distinct decision point, each institution considers the sum of their roles to be an indication of their standing within the borrower’s stable of lenders and advisors. There is no formula for how borrowers make the decision on how to award roles and economics; it’s a balancing act that takes into consideration balance sheet strength, credit appetite, reputation and product expertise.

ABFJ: What are current market conditions for high-yield and leveraged loans and what’s the forecast for post-Labor Day activity?

DK: Given the recent U.S. debt ratings downgrade and broad-based volatility across the global capital markets, it’s difficult to predict fall activity as we sit here in early August. The high-yield market has likely gone on its annual August hiatus much earlier than usual and the institutional loan market is suffering through a substantial pull-back. Continued volatility across capital markets will undoubtedly limit many asset-based borrowers’ ability to fully lever or refinance their capital stack over the remainder of 2011. But, we’re also hopeful that we’ll see windows of opportunity in the high-yield and term loan markets post Labor Day.

Regardless of conditions in the high-yield and institutional loan markets, we expect that lender appetite for asset-based loans (especially new money loans) will remain strong through the second half of the year unless global markets and the economic outlook weaken substantially from current levels.

Dorothy M. Killeen is a managing director in Wells Fargo Capital Finance’s Loan Sales & Syndications group. She has primary responsibility for developing syndication strategies, distributing syndicated loans and managing investor relationships.

Wells Fargo Capital Finance is the trade name for certain asset-based lending, accounts receivable and purchase order finance services, and channel finance services of Wells Fargo & Company and its subsidiaries.

The opinions expressed in this document are general in nature and not intended to provide specific advice or recommendations for any individual or association. Contact your banker, attorney, accountant or tax advisor with regard to your individual situation. The opinions of the author do not necessarily reflect those of Wells Fargo Capital Finance or any other Wells Fargo entity.