November/December 2012

Looking Back to Move Forward: The Syndicated Loan Market — Yesterday and Today

In an effort to provide an end-of-the-year update on the syndicated loan market, Trimingham’s Hugh Larrett-Smith discusses the sector both here and abroad with leading lenders. He also offers an historical perspective detailing the success of Bernard Baruch and how syndicated loans have thrived throughout the centuries.

Bernard Baruch is not as well known as other loan and stock syndicators such as J.P. Morgan, William Whitney, Anthony Drexel or George Fisher Baker on Wall Street and William Crocker in San Francisco. However, his success as a loan and stock syndicator and investment banker to clients such as the Guggenheims was underscored by his private Pullman railroad car, his 32-room mansion on Fifth Avenue, his Scottish castle and his estate in South Carolina. His first major investment gain on Wall Street was American Sugar, in which his $300 investment netted an astonishing $60,000 gain.

In 1894, The Wall Street Journal had deemed only two industrial stocks important enough to include in its 12 stock average: American Sugar and Western Union. At the turn of the century, financial reporting was spotty. American Sugar, one of the most actively traded stocks of the 1890s and the one in which Baruch made millions, disclosed nothing about its profits until 1909. The annual report of the United States Leather Company in 1900 consisted of a single sheet of paper.

“As a general thing,” complained The Wall Street Journal about financial disclosure in syndicated finance in 1899, “very few figures are published, and those figures are usually in such a form that it is impossible to canvass the integrity of net earnings. In fact, the figures necessary for this process are the very figures most jealously guarded from competitors. In 95 cases out of 100, the stockholder in an industrial company is obliged to take the word of the managers — for all that that implies — for the company’s net earnings.”

In those days, loan and stock syndications were conceived and structured over cigars and brandy at New York clubs like The Metropolitan Club and The Knickerbocker Club, and at The Union Pacific Club in San Francisco. Financial information as we know it today could be as ethereal as the cigar smoke.

Fast forward to today — the success of syndications is measured on trading floors and via computer networks that operate at the speed of light and provide a dizzying amount of accurate and timely information.

For the past 18 months, the capital markets have been awash with liquidity and financing activity, as evidenced by the record $101 billion of ABL syndicated loans that were inked in 2011, totaling 394 facilities. Between Q1/12 and Q3/12, $57 billion in ABL syndicated loans cleared the market, totaling 242 facilities, Thomson Reuters LPC reported. The marketplace has been poker hot, with lots of re-pricings and refinancings. Indeed, refinancings accounted for 82% of syndicated ABL deals in 2011, and 78% in 2012, according to Thomson Reuters LPC.

One reason for the rebound in volume in the past five years is that CDOs and CLOs are back after an absence of many years, which has created a huge demand for syndicated debt. The year was the biggest CLO issuance year since 2008.

Britt Canady, head of Middle Market and ABL Leveraged Finance group head, Bank of America Merrill Lynch commented on the current state of the market: “ABL lenders are wondering where the deal flow will come from. Outstanding commitments are roughly $205 billion and the ABL market has closed approximately $158 billion since the beginning of 2011. We expect volume driven by maturities to be light until 2015.”

Ben Chu, vice president, Loan Syndications, ABL Group, Union Bank added: “Market liquidity is as robust as ever, with new competitors having entered the ABL market and most existing lenders expanding their presence and ABL books. At the same time, ABL volume has been trimmed down in 2012, with the refinancings of the once formidable ‘maturity wall’ having been done over the past year and a half. All these factors together have created a borrower-friendly environment in which pricing and fees on conforming ABLs have fallen to the bottom of the range. As a result, most bank-affiliated ABL lenders are looking toward ancillary business, from capital markets to treasury management services, to help boost yields and meet internal return hurdles.”

In Q1/09, the average drawn pro-rata spreads on ABL loans was 432 basis points; in Q3/12, it was 227 basis points, according to Thomson Reuters LPC.

Canady noted: “Pricing has been relatively stable for the last five to six quarters.  Although average spreads fell by roughly 136 basis points in the five quarters through June 2011, they’ve only fallen 13 basis points in the five quarters to September 2012.  Lenders seem to be taking a longer term view of capital deployment and profitability, given the phase-in of Basel III over the coming years.  Lenders continue to be disciplined around structure, but seem to be getting more aggressive around hold levels and arrangement fees.”

Barry Bobrow, managing director, Wells Fargo Securities LLC, commented: “I think banks have been quite disciplined when it comes to pricing. In the last 18 months, pricing has been quite stable, and seems to have settled in at levels slightly higher than we saw in 2007/2008.”

Jeffrey Wacker, director, Syndicated and Leverage Finance, TD Securities USA added, “ABL has become much more common in usage, especially on larger sub-investment grade financings.  If you have the assets to pledge to an ABL structure, the pricing can be significantly cheaper than a cash-flow equivalent structure. Those savings are appealing, especially on more leveraged or lower-rated credits. Pricing in the ABL market has been incredibly stable over the last four to five quarters, while cash flow pricing has moved through more of a range, so capital market conditions at the time of issuance have less bearing on issuers who choose to use ABL.”

Chu said,“Over the past few years, the ABL loan product has become much more mainstream and accepted by corporations. The HollyFrontier $1 billion ABL transaction in 2011 is an example of a new industry segment and a strong credit profile company that switched to an ABL structure to reap the benefits of what ABL has to offer. ABL is no longer used only as a ‘loan of last resort’ and now viewed as an attractive alternative to conventional loan products.” Union Bank was joint lead arranger, administrative agent and collateral agent on this syndicated energy financing.

“Syndicates on larger deals are also characterized by larger lender holds, partly owing to numerous bank mergers in the last three years, which has resulted in bigger commitments by a number of bulked-up lenders,” noted Wacker.

Bankers will compete aggressively to be “left lead” on a syndicated financing. The left lead on paperwork on the deal generally gets more say in shaping the deal and some additional access to the company, not to mention bragging rights for getting tapped. Many large deals have multiple Agent banks to spread the business around. “In many instances, an ABL lender needs to fend off cash-flow/mezzanine and unitranche structures,” commented John DePledge, SVP and head of Business Development – TD Bank, Asset Based Lending.

Bobrow stated, “In today’s syndicated ABL marketplace, two types of deals that can be challenging to syndicate are turnarounds and transactions with low/no utilization. It is very difficult to clear market at any price with a transaction that the market feels may not be a pass credit with the OCC due to its trailing cash flows. Likewise, low/no utilization deals can be very challenging to syndicate, because despite their eagerness to book loans, banks don’t want capital tied up in a deal where there are no borrowings. Typically, the only participants you can find for this type of deal are existing relationship lenders and investment banks who are participating in the company’s capital markets business.”

Borrowers have a natural inclination to keep lenders at arms’ length wherever possible. Capitalizing on the poker-hot marketplace, investment banks have structured many new deals for their clients with weaker lender consent rights such as limits on acquisitions, asset dispositions and the sale of subsidiaries.

Another sign of the times: debt issued to fund private-equity dividends has topped $54 billion this year, according to Standard & Poor’s Capital Q1 LCD. That tops the record $40.5 billion funded in 2010, when credit markets reopened after the crisis. Six companies have sold PIK-toggle bonds to pay private-equity dividends in September and October 2012, double the number sold in the previous 14 months, according to The Wall Street Journal.

Another driver of the trend is to do dividend recaps before the potential Fiscal Cliff. In a recent deal, Leonard Green and CVC Capital Partners recouped 100% of the cash investment in a $2.8 billion buyout of BJ’s Wholesale Club Inc. a year ago. BJ’s sold debt last month to help pay a $643 million dividend to the owners.

As a driver of syndicated ABL finance, M&A has been a disappointment. Indeed, in the Q1/12 to Q3/12 period, only 8% of syndicated ABL loans were used to finance M&A, according to Thomson Reuters LPC. Chu commented, “The M&A surge that everyone hoped for in 2012 has yet to materialize as private equity firms find themselves in the same boat as corporate leaders, dealing with the uncertainty and finding investment returns that make sense for their investors. Until these layers of uncertainty begin to be removed, it remains unclear where loan activity will come from in the foreseeable future.”

The European syndicated loan marketplace is challenging for U.S. banks, given the turmoil in the euro-zone. (The most useful credit-analysis tool for international syndicators these days is a very simple one: a map. Northern European borrowers are increasingly able to lock in extremely cheap financing — including at negative real rates — while southern companies in Greece, Spain and Italy are left out in the cold.)

Bobrow noted of European syndications: “Most U.S. banks are not set up to lend directly there, and can only participate in transactions where the European loan is part of a larger U.S.-based loan package. In addition, British and other European-based banks are not eager to let an American bank take left lead position on a syndication for a good British or European corporate borrower.”

Two international syndicated deals that were right across home plate for U.S. banks this year were MRC Global and the $1.2 billion Algeco Scotsman deal due 2017. Both deals had an attractive balance of U.S. domestic borrowings coupled with multi-currency tranches in other countries. The Algeco Scotsman deal was oversubscribed.

In addressing the Asian ABL marketplace, Bobrow said: “As for Asia, legal impediments and the dominance of China’s big state owned banks have made the growth areas of Asia a tough nut to crack for U.S. banks. There is plenty of traditional trade finance business in Asia for American lenders, but the syndicated ABL marketplace is not as robust as you might expect given the level of economic activity.”

With today’s market information technology in the loan syndication and other money markets, the loan and stock syndicators of yesteryear like Baruch wouldn’t have been able to capitalize on opaque financial information, market imperfections and the arbitrage opportunities that were so profitable.

In 1905, with his earnings from loan and stock syndications, and adroit investing, Baruch bought a yellow Mercedes for the then astronomical sum of $22,000 (in 1909, the Model T cost $850). He clocked the unheard of speed of 60 miles per hour in a race against an American car driven by Standard Oil heir, A.C. Bostwick. As is the case today, many loan and stock syndicators had a passion for cars. In 1929, one of Baruch’s banking contemporaries on Wall Street and the founder of what is now Citibank, George Fisher Baker, commissioned the construction of a one-of-a-kind Pierce-Arrow town car for the wedding of his daughter. The car’s uniquely high roof line (5″ taller than standard models) was specifically requested by Baker, who wished to wear his top hat while riding in the car.

In 1958, The School of Business at The City University of New York was renamed The Baruch School, in honor of its alumnus, “The Man Who Sold Out Before the 1929 Crash.”

A Brief History of Syndication

Syndicated finance had some of its roots in the coffee shops in Amsterdam and London in the 1600s and 1700s, where individual investors formed syndicates to finance sailing ships and the spice trade. In the 1630s, syndicates were even formed to finance individual purchases of tulip bulbs in the Dutch Tulip Bubble. As well, during this time, lending syndicates financed various European wars (tough to assign risk ratings to loans like that!).

Syndication became more widespread and commonplace with the founding of the insurance syndicates at Lloyds of London, in which insurance risks were syndicated to individual investors, known as “names.” Under these insurance policies, names had unlimited financial liability. The disclosure of financial information to names about the risks of the insurance policies was often verbal, ad-hoc and spotty. (In the 1980s, Lloyds’ reputation was pole-axed when it was learned that the many of the riskiest policies were specifically syndicated to new U.S. and Canadian names, which suffered devastating losses).

During the first railroad boom in the U.S. from 1830 to 1860, syndicated loans and bond issues were a critical component in the capital structure of railroads. (Indeed, by 1860, the United States had more miles of railroad than the rest of the world combined, which was, in no small part, due to sophisticated syndicated financing).

In the 20th century, financial disclosure increased lockstep with the rapid evolution of the syndicated debt markets for bonds and short term debt obligations such as U.S. Treasuries, UK Gilts and commercial paper.

Taking a page from the history books, U.S. banks began to finance ships in the 1960s with syndicated club loans in London. Syndicated loans became quite common in project finance banking in the late 1970s, in which the project was financed by loans that had limited recourse to the project sponsor. The concept of “recycling OPEC petrodollars” in the 1970s led to the growth of the sovereign syndicated loan marketplace (OPEC countries deposited money at banks, who then lent to money to sovereign nations which were facing liquidity pressure due to the energy price shock!)

During the 1970s, to the extent that a U.S. bank customer’s borrowings were too large for one lender, “syndicates” would be formed, but these were really club deals where one lender would lead the deal and either the lender or the borrower would invite participants to join.  Forming these clubs was always a “best efforts” undertaking — no bank was taking the risk of fully underwriting deals with a view to future sell-down and syndication. Major impediments to syndication in many banks were the corporate bankers that fought tooth and nail to make loans, and jealously guarded their corporate banking relationships — “why share the loans with our competition? (A similar anguished cry can be heard today when an incumbent agent bank is faced with the prospect of losing the agent position in a refinancing!)

A key timeline in the evolution of the syndicated market in the early 1980s was when banks had to reach out on the risk curve for greater yield. Many banks found themselves being replaced with commercial paper and the junk bonds. At the same time, banks began taking a greater role in financing leveraged buyouts. This ushered in the concept of higher-risk term lending, with the term loan being a meaningful piece of a higher risk capital structure with its repayment dependent upon borrower performance. In some LBOs, the repayment mechanisms were similar to limited recourse project financings. Bigger deals with more aggressive risk profiles required syndication to spread the increased risk.

The meltdown of the Latin America syndicated loan in the early 1980s prompted loan trading for distressed syndicated loans. The secondary market for syndicated loans was born. An important driver in loan trading, as it was then called, was rapidly improving information technology in the markets, including the growth of companies such as Bloomberg and Thomson Reuters.

The next big development in syndication occurred in the 1980s, when the lead or agent banks fully underwrote deals, and subsequently sold down. Many of us can remember underwriting lenders getting stuck with large unsold positions when they were overly aggressive and/or when market conditions changed. One or more underwriting lenders owned the deal on whatever terms they had bargained for, and sought to bring in others. If you bought in, you had voting rights, but it was a much less democratic structure than the old club deals where like-minded, carefully — selected lenders tried to reach consensus on everything. In the more “pure–form” syndicated deals, one left lead lender owned the deal and really drove the bus. Others voted their percentage, but often times got dragged along for the ride. This evolution was also a contributor to the emergence of the secondary loan trading market, as dissenting lenders sought a way out of positions that they no longer wanted.

In the late 1990s, the accelerated evolution of the syndicated loan marketplace was driven, in part, by the death of the Glass Steagall Act in 1999 which triggered the blurring of investment banks and commercial banks, and the relaxation of many pension investment rules. The emergence of the CLO marketplace in the early 2000s provided significant jet-fuel for the recent growth of the syndicated loan marketplace.

Hugh Larratt-Smith is a managing director at Trimingham Inc., a financial advisory and restructuring firm, and a regular contributor of the ABF Journal. He is on the board of directors of the Commercial Finance Association Education Foundation.