January/February 2012

Tales From a Gilded Age — Are We in a New Bubble?

Hugh Larratt-Smith wonders: How did pricing get back to pre-crisis bubble levels so quickly? In the following article, he draws a parallel between the maneuverings of financier Jay Gould during the gilded age of U.S. industry and commerce and the realities of today’s lending environment.

Lyndhurst, known as The Jay Gould Estate, is a magnificent Gothic Revival mansion overlooking the Hudson River, just south of the Tappan Zee Bridge. Its four-story Gothic tower and castle-like turrets loom over the 65-acre garden of the estate. The mansion’s glass and steel conservatory is 400 feet long and was the first in the United States. Along with The Breakers and other mansions in Newport and the Hudson River Valley, Lyndhurst became a symbol of the Gilded Age of finance and industry. It was a home that any modern day hedge fund manager in Greenwich would envy today.

In 1869, Gould created a price bubble in gold when he attempted to corner the U.S. gold market. The two-week frenzy on the gold market virtually halted the country’s foreign trade, which relied on gold as the medium of exchange, and threatened to broaden into an economic panic.

Fast forward to January 2012:

  • A clothing retailer that sold products targeting customers 55 and older, borrowed extensively against pro-forma EBITDA in 2009-2010. When this pro-forma EBITDA failed to materialize, the company filed Chapter 11 in 2011 with $725 million in funded debt. The bankruptcy plan eliminated $400 million of this debt. One cash-flow lender that had $463 million in first and second lien debt had to mark its debt down to $89 million, and take some equity;
  • A trucking company, which is three months into its turnaround, borrowed $35 million in a borrowing base — lite structure at LIBOR+2.5% for two years from a commercial bank;
  • ZYNGA, a producer of online games including Farmville where players buy digital tractors and other virtual products, has delayed its IPO due to accounting treatment issues (whoops). Its targeted $9 billion valuation is 18 times its 2010 revenues;
  • Groupon, a two-year-old company with minimal proprietary technology and limited barriers to competition, raised $950 million in January 2011, of which $810 million went straight into the founders’ and early investors’ pockets. Groupon’s share price has been up and down like a toilet seat, dropping 30% off its November IPO price, and has become a target for shortsellers;
  • Most industry players would say that the pricing in the ABL and cash-flow marketplace is back to pre-crisis bubble levels. When it comes to structure, many players will say that a bubble seemed to be forming in early 2011, but caution has resurfaced.

How did pricing get back to pre-crisis bubble levels so quickly?

The rebound in the junk bond market in 2009-2010 spurred the unprecedented liquidity and yield compression in the large buyout marketplace. The payout obligations of many large pension funds were built on the assumption of 8% annual yield in perpetuity. The financial crisis and ensuing low interest rate environment has forced a reevaluation of this expectation. Searching for yield in 2009-2010, many pension funds turned to the junk bond and leveraged loan marketplace.

Historically, asset-based lending has always led the U.S. out of an economic downtown, followed by cash-flow loans. However, due to the liquidity provided by the junk bond market, cash-flow loans surged in volume in 2010, much to the surprise of many industry veterans. At the end of 2009, $404 billion of leveraged loans were set to come due between 2012 and 2014, according to the LCD team at Standard & Poor’s Capital IQ. Many industry observers were predicting a credit crunch. Now, the burden is under $150 billion as firms have paid off debt and refinanced with bonds or cash-flow loans.

The initial post-recession growth in asset-based lending is typically triggered by several factors. Firstly, “collateral-good” deals are highly coveted because of the downside protection. Secondly, recessions create many fallen angels, which asset-based lenders like — “broken wing” companies with understandable and fixable problems. Companies dying from 1,000 cuts don’t typically survive recessions, although some will argue that the low interest rate environment today has allowed many companies’ managements to “kick the can down the road.”

In the 2002-2003 economic recovery, asset-based lending exploded overnight — from a situation where nobody was lending much to anyone, deal flow increased exponentially. Spreads on ABL credits swiftly declined from LIBOR+5% to LIBOR+2% in many deals.

One ABL president at a major bank recently expressed surprise at how quickly the market has been willing to give up the pricing disciplines of 2008. Today, pricing pressure is so intense that the occasional deal is getting done at LIBOR+1. With many borrowers, LIBOR floors are ancient history.

The downward pressure on pricing is largely a function of the lack of new activity with borrowers that substantially utilize their loan facilities. With utilization rates in the low 40%, asset-based lenders are jumping on deals that offer good utilization. Borrowers that offer good utilization are getting unitranche deals done, which require less documentation.

One of the reasons that the volume and pricing of dividend recaps have rebounded so quickly from the financial crisis is that these loans offer significant utilization. For example, one middle-market issuer, NewWave Communications, recently closed a $134 million dividend recap deal that was sold to banks. The deal included a $34 million revolving credit facility and a $100 million term loan A priced at LIBOR+4% with a 50 basis point front-end fee. The deal provided a recapitalization, paid a dividend to shareholders and repaid existing debt, some of which had been in the form of an institutional term loan B. Had the issuer gone out to institutional investors, it would have likely paid a higher spread to execute a dividend deal.

Buyout financing can hold the promise of high utilization: 62% of debt was used in buyouts in 2011, compared with 56% in 2010 in LBOs in the $250 million to $1 billion range, according to Pitchbook. Total debt in deals is also increasing. According to Pitchbook, total debt was 5.29 times EBITDA in Q3/11 compared with 3.81 times EBITDA in 2009. The peak of the market in 2007 was 6.07 times EBITDA.

Without enough paper to absorb the liquidity, spreads on deals have been pushed down as banks, which are swimming in deposits, vie for relationship deals, ancillary business and increased market share. The majority of deals in the past 12 months have been refinancing, and typically the pricing goes down, not up.

The attractive spreads available to borrowers from lenders (particularly regional commercial banks with turf to protect) is causing some companies to tap the bank market to refinance debt or raise new money instead of opting for more expensive institutional tranches. In the current market, one of the big takeaways is the spate of deals where borrowers are refinancing out of the term loan B deals in the institutional marketplace into term loan A bank deals. For example, a BB profile borrower can currently refinance a term loan B priced in the LIBOR+4.5% range with a 1.50% floor into a term loan A at LIBOR+2.5% -3% with no LIBOR floor, with a front-end fee of less than 1%. Recently, Newport Corporation raised a $185 million term loan A for acquisition financing. The deal was sizeable enough to have been executed in the institutional market, but the issuer opted for a bank deal.

Bank ABL players are by far the biggest in the marketplace. With their low cost of funds and ability to cross-sell, they compete comfortably in the lower priced deals. Banks are also willing to increase hold sizes, in some cases committing as much as two times what other lenders are willing to hold, further grabbing market share. However, while some banks are more willing to decrease pricing or increase hold sizes, banking sources say they are less willing to give up on structure. Asset-based lending has become a product in some banks that also have investment banking arms. In some larger multi-tranche deals, the investment bankers will be tempted to push aggressive ABL pricing down the throats of their ABL brethren in order to please the client.

This year, term loan A volume has grown significantly as a share of middle-market sponsored issuance. In Q3/11, term loan A deals made up approximately 42% of sponsored deals compared to just 17% in Q1/11. In contrast, institutional volume as a percentage of sponsored issuance has fallen by roughly half over the same period. In Q3/11, middle-market institutional deals made up 30% of sponsored issuance versus nearly 60% in 1Q 2011.

An additional driver of the relaxation of pricing and terms in the sponsor finance marketplace is that 50% of deals in 2011 were add-ons, up from 44% in 2009. Add-on financings are a much easier sell to bankers’ credit committees.

At a recent financing conference in New York, one panelist remarked that it’s not a smooth curve between bank-only deals and hybrid deals. I think what he meant was that it may be easy to go from a term loan B deal to a term loan A deal, but not the other way around.

One subtle element in the ABL pricing wars is that for lenders, the decrease in spreads may not fully impact their P&Ls for two to three years, so the full effect of low pricing is not immediately felt. With the current low interest rates, giving up 100 basis points due to refinancing pressure can have a big impact on the profitability of a loan.

As we all know, pricing is a function of risk. In June 2007, the expected default rate on leveraged loans fell to an all-time low of 0.15%. This expected default rate climbed to 10.8% in November 2009. Today, the expected default rate is near its all-time low, hitting 0.17% in November 2011, according to the LCD team at Standard & Poor’s Capital IQ. With the headlines dominated by news of China’s slowdown, continued European problems, Washington gridlock and insolvent state and municipal pension plans, the expected default rate may appear optimistic. Not so long ago, the phrase “Greek and Italian ruins” brought to mind travel plans, rather than the health of the Greek and Italian banks today.

Many lenders would concur that there is a bubble in pricing, but don’t think there’s a bubble with respect to structure. For starters, lenders are pulling back from lending against pro-forma EBITDA. In Q1/11 and Q2/11, many deals got done earlier with pro-forma EBITDA. Today, pro-forma EBITDA is the proverbial third rail in a deal. The growth outlook for the economy is too uncertain to lend against significant growth. As an underwriter in a deal, underwriting too much hockey stick growth can put you in the penalty box.

Deal sponsors and their advisors need to be careful about passing the threshold of EBITDA adjustments, or people will put the book down. Many EBITDA adjustments fall into a gray area that is widely open to interpretation. In a hot market, lenders will accept many EBITDA adjustments that would cause heartburn for a credit committee in challenging economic times like this.

For lenders that are prepared to lend against pro-forma EBITDA and adjustments to EBITDA, they are using a discount factor of 20% to 25% in stress tests on base cases, as opposed to 5% in the pre-crisis days.

Springing cash dominions have returned, which has irked many credit committees. A new wrinkle in cash dominion is the emergence of electronic deposits, which can be a challenge for lenders.

In the lower middle market, some asset-based lenders are being asked to do “stretch” deals, often 20% to 30% above the collateral values. The immediate response is to bring in some mezzanine or “B” lenders.

“There has been an uptick in use of the unitranche product, which allows a borrower to avoid the time and incremental cost of negotiating loan documentation for separate senior and mezzanine credit facilities,” according to Leonard Lee Podair at Hahn & Hessen in New York. “Borrowers and equity sponsors also like this structure because they can deal directly with one agent, although that agent is usually bound by an extensively negotiated intra-lender agreement similar to an intercreditor agreement. The increased popularity of the unitranche product has presented an opportunity for lenders that normally slot into the lower levels of the capital structure, whereby they win the agency by underwriting the ‘B’ piece of the unitranche facility and then bring in more traditional senior lenders to do the ‘A’ piece.”

Many lenders view 2012 as a continuation of the challenges of 2011. Each year, lenders are confronted with budgets in their organizations that call for growth in loan volume and revenue. However, many are predicting lower volumes in 2012. With the amount of liquidity in the banks, it would appear that the tight pricing is here to stay.

M&A activity in 2011 started quite robustly, only to peter out by Q4/11. There are several reasons for this. The M&A marketplace in 2011 was the Tale of Two Markets with Corporate America sitting on $2.1 trillion in cash at the end of September 2011, and institutional investors sitting on $466 billion of dry powder. If it’s a good company, there will be many strategics bidding that may bid 1 times EBITDA more than financial bidders. This contingent is putting a floor under the prices of good companies. On the other hand, numerous buyout funds are nearing the end of the runway: their funds expire in 12 to 18 months, so they want to get funds deployed and are willing to pay up for transactions, even at lower leverage levels than in the past. However, financials are getting outgunned by strategics when they see a target they want.

Deals are taking a long time to close, often 90 to 120 days. As a result, often the market conditions have changed by the time the deal closes. Sometimes the buyer or seller tries to change the price at 80 days, causing the deal to crater. Industry observers say that if we can get two months of market stability, we’ll see many more M&A deals come to the market.

Buyers want to stay away from industries that are experiencing paradigm shifts like advertising, media and companies affected by China that may target their industry as a strategic investment area. China recently announced strategic investments domestically totaling $1.2 trillion, targeting sectors that they intend to dominate.

For lenders there is some cause for optimism:

  • A survey by TD Bank in December 2011 revealed that middle-market CFOs are prepared to increase capital expenditures by dipping into their stockpile of cash reserves. According to the survey, half (51%) expecting to increase their capital expenditures in 2012, up from 39% last year.
  • The median buyout size was three times higher in 2011 than in 2009. The median capital invested per U.S. buyout was $122 million in 2011 versus $40 million in 2009.

As a “hardball” lender and investor focused on hard assets, Gould probably would not have been a big fan of pro-forma EBITDA or sympathetic to EBITDA adjustments. In 1882, Gould gained control of the Union Pacific Railroad and the Missouri Pacific Railroad, eventually commandeering 15% of the railroad track in America. He zeroed in on the fulcrum debt securities of struggling railroads and gained control through a combination of bankruptcy tactics, metering in cash at opportune times and “stock-watering” ( stock watering was a term borrowed from the cattle trading industry where cattle drank water before weighing).

During these epic corporate battles, Gould crossed swords with giants like Cornelius “The Commodore” Vanderbilt and Leland Stanford. Some historians dismiss Gould as a robber baron who was a brazen Wall Street stock and gold manipulator. Others characterize him as a highly disciplined investor who memorized every operating detail of his railroads, and simply an actor on the stage during the Gilded Age of American history where the corporate finance laws were far and few between.

For the record, Gould’s fortune was $72 million in 1892, which was 1/2% of America’s GDP at the time. Lyndhurst, once a symbol of swashbuckling finance, is now governed by The National Trust for Historic Preservation.

Hugh C. Larratt-Smith is a managing director at Trimingham Inc., a turnaround and restructuring firm with its head office in New York. He is on the board of directors of The Commercial Finance Association Education Foundation.