J Applied Corp Finance - 2005 - Barnish - THE NEW LEVERAGED LOAN SYNDICATION MARKET

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Journal of Applied Corporate Finance
10 . 1
V O L U M E
The New Leveraged Loan Syndication Market
Portfolio Management Data, LLC, and

BancAmerica Securities, Inc.,
BancAmerica Securities, Inc.

Michael Rushmore,
by Keith Barnish,
Steve Miller,
19 9 7
S P R I N G
17456622, 1997, 1, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/j.1745-6622.1997.tb00128.x by Universidad Publica De Navarra, Wiley Online Library on [15/11/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
THE NEW LEVERAGED by Keith Barnish,
BancAmerica Securities, Inc.,
LOAN SYNDICATION Steve Miller,
MARKET Portfolio Management Data, LLC, and
Michael Rushmore,
BancAmerica Securities, Inc.
ver the past ten years, commercial

O lending has undergone a startling trans-
formation. Traditionally a one-off, bilateral “market”
in which issuers maintained one or more separate
banking relationships, the bank loan market has
recently come to operate more like a capital market
in which one or more underwriters structure and
price loans for syndication to groups of investors.
This market-driven evolution has been most dra-
matic in the leveraged lending segment (defined as
loans priced at LIBOR plus 150 basis points or more),
where wide margins have attracted a large and
growing field of underwriters, intermediaries, and
investors. In this article we discuss how financial
sponsors, issuers, and investors are benefiting from
the loan market’s rapid evolution.
79
BANK OF AMERICA
JOURNAL OF
JOURNAL
APPLIEDOF
CORPORATE
APPLIED CORPORATE
FINANCE FINANCE
OVERVIEW equity contributions to leveraged buyouts averaged
nearly 23% in 1996, as compared to the single-digit
Liquidity is the overriding theme in today’s levels of the late 1980s.
syndicated loan market. Commercial banks are flush
with cash and investing heavily in the loan market. THE EVOLUTION OF THE LEVERAGED
At the same time, institutional investors and bulge- LOAN MARKET
bracket investment banks are stepping up their
market profile significantly. This increased liquidity Syndication has been a prominent feature of the
has been a boon for financial sponsors and issuers, commercial loan market for decades. Large banks
enabling them to: began “participating out” credit risk to correspon-
Reduce interest costs by arranging bank financing dent banks as far back as the early 1970s. It was not
at attractive rates, or refinancing bank loans at lower until the mid-1980s, however, that the syndicated
spreads and fees; loan market emerged as a vehicle to finance large
Extend tenors; leveraged buyouts. The market was pioneered by a
Enhance shareholder value by financing spinoffs, small group of money center banks. These banks set
acquisitions, and other strategic transactions; up loan distribution desks that arranged, underwrote,
Sell non-core assets to strategic or financial buyers and sold pieces of large loans to syndicates of banks.
backed by syndicated loans; The loan distribution process allowed lead banks to
Finance developing technologies such as per- reduce their exposure to credits while keeping the
sonal communications systems (PCS) and satellite lion’s share of structuring and underwriting fees, and
systems; and skimming a portion of the credit spread.
Restructure and recapitalize their balance sheets. In the 1980s, foreign banks—led by Japanese
For investors, reduced loan pricing and more institutions—were far and away the largest market
flexible credit structures have been balanced by for these loans. Foreign banks were using syndicated
much greater access to a large volume of diversified loans to expand their lending activity in the United
assets, as well as the ability to manage asset-specific States and to gain access to client relationships that
and portfolio risk more effectively. In addition, the domestic commercial banks had developed over the
active participation of investors in the syndicated preceding decades.1 Syndicators also began to estab-
loan market has the benefit of reducing asset origi- lish relationships with insurance companies and
nation and management expenses. mutual funds to build a more stable and liquid inves-
In the investment grade market, excess bank tor base for leveraged loans. And, by 1988, a handful
liquidity has caused credit spreads and fees to nar- of these institutional investors had entered the lever-
row significantly, thus reducing expected risk-ad- aged loan market. Institutional investors were attracted
justed returns. In the leveraged market, by contrast, by a unique risk/return opportunity; loans provided
although pricing has fallen somewhat, the compres- wide margins, a stable return due to the floating in-
sion of spreads has been much less dramatic. Credit terest rate, and considerable protection from princi-
structures, to be sure, have come under pressure in pal loss in the form of covenants and security.
recent years as the purchase price multiples paid by By the late 1980s, the syndicated loan market,
buyout firms in leveraged transactions have increased. along with the high-yield bond market, had be-
But it is important to keep in mind that, while come an important source of financing for equity
acquisition price multiples in leveraged deals have sponsors. These markets supported a staggering
risen to levels that recall those of the late 1980s, the volume of leveraged loans and Highly Leveraged
credit structures in today’s transactions are more Transactions (HLTs), such as leveraged buyouts,
conservative. In general, the additional capital that recapitalizations and acquisitions, where loans were
has been required to fund the higher multiples has priced at LIBOR plus 250 basis points or more. The
been provided through a combination of debt and syndicated loan process was quickly translated from
equity. The most telling statistic: Financial sponsors’ the leveraged market to the investment grade mar-
1. For an account of the leveraged loan market in the 1980s, see Dennis
McCrary and Jo Ousterhout, “The Development and Future of the Loan Sales
Market,” Journal of Applied Corporate Finance, Vol. 2 No. 3 (Fall 1990).
80
VOLUME 10 NUMBER 1 SPRING 1997
While acquisition price multiples in leveraged deals have risen to levels that recall
those of the late 1980s, the credit structures in today’s transactions are more
conservative. Financial sponsors’ equity contributions to leveraged buyouts averaged
nearly 23% in 1996, as compared to the single-digit levels of the late 1980s.
ket. Traditionally, investment grade borrowers main- market, derivatives, independent credit ratings, and
tained a sprawling group of bilateral credit agree- research. The net effect of these innovations is a
ments. Although this had the benefit of allowing sophisticated, diversified leveraged finance market
the borrowers to control their bank group, it also that issuers can tap to finance strategic transactions
resulted in high administrative costs. Syndicated or simply to refinance debt.
loans offer these borrowers the ability to reduce
their administrative burden and cost, while relin- TECHNICAL TRENDS IN THE LOAN MARKET
quishing some control over their bank group. In
addition, syndicated loans establish a lender group The syndicated loan market has been a continu-
that the borrower can later tap in order to finance ous bull market since the end of the credit crunch in
acquisitions or other strategic transactions. These early 1992. In recent years, the bank loan market has
advantages have proved so compelling that most been characterized by annual increases in primary
corporate borrowers have all but abandoned bilat- loan issuance coupled with compression of loan
eral lines in favor of syndicated loans. spreads and fees paid to underwriters and investors,
In the early 1990s, however, a liquidity crunch and more flexible structure and covenants. Although
in the leveraged finance market was caused by a the combination of reduced pricing and greater
confluence of events that included (1) slowing flexibility may seem like an issuer’s dream, these
economic growth; (2) soaring default rates; (3) in- developments have occurred together because li-
creased regulatory scrutiny of HLTs; and (4) outflows quidity has outpaced supply on both the sell-side
from high-yield funds resulting from the collapse of and the buy-side of the leveraged loan market. On
the high-yield bond market.2 During this period, the origination side of the market, a growing number
many foreign banks, regional banks, and institu- of investment banks and commercial banks—both
tional investors retreated to the sidelines. U.S. banks foreign banks and former regional banks that have
were forced to take charge-offs against commercial grown through consolidation and expansion—have
and real estate loans and to comply with more established loan syndications groups and now com-
stringent capital requirements stemming from the pete toe-to-toe with the handful of money center
Bank for International Settlements Basle Accord. banks that traditionally dominated the market. On
And, in the midst of this turmoil, institutional inves- the investor side, the demand for loan assets has
tors withdrew from most leveraged finance activity, expanded as traditional bank lenders, flush with
including leveraged loans and high-yield bonds. capital, search for high-yielding assets and institu-
In recent years, however, the leveraged finance tional investors increasingly tap the market as a
market has staged a dramatic recovery. Since 1992, source of floating-rate, high-yield assets.
the competitive landscape of the leveraged loan and
high-yield bond markets has changed radically, and LOAN PRICING
liquidity has reached unprecedented levels in both
markets. Many commercial banks have consolidated Loan spreads have tightened across the credit
their loan syndications activities with new high-yield spectrum from the highest-quality investment grade
bond underwriting and trading businesses in Section borrowers to speculative grade, highly leveraged
20 subsidiaries. At the same time, bulge-bracket borrowers. While pricing compression is most pro-
securities firms have expanded their bank loan nounced for investment grade issuers, higher-qual-
trading operations to include loan underwriting and ity leveraged borrowers have also benefited from
syndication. Syndicators have developed new prod- this trend. Commercial banks, which are the primary
ucts to serve the institutional investors that entered investors in higher-quality transactions, have been
the loan market as the number and importance of more flexible on pricing due to the importance of
loan trading desks also increased. client relationships and many banks’ willingness to
In sum, the leveraged loan market now offers cut credit spreads to maintain those relationships
issuers and investors most of the key features of that enable them to sell a full complement of non-
public capital markets, including a robust secondary credit services. By contrast, the credit spread on
2. David J. Denis and Diane K. Denis, “Leveraged Recaps and the Causes of
Financial Distress,” Journal of Applied Corporate Finance Vol. 8 No.4 (Winter 1996).
81
JOURNAL OF APPLIED CORPORATE FINANCE
FIGURE 1
SYNDICATED LOAN
VOLUME UP SHARPLY . . .
BUT OVERWHELMING
LIQUIDITY DRIVES DOWN
PRICING & FEES
Source: BancAmerica Securities, Leveraged Comps System and Loan Pricing Corp.
FIGURE 2
LOAN SPREAD
COMPRESSION IS
CONCENTRATED IN THE
INVESTMENT GRADE AND
NEAR INVESTMENT GRADE
SECTOR
Source: BancAmerica Securities and Loan Pricing Corp.
highly leveraged loans (defined as those priced at consequence, the participation of institutional inves-
250 basis points or more over LIBOR) has been tors in the market has helped stabilize the pricing of
relatively stable. Institutional investors brought a leveraged loan credit risk, even as excess liquidity in
new approach to the syndicated leveraged loan the bank market has driven down pricing in the
market in the 1980s, which remains a factor in the investment grade and near-investment grade mar-
market today. While most banks consider loans part kets. This pricing discipline, along with historically
of a broader client relationship that does—or can— attractive relative values, has in turn attracted an ever
include other non-credit business, the pricing deci- greater number of institutional investors to the
sions of nonbank investors are not influenced to leveraged loan market.
nearly the same extent by non-credit considerations. One notable exception to this relative stability
Institutional investors focus on loans primarily as in the leveraged loan market may be the sponsored
stand-alone investments rather than as a foundation deal market. Large LBO funds have once again
for issuer relationships that generate other, non- become an important source of leveraged deal flow,
credit business. (An important exception to this rule making strong relationships with the most influential
is the case of loans to the best-known financial financial sponsors crucial to both agents and inves-
sponsors, in which case some investors will offer tors. Even so, it has been only a select group of
price concessions with the hope of being offered sponsors that have been able to command pricing
future opportunities with the same sponsor.) As a concessions on recent leveraged transactions.
82
Syndicated loans offer investment-grade borrowers the ability to reduce their
administrative burden...and to establish a lender group that can later be tapped to
finance acquisitions or other strategic transactions. These advantages have proved so
compelling that most such borrowers have all but abandoned bilateral lines in favor
of syndicated loans.
MORE FLEXIBLE COVENANTS ibility in making strategic acquisitions, paying divi-

AND STRUCTURE dends from excess cash flow, and stretching out
repayments.
While reduced pricing has been the most obvi-
ous—and easily quantified—concession made to STRUCTURAL MARKET CHANGES LEAD
borrowers in the face of overwhelming liquidity, TO INCREASED SOPHISTICATION
structure and covenants have also become more
flexible. This is particularly evident in the case of the In recent years, the leveraged loan market has
best-known financial sponsors, which often prefer a taken on many of the most important aspects of a
more flexible loan structure to a larger pricing con- traditional capital market, including the participa-
cession. Loans, of course, are the most senior instru- tion of institutional investors and securities firms—
ments in the capital structure of leveraged borrow- led by commercial banks’ Section 20 affiliates—as
ers. They are also the least costly, from an interest well as secondary trading, credit ratings, research,
perspective, although they typically carry covenant and institutional investors. The loan market’s grow-
restrictions and financial compliance requirements. ing sophistication and increased liquidity are result-
After the credit crunch of the early 1990s, most ing in smaller spreads and fees as well as more
leveraged loan agreements were very tightly crafted. flexible structures.
In recent years borrowers—particularly those affili-
ated with strong equity or corporate sponsors—have Secondary Market Liquidity Increases
begun to enjoy more breathing room. This breathing
room reflects the continuing strong credit statistics of Secondary loan market liquidity began to de-
leveraged finance transactions and is often tied to velop following the build-up of HLT loan volume
borrower performance. in 1989. Commercial bankers became concerned
One aspect of loan structure where greater with concentrations in several highly leveraged
flexibility is being provided borrowers is in manda- loans, including loans to Federated Department
tory prepayment provisions. In the past, leveraged Stores, Macy’s, Stone Container, Black & Decker,
loans were structured so as to be repaid with RJR Nabisco, HCA, and Time Warner. A handful of
substantially all proceeds from asset sales and debt commercial and investment banks established loan
issuance, and with a specified percentage of cash trading desks to make a market and broker these
flow after all cash expenses and equity issuance higher-profile HLTs. Over the past eight years,
(referred to as the “cash flow sweep”). But, in recent approximately 30 loan trading desks have been
years, the percentage required to be repaid from established, split about equally between commer-
excess cash flow and equity issuance has declined. cial banks and investment banks.
For example, during the five quarters ended March The secondary market for leveraged loans has
31, 1997, the average cash flow sweep for a broad brought about significant changes in the primary
sample of leveraged loans was 64%, down from 68% loan syndication process. Today banks originating
in 1994.3 Over the same time period, the average leveraged loans use the market perspective provided
prepayment requirement from equity issuance de- by their loan traders to better understand and
clined from 82% to 74%. evaluate their underwriting risk. At the same time,
In addition, an increasing number of credit investors use loan trading desks to source assets,
agreements allow prepayments from cash flow and manage loan portfolios, and hedge the risk of the
equity to “ratchet down” as borrowers achieve primary syndication process. In addition, the liquid-
certain performance goals. For example, the $650 ity provided by the secondary loan market has
million credit that backs KKR’s October 1996 lever- diminished the illiquidity stigma that was once
aged recapitalization of E & S Holdings allows the attached to bank loans, thus enabling many new
cash flow sweep to fall from 50% to zero when the nonbank investors to enter the market. This, in turn,
borrower’s ratio of debt/EBITDA falls to 4.0x or less. has increased demand for loans and helped drive
Lenders are also providing borrowers greater flex- down credit spreads.
3. According to Leveraged Comps System (LCS).
83
FIGURE 3
SECONDARY MARKET
ACTIVITY IS INCREASING...
SECONDARY TRADING
VOLUME OF PAR AND
NON-PAR LOANS
Source: Loan Pricing Corp./Gold Sheets
Credit Rating Agencies Enter the Leveraged Institutional investors, by contrast, tend to be
Loan Market thinly staffed and have limited resources to evaluate
and manage credit risk. As a result, third-party credit
Over the past several years, the largest credit risk evaluation is far more important for these investors
rating agencies have undertaken initiatives to pro- and, by extension, for leveraged issuers. The difference
vide credit ratings for loans. Moreover, there is an between a single B and BB rating can be more than 100
important difference between credit ratings for bonds basis points on the spread of a syndicated loan. As a
and ratings for loans that makes loan ratings espe- consequence, more and more issuers and syndicators,
cially valuable to the market. Whereas bond ratings therefore, are arranging for rating agencies to help tell
are primarily an estimation of the probability of their “story” to potential investors by assigning a rating
default, bank loan ratings take the risk analysis one and providing a credit write-up.
step farther and consider the loan’s structural char-
acteristics (covenants, cash flow sweeps, etc.) and Portfolio Management
collateral support. In so doing, this extra analysis
effectively combines traditional default analysis with One factor contributing to the decline of the
loss analysis to provide an estimate of the expected leveraged loan market in the early 1990s was exces-
loss on the loan. A company’s loan rating can vary sive portfolio concentration. When default rates
from its subordinated bond rating by as much as soared in 1990 and 1991, many lenders, including the
three “notches” (that is, a firm with a B+ bond rating leading underwriters, suffered large concentrations
may have a loan rating as high as BB+), depending in defaulted names. Today, most bank loan investors
on how the loan and bond are structured, and on the are taking advantage of the more liquid secondary
business risk of the issuer. This added degree of loan market to accomplish more effective implemen-
precision in the risk measure can be useful informa- tation of portfolio management strategies that reduce
tion for investors in the loan market. industry and issuer exposure. At the same time, the
But such differences notwithstanding, the same development of a deeper market for distressed loans
dynamics that support rating-agency activity in the has provided banks a better understanding of the value
bond market are at work today in the leveraged loan of specific loans while giving their loan portfolio
market. When the loan market was comprised of managers the option of selling distressed assets at
only banks, ratings were of little value. Banks then significantly higher prices (and with much narrower
relied entirely on their internal credit departments to bid-ask spreads) than in the early 1990s. As a result,
assess the risk of leveraged and middle market lenders are less vulnerable to credit problems with
loans—while investment grade loans were, of course, individual issuers or a given industry segment, and the
unsecured and so bond ratings were used, as they bank market as a whole should be much less subject
are today, as proxies for risk. to disruption than it proved to be in the early 1990s.
84
The leveraged loan market now offers issuers and investors most of the key features
of public capital markets, including a robust secondary market, derivatives,
independent credit ratings, and research.
Growing Institutional Investor Activity repaid an average of 40% prior to default, according
to a study by the Loan Pricing Corporation (LPC).
The most compelling evidence of the evolution Unsecured bonds, by contrast, typically have bullet
of the loan market is the growing presence of maturities and call protection and therefore experi-
institutional investors, including mutual funds, in- ence little or no repayments prior to default.
surance companies, and structured securitization Low Loss Rates. In the event of default, leveraged
vehicles. In 1996, institutional investors accounted loans have materially higher average recoveries than
for 31% of the primary market for highly leveraged defaulted, unsecured bonds due to a combination of
loans, up from 23% in 1994 and 10% in 1989.4 The collateral protection and, in many cases, seniority in
number of institutional investors is up even more the capital structure. The average loss given default
dramatically. Today, 46 institutional investors were for secured leveraged loans is less than 20%, accord-
actively buying leveraged loans—and as many as six ing to a study of 23 defaulted loans by LPC. (Using
new structured loan vehicles are coming to market— a 15% discount rate and two-year average petition
up from 14 such investors in 1993 and less than 10 period, this translates into a 35% loss given default
in 1989.5 Though the total dollar amount of loan rate.) Subordinated bonds, by comparison, suffer an
assets held by institutional investors is impossible to average loss given default of 65-70%, according to
quantify with certainty (because bank loans are Moody’s Investors Service.
private instruments), BancAmerica Securities esti- Low Volatility. The combination of low loss given
mates that these investors hold roughly $25-30 default experience and the floating-rate coupon for
billion of leveraged loans today, up from $10-15 bank loans results in relatively low volatility of
billion in 1993 and $5-6 billion in 1989. returns to leveraged loan investors, and an attractive
Many institutions are sophisticated “relative- “Sharpe ratio” (that is, risk premium divided by
value” investors that evaluate the risk/return of standard deviation of returns), as compared to the
securities across the different leveraged finance returns earned by high-yield bond investors.6
segments—including leveraged loans, privately Access to an Alternative Source of High-yield
placed debt, and high-yield bonds—and then Paper. Strong leveraged loans issuance, particularly
choose to invest in the most attractive asset. With in the face of slack high-yield placement volume, has
increased institutional participation in the lever- attracted a growing number of insurance companies
aged loan market, relative-value considerations are into the leveraged loan market. Leveraged loan
now integrated into the loan pricing and structur- volume totaled $135 billion in 1996 (according to
ing process. LPC), as compared to the $60 billion of high-yield
Institutional investors have been drawn to the loan bonds and 144a placements (reported by Securities
market by a number of factors, including: Data Corporation).
Flat Yield Curve. Between 1993 and 1996, the gap Liquidity. As described above, the secondary loan
between three-month LIBOR—the base rate of most market has grown and matured in recent years. The
loans—and 10-year Treasuries narrowed from three growing secondary market has reduced the percep-
percent to approximately one percent (1.1% at April, tion of illiquidity that historically has kept many
1997). As a result, the yield pick-up from trading institutional investors out of the market.
short-term, floating-rate loans for fixed-rate, inter- Improved Credit Quality. Credit statistics for most
mediate term bonds has evaporated. leveraged deals today are far more conservative than
Reduced Interest Rate Risk. Loans are floating-rate those seen in the late 1980s. As noted earlier, equity
instruments that typically reprice every three to six contributions to LBOs, which were often in the single
months. As a result, they carry little of the interest risk digits prior to 1990, are rarely less than 20% today.
of traditional fixed-income investments. More conservative credit statistics are largely respon-
Covenant Protection. Loans have mandatory pre- sible for the renewed commitment of banks in the
payment provisions that require prepayments from leveraged loan market as well as a growing universe
asset sales, excess cash flow, and capital markets of institutional investors among mutual funds and
issuance. As a result, syndicated leveraged loans are insurance companies.
4. Ibid. 6. Elliot Asarnow, “Corporate Loans As An Asset Class,” The Journal of Portfolio
5. Ibid. Management, Summer 1996.
85
FIGURE 4
EQUITY CONTRIBUTIONS
COMPARE FAVORABLY TO
EARLIER PERIODS...
EQUITY CONTRIBUTIONS
TO LBOS
TABLE 1 Revolver/Term Loan Institutional Paper High Yield Bonds

CHARACTERISTICS OF
LOANS VERSUS BONDS Coupon Floating rate Floating rate Fixed rate
Ranking Senior debt Senior debt Subordinated debt
Security Secured Secured Unsecured
Maturity (yrs) Five to Seven Six to Ten Ten to Twelve
Covenants Strong covenants Strong covenants Incurrance Test
Repayments Amortizing Very limited amortizing Non-amortizing
Event Related Prepays Required Optional No
Callability Callable, no fee Callable, possible fee No call period, fee
Market Private market Private market Public market
New Products. In the early 1990s, syndicators THE CONVERGENCE OF THE BANK LOAN
helped draw institutional investors into the market AND BOND MARKETS
by carving out longer-term, higher-priced tranches
of term loans crafted specifically for these investors. With the relaxing of commercial banking regu-
More recently, several of these tranches have been lations, many banks expanded their product offer-
structured with prepayment fees during the initial ings to include high-yield and investment grade
term of the loan in an effort to ease investor concerns bonds. Investment banks originally responded to the
over reinvestment risk resulting from early prepay- threat to their fixed income franchise by establishing
ment. The structure of institutional loans serves as a loan trading desks, and, more recently, by creating
bridge between the bank loan and bond markets. loan underwriting and syndication capabilities. This
During the first quarter of 1997, the line between move toward “one-stop shops” has become perva-
the institutional term loans and high-yield bonds was sive; today most large commercial banks and invest-
further blurred by Huntsman’s issuance of a $135 mil- ment banks offer clients the full array of leveraged
lion “hybrid” loan. The instrument was a hybrid in the finance products, including high-yield bonds, 144a
sense that, although floating-rate, it featured a larger placements, and leveraged loans. As a result, the
prepayment penalty than previously granted loan in- leveraged finance market has become increasingly
vestors, and a second lien on the assets in place of a fluid, a development that has benefited issuers,
bank loan’s traditional pari passu claim on assets. underwriters, and investors.
Reflecting this hybrid structure, this private market loan Greater Flexibility: Issuers have benefited from
was placed with a combination of high-yield bond and the convergence of the leveraged finance markets as
bank loan investors. underwriters have developed the capability to un-
86
Most bank loan investors are taking advantage of the more liquid secondary loan
market to accomplish more effective implementation of portfolio management
strategies that reduce industry and issuer exposure. As a result, the bank market as a
whole should be much less subject to disruption than it proved to be in the
early 1990s.
derwrite entire financing structures drawing on all development of new products—products that, in
markets. Such versatility gives issuers and their some cases, promise to provide more value to clients
underwriters the option, until late into the financing in the future than they do today.
process, to survey the leveraged loan, high-yield
bond, and 144a placement markets in search of the Credit Derivatives
best mix. It is now common for the issuer and the
underwriter to adjust the sizes of the loan and bond Perhaps the best example of such product
tranches prior to closing to obtain better terms for the innovation are credit or loan derivatives. Although
issuer. For example, while arranging the $265 million relatively new, loan derivatives are building a strong
credit that backed Stonington Partners’ leveraged following among institutional investors and insur-
buyout of Packard BioScience, BancAmerica Securi- ance companies. The most popular type of loan
ties reduced the loan portion by $35 million and derivative at present is the total rate of return swap.
substituted additional high-yield bonds. The larger These instruments enable an investor to purchase the
bond offering was desirable for the issuer because returns associated with a loan, or a basket of loans,
it offered a longer term and, unlike the bank loans, in exchange for a fee that can take the form of the
did not amortize. On the flip side, in underwriting the spread on a loan to finance the derivative or an upfront
financing for the acquisition of Del Monte Corpora- fee built into the deal. Regardless of the form it takes,
tion by TPG Partners LP, BA Securities increased the the investor’s fee normally amounts to 50-100 basis
Term Loan B tranche and reduced the bond financ- points annually on the amount of the derivative. The
ing after the high-yield bond market became less size of the fee is generally a function of the counterparty
attractive to the issuer on a relative-value basis. risk and the complexity of the transaction.
Reduced Transaction Expenses: When underwrit- For potential investors, the advantages of loan
ers lead both the loans and bonds of the same swaps over direct cash purchases are compelling.
transaction, issuers can benefit from reduced fees They include:
because underwriters in such cases can spread their Leverage. Derivatives allow investors to leverage
structuring and relationship expense over two prod- their capital five or more times and thereby increase
ucts and pass these savings through to the issuer. their return on capital—and, of course, their risk—
Investor Access to Paper: For investors, a more fluid exponentially.
leveraged finance market offers the ability to take a point Rating. Derivatives on a basket of loans can carry
of view on an issuer and invest in the most appropriate a rating of BBB-/Baa3 or higher. This is crucial for
tranche of the capital structure. For example, if the insurance companies and mutual funds. For insur-
investor believes an issuer’s outlook is positive, it may ance companies, an investment grade rating means
instead choose to invest in the issuer’s bonds and have a lower capital requirement under National Associa-
call protection and potential gains. But if the company’s tion of Insurance Commissioners guidelines. For
fundamentals are less robust, it may choose to invest in many mutual funds, an investment grade rating is a
the issuer’s loan and thereby have a shorter duration, prerequisite for purchasing an investment.
prepayment provisions, and security.7 Reduced Administrative Burden. Derivatives allow
investors to avoid the administrative burden of direct
THE NEXT FRONTIER cash purchases. In a derivative, the selling institu-
tion—generally the originating bank—continues to
The leveraged loan market will become increas- handles repayments, prepayments, and amendments.
ingly sophisticated, liquid, and competitive as non-
bank institutions continue to migrate into the market. A TOTAL RATE OF RETURN SWAP. For illustrative
Commercial and investment banks will be under purposes, consider a recent three-year swap on a
extraordinary pressure to continue to be innovative $10 million piece of Riverwood International’s Term
in order to win client relationships with issuers and Loan B. The buyer of the swap, a large insurance
investors. One form that such innovation will take is company, borrowed $10 million from the seller at
7. See Asarnow, cited above, who argues that institutional investors can use
bank loans to assume a more neutral asset liability profile by accumulating short-
duration assets.
87
LIBOR plus 75 basis points (bp). To execute the ued to seek out value in the bank loan market, the
transaction, the buyer put up $1 million as collateral, lines between the geographic markets have be-
which was invested in Treasuries. Normally the come increasingly blurred. The relative value analysis
buyer—a AA rated institution—would borrow at described earlier is now being applied by investors
12.5 bp over LIBOR, meaning a 62.5 bp fee to the in a global context, as agent banks seek out financ-
seller. In exchange, the buyer receives the return of ing bargains provided by disparities in the risk/
Riverwood’s Term Loan B—300 bp over LIBOR— return relationship across various geographic mar-
plus any gains or losses in market value. The swap kets. For global investors, this means that the
amortizes by scheduled and unscheduled repay- combination of (1) better information from re-
ments and there is an undisclosed break-up fee. search and technology, (2) a centralized source of
The buyer’s expected return over Treasuries on its $1 deal flow from the largest and most sophisticated
million of capital—assuming, of course, no default—is agent banks, and (3) the preference of issuers for
22.5%. However, a 10% decline in the loan’s value at any “seamless” investor support across geographic
point in the life of the loan will wipe out the buyer’s boundaries is leading to a true globalization of the
entire capital position. syndicated loan market.
CONCLUSION
LOAN MARKET RESEARCH
Liquidity is the overriding theme in today’s
As institutional investors continue to grow market syndicated loan market, making the market a more
share in the leveraged loan market, and underwriters user-friendly one for corporate borrowers and deal
with public securities market research capabilities sponsors. As a result, a record number of corporate
compete for underwriting mandates in the loan issuers are taking advantage of the syndicated loan
market, leveraged loan market research services will market to finance strategic transactions or simply to
be expanded as a core competency of leading under- reduce their borrowing costs. Deal sponsors, too,
writers. In much the same way as many of the com- are tapping the market to finance leveraged buyouts,
ponents of bonds (longer maturity, call protection, recapitalizations, and acquisitions at a pace not seen
subordination, etc.) are being incorporated into loan since the late 1980s.
assets, structural characteristics of the bond market And the market’s prospects are bright. Despite
will be incorporated into the loan market. the rapid growth of institutional loan investors, these
investors represent less than 20% of the estimated
GLOBALIZATION $200 billion of leveraged loans outstanding. Over the
next several years, institutional involvement seems
The largest commercial banks, which under- poised for significant growth as the leveraged loan
write the majority of bank loans, have global client market acquires still more of the capabilities and
relationships that are supported by international efficiency of a true capital market with a diversified
loan syndications groups. During the early 1990s, investor base, derivatives structures, research, rat-
these operations tended to operate more or less ings, and a deep secondary market with established
autonomously as a reflection, in part, of the seg- conventions. For issuers, the continuing flood of
mented nature of global capital markets. However, institutional money into the leveraged loan market
as worldwide capital markets have become progres- undoubtedly will mean lower pricing and more flex-
sively more integrated, and as investors have contin- ible structure along with increased access to capital.
KEITH BARNISH STEVE MILLER
is Senior Managing Director and head of Loan Syndications for is co-founder of Portfolio Management Data, an information
BancAmerica Securities Inc. company that provides database and analytic services to the
leveraged finance market, including the Leveraged Comps
MICHAEL RUSHMORE System cited in this article. Before co-founding PMD in 1996, he
worked for Bankers Trust’s syndicated loan department and
is Managing Director and head of Loan Research for BancAmerica Loan Pricing Corp.
Securities Inc.
88
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17456622, 1997, 1, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/j.1745-6622.1997.tb00128.x by Universidad Publica De Navarra, Wiley Online Library on [15/11/2022].

The New Leveraged Loan Syndication Market

Portfolio Management Data, LLC, and

BancAmerica Securities, Inc.

ver the past ten years, commercial

formation. Traditionally a one-off, bilateral “market”

in which issuers maintained one or more separate

banking relationships, the bank loan market has

recently come to operate more like a capital market

in which one or more underwriters structure and

price loans for syndication to groups of investors.

This market-driven evolution has been most dra-

matic in the leveraged lending segment (defined as

loans priced at LIBOR plus 150 basis points or more),

where wide margins have attracted a large and

growing field of underwriters, intermediaries, and

investors. In this article we discuss how financial

sponsors, issuers, and investors are benefiting from

the loan market’s rapid evolution.

Source: BancAmerica Securities and Loan Pricing Corp.

MORE FLEXIBLE COVENANTS ibility in making strategic acquisitions, paying divi-

3. According to Leveraged Comps System (LCS).

Source: Loan Pricing Corp./Gold Sheets

TABLE 1 Revolver/Term Loan Institutional Paper High Yield Bonds

KEITH BARNISH STEVE MILLER

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