1. Credit Market Update
December 2008
INVESTMENT BANKING SERVICES SINCE 1987
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2. How Tight is the Credit Market Today?
Advertisement in BusinessWeek 11/17/08
General Electric, which relies on low-cost Commercial Paper to lend
through GE Capital, has found that the contraction in CP has driven
Presentation for: up the cost of capital to a point where it is cheaper to offer debt
instruments direct to consumers
Pg. 2
3. How Tight is the Credit Market Today?
ABL pricing is LIBOR + 500 to +600 (inclusive of points
paid at closing)
Cash flow loans are pricing at LIBOR + 800 to +1500.
Most middle-market borrowers closing on cash flow loans
since mid-September are paying north of 15% all-in
Covenant-lite deals went away in 1H 2007 and have given
way to an average of three maintenance covenants on new
issues
LIBOR, taking a beating from Central Bankers world wide,
is losing its luster as a benchmark - as such, nearly half of
all loans in 1H 2008 included a LIBOR floor.
Presentation for: Recent loans are being priced with an absolute rate floor of
5.0% to 5.5% Pg. 3
4. How Tight is the Credit Market Today?
There is virtually no mezzanine lending going on today.
Sub-debt providers, tasked with getting unlevered returns
of 15%, can do better in the secondary market, buying
senior secured paper at a discount
There is virtually no DIP lending going on today, other than
from participants already in the capital structure
Exit financing for companies in bankruptcy is nearly
impossible to find
Major players like GE Capital, Madison, Wachovia, GMAC,
Textron, and CIT are essentially out of the market
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Pg. 4
5. How Tight is the Credit Market Today?
Net percentage of U.S. banks that indicate tightening credit standards on corporate loans
100
80
Shading indicates
period of recession Large and Mid-Size Borrowers
60 Small Borrowers
40
20
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
-20
-40
Source: Federal Reserve (published in the Wall Street Journal, November 4, 2008)
Recent tightening is more significant and widespread than at any
time in the past 20 years.
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Current bias among lenders is to tighten in anticipation of recession,
falling corporate earnings, and rising default rates. Pg. 5
6. Cost & Availability of Capital
Commercial Paper: Costs have doubled, and maturities
have shortened to days, not weeks.
CLO Market: Major finance companies, unable to raise
capital in the CLO market, are having to draw down
warehouse lines with ever-widening spreads.
De-Levering: Major lenders are looking to de-lever their
balance sheets, and are selling off loan participations and
distressed assets.
Competition from the Secondary Market: The glut of
secondary market debt has driven up the implied interest
rates on BB corporate bonds to 15% and higher.
Staggering hedge fund redemptions, seizures (such as Highland
Credit Strategies’ $672 million fund), and bankruptcy filings have
generated liquidations of debt. Fortress said 11/13 that it
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received $2.6 billion in withdrawal requests for its funds,
which manage $9.1 billion.
Pg. 6
7. Cost & Availability of Capital
Potential Liquidations of Debt Securities (by Investor Type)
Mkt Value Assumed Forced Near-Term Net
Investor Type ( of Holdings
X Liquidation ) = Liquidations - Maturities = Liquidations $
Collateralized Loan Obligations (CLOs) 179.3 5% 9.0 11.7 -2.7
Hedge Funds, High Yield Funds 136.8 50% 68.4 9.0 59.5
Prime Rate Funds 23.6 0.0 1.6 -1.6
Insurance Companies 14.2 0.0 0.9 -0.9
Finance Companies 28.3 0.0 1.9 -1.9
Banks 89.6 0.0 5.9 -5.9
Source: UBS, Standard & Poor’s
Note: Debt Maturing Between October 23, 2008 and January 23, 2009
As much as $46.6 Billion of debt securities, including traditional
loans, syndications, and corporate bonds may trade before year-end
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Until the selling pressure subsides, the secondary market will
continue to compete with new borrowers for scarce capital Pg. 7
8. Cost & Availability of Capital
Who owns the “Leveraged Loans”? Everybody.
Purchasers of Leveraged Loans Q1-Q3 2008:
“Leveraged Loans” are cash flow loans made at 4x – 6x EBITDA,
many of which were used to finance LBOs and dividend recaps
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It’s not just the hedge funds that provided the debt. It was BofA,
Wachovia, GE Capital, Madison, Allied, CapitalSource and others. Pg. 8
9. Cost & Availability of Capital
Sample of Benchmark Loans offering Yields upwards of 28%
The glut of corporate debt trading in the secondary market makes it
possible to buy existing secured debt in large cap companies with
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strong earnings at yields that are significantly “above market” relative
to current loan underwriting.
Pg. 9
10. What are the Experts Saying?
The great sucking sound of the secondary market: Bank Loans
“Performing bank loans with no near term probability of
default, are trading at 71 cents on the dollar. It used to be
that anything under 80 was ‘distressed’… when a bank can
buy that loan at LIBOR +900, why lend at LIBOR+ 400 bp?”
Bank of America
“We have bought out several positions from [Large National
Bank] in club deals where we already had an interest,
generally at a discount that gave us returns better than what
we are getting in primary lending [which is currently L+600]”
Wells Fargo
“We didn’t do syndications on the origination side, but we
have several relationships at [Large Regional Banks] which
have given us the opportunity to buy participations [in recent
months] at a discount” Danversbank
“There are more non-bank lenders than banks, and the
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delevering of the non-bank lenders is driving the market,
rather than the bank work-out officers.” Spring Street Capital Pg. 10
11. What are the Experts Saying?
About default rates
“There is an expectation that default rates across all industry
sectors will rise from current historic lows” RBS Citizens
“Default rates don’t really matter, because everything is
trading like it will default. If I had to guess, I’d say defaults
will be 15% next year” Monarch Alternative Capital LP
“I have been involved in several situations where lenders
have refused to deliver even routine ammendments, and are
instead putting companies in default.” Choate
“Lenders got into bad habits, and for years their work-out
strategy was ‘go borrow from someone else’, but that is no
longer the case” Turnaround Professional
“High yield default rates will go to 10%. We will get a couple
of 10% years like we had in 1991 and 1992” King Street Capital
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Pg. 11
12. What are the Experts Paying?
Implied default rates and loss given default
Loan Index (D) x (L) = (A)
Spread (S) Loss Given Anticipated Risk (S) - (A) =
(% over LIBOR) Default Rate (D) Default (L) Spread Excess Spread
WHERE IS THE MARKET TODAY?
Current Market for Bank Loans 6.0% 3.0% 30.0% 0.9% 5.1%
Current Market for Leveraged Loans 14.0% 3.0% 30.0% 0.9% 13.1%
WHAT IS quot;NORMALquot;?
Long-Term Average 3.3% 3.8% 30.0% 1.1% 2.2%
Historical Worst-Case 8.0% 8.0% 30.0% 2.4% 5.6%
MARKET PRICING RELATIVE TO LONG-TERM AVERAGE EXCESS SPREAD
Current Market for Bank Loans 6.0% 7.6% 50.0% 3.8% 2.2%
Current Market for Leveraged Loans 14.0% 23.6% 50.0% 11.8% 2.2%
Buying secured bank loans at a discount of 39%*, generates an implied
LIBOR spread of 1400bp.
1400bp suggests that either defaults will reach 23.6% with loss given
default of 50%, or some similar scenario.
If we experience 18% defaults (10% greater than the worst ever for
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loans), lenders would have to recover just 53% (25% less than historic
average) to match historical MAX excess spread.
*Lyondell Chemical Company, $16 billion in assets, Bank Debt/EBITDA = 2x. TLB traded at 61 as of October 23rd, a 17.5% YTM Pg. 12
13. What are the Experts Saying?
Default rates on Corporate Debt Since 1990
Looking back over the last 40* years, the highest default rate was less than 15%!
Source: Standard & Poor’s LCD, FRM * Data back to 1990 shown.
Given the history of loan defaults over the past 40* years, the “worst
case” scenario would seem to be <15% default rate. The average loss
on default is 30%. Therefore the likelihood of a loss, on average would
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warrant an excess spread of ~450bp. Yet ABL is now pricing at +600bp,
and cash flow loans at +800bp.
Pg. 13
14. Current M&A Climate
Debt Multiples are down relative to 2007
Debt Multiples for Large LBOs (EBITDA >$50M)
7
6
5
4
3
Subordinated
Debt/EBITDA
2
Second Lien & Other
Sr. Debt/EBITDA
1
Senior (First Lien)
Debt/EBITDA
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08
Source: Standard & Poor’s LCD
Debt financing, which drove up LBO valuations through 2007,
has dropped off significantly
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Second Lien, which pumped up LBO debt in 2006 and 2007, has
effectively gone away
Pg. 14
15. Current M&A Climate
Lower-Middle Market Debt Multiples are at 2002 Levels
Debt Multiples for Lower Middle-Market LBOs (EBITDA <$10M)
6
5
4
3
Subordinated
Debt/EBITDA
2
Second Lien & Other
Sr. Debt/EBITDA
1
Senior (First Lien)
Debt/EBITDA
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08 4Q08
Source: Mirus Survey Data
Tightening credit standards and higher interest rates have reduced debt
available for LBOs, driving down valuations for LBOs (and M&A overall)
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Senior leverage on lower middle-market deals is down to approximately 2x
EBITDA, from an average multiple of more than 4x in Spring 2007
Pg. 15
17. What are the Experts Saying?
About the current LBO market
“The market (for LBO debt) is broken and will need to be
reconstituted in some fashion.” Bank of America
“ABL is now pricing at L+500 or 600. Senior leverage, if you
can get it, is at 2x (EBITDA). Nobody with a healthy and
growing business is a seller right now, to the chagrin of the
Private Equity guys.” HIG Capital
“DIP lending really isn’t available right now” Sun Capital
Partners
“Right now we are looking at micro cap and smaller public
companies that have 4x and 5x levereage that can't get
liquidity, and doing PIPEs” HIG Capital
“I fear that banks are going to take this opportunity to put
pressure on disfavored borrowers to exit [the facility].”
Choate
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Pg. 17
18. Current M&A Climate
Large LBOs held up through Q3, driven by equity, not debt
Breakdown of Valuations in Large LBOs (target EBITDA >$50M)
12
9.8x
10
7.9x
8
6.1x
5.7x SENIOR
6
4.5x 3.6x
Subordinated Debt &
Other/EBITDA
4
Senior Secured
Debt/EBITDA
2
Equity/EBITDA
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08
Sources: Standard & Poors LCD
Despite tightening credit that brought senior debt multiples from
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5.7x in 2007 to 3.6x in Q3, buyers continued paying high multiples
through August of 2008, filling the void with more equity and mezz
Pg. 18
19. Current M&A Climate
Middle-Market LBO prices are back to 2003-2004 levels
Breakdown of Debt and Equity in LBOs (target EBITDA <$10M)
8.0
7.0
Seller-financed
subordinated
6.0
debt
5.0
4.0
Subordinated
3.7x
2.1x Debt/EBITDA
3.0 SENIOR
Senior quot;Stretchquot;
2x /EBITDA
2.0
Senior Secured
Debt/EBITDA
1.0
Equity/EBITDA
0.0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08 4Q 08
Sources: Based on Mirus Survey (middle-market debt multiples) and Standard & Poors LCD (equity contribution)
Lower Middle-Market Valuations held up through early September
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close to 6x EBITDA. However, senior secured is now at 2.1x and
there is no “stretch” or mezzanine debt available.
Pg. 19
20. Fall-Out Q4 2008
Borrowers are drawing down revolvers to “test” their
availability (or horde cash)
Lenders, trying to protect their balance sheets, are finding
creative reasons (technical defaults) to not fund
Asset-Based Lenders are being directed by credit
managers to get new appraisals
Appraisers, worried about a flood of distressed assets
coming into the market, are issuing very conservative
appraisals on equipment, inventory, real estate and other
assets
ABL formulas will require many borrowers to contract their
revolving credit facilities in Q1 2009
Weakness in retail, automotive, building products and
consumer discretionary will result in significant defaults in
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Q4.
Pg. 20
21. Expectations for 2009
Banks are looking to de-lever, reducing their loans
outstanding by 10%-20%, meaning significantly less capital
available to borrowers.
Leveraged lenders, such as GE Capital, Textron, Newstar,
etc. may need to de-lever by as much as 30%, depending
on what happens with CP and TARP.
CLOs and Hedge Fund assets will mature and create new
demand, without supply to match
Refinancings will be more difficult, especially for
overleveraged borrowers
Default rates may reach 10% as soon as late Q1 2009, as
borrowers run into issues with collateral appraisals,
declining revenues, shrinking margins, severance costs,
restructuring charges, etc.
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Pg. 21
22. Expectations for 2009
With DIP financing scarce, borrowers will be forced to work
out more loans with their lenders to avoid uncertainty of
Chapter 11
Inter-creditor agreements and complex capital structures,
as has been seen with the home mortgage market, will
create systemic challenges to effective work-outs
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Pg. 22
