The State of the Credit Markets: Implications for the Restructuring Community

Credit Markets: 'The Way We Were'

Once upon a time in the mid-1990s, a group of banks (a/k/a a “Club”) would typically fund the senior tranches of bank debt. If the borrower was of substantial scale, it could also issue bonds either as senior securities or subordinated high yield instruments to finance leveraged balance sheets or buyouts. Smaller non-public borrowers might issue a private placement provided by a handful of insurance companies rather than a bond. Private companies needing additional leverage might have also sought funding from the mezzanine market, but those yields were cost prohibitive with equity-like returns and terms. The common thread between these legacy debt facilities (other than bond indentures), was that a small group of lenders both underwrote and planned to hold their loans over the life of the loan. When a default occurred in a specific loan, the actual economic lenders (banks, insurance companies, etc.) were forced to take action to “workout” the loan in concert with the borrower in order to receive maximum value. Workout actions included hiring of turnaround management, recapitalizations, divestitures, etc, and usually required the retention of one or more restructuring firms and insolvency attorneys.

The Modern-Day Credit Market: The Rise of the 'CLO'

With substantial deregulation of the financial and banking sectors in the late 1990s, banks, insurance companies and other investors were permitted to grow assets and consolidate rapidly. The reinterpretation and ultimate repeal of The Glass-Steagall Act of 1933, passage of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, and the sweeping reclassification of Tier 1 capital requirements during this period provided pathways for even highly regulated entities to decrease capital holding requirements and increase leverage.

With the change in regulatory environment, a popular way to grow assets as a lending institution became shifting loan assets off balance sheet via the CLO. Securitization of assets via bankruptcy remote entities had been around for decades, but for the first time, banks began using CLOs (with the assets being corporate loans) to monetize all but a small equity tranche of low-yielding assets and reduce capital holding requirements. As the use of the CLO structure evolved, so did the variety of institutions taking advantage of the CLO as a funding source. Instead of money-center banks, CLOs structured in the last decade were primarily used by “lending funds” that bought corporate loans originated, but usually not held, by investment banks. Every CLO raised was unique, but the typical loan agreement including the following tenets: 1) an investment period of five to seven years; 2) manager compensation based on outstanding assets and equity tranche participations; and 3) restrictions on non-cash pay and sub-investment grade assets. The basic terms of the CLO structure created unique motivations for CLO-backed funds, which as we will discuss in more detail, have contributed greatly to the difference in restructuring activity during this cycle.

The Great Credit Recovery

The burst of the credit bubble and the resulting shortage of liquidity experienced by the market began to reverse in early 2009. On the backs of numerous government intervention programs designed to increase money supply in the market, capital seized on opportunities for truly outsized returns. First impacting a severely dislocated secondary bond, loan, and equity market, capital soon began to drive demand for new bond and high yield issuances. Demand became so strong that in 2009, the high-yield market set a record for issuance dollars despite being essentially closed until April. Given that most borrowers were highly leveraged, the preponderance of proceeds from the record high yield volumes were used to repay existing corporate loans provided by banks and CLO-backed funds.

CLO managers became awash with cash from these “bond for loan” takeouts. Unlike banks, however, CLO-backed funds did not first use their cash to shore up capital ratios and repay government loans. What CLO funds instead required was yield on their repaid capital. Still within their five- to seven-year investment windows, CLO managers quickly became desperate to put capital to work. With the secondary markets recovered and not providing substantial yield, what ensued was a remarkable rebound in the new issue loan market. By March and April 2010, pricing and terms in the market began to resemble early credit bubble levels. However, and ultimately tempering the market, CLO managers only had the capital returned from bond takeouts to invest, as the market for issuances of new CLO vehicles continued to remain limited.

In late April and May, the capital markets began to show the strains of the sovereign debt issues in Europe. According to Lipper FMI, skittish high-yield investors withdrew $4.3 billion for high-yield mutual funds in May, marking the highest redemption level since September 2001 and erasing all inflows to date in 2010. As the high-yield markets cooled, cash balances at CLO funds begun to decline as “bond for loan” capital was put to work and not replenished with further activity. With liquidity again draining from bond and loan market, the credit market reversed course in May. Secondary loan paper traded two to three points lower (higher yields), and all but the highest-quality new issuances re-priced, downsized or shelved. The retrenchment in demand was ill-timed, as forward loan supply from pent-up refinancing and buyout activity quadrupled 2009 levels in May 2010 at approximately $20 billion, according to S&P LCD. The resulting credit supply/demand dynamics have lead to concerns about the sources of credit to fuel what had appeared to be a recovering buyout and financing market.

Despite this recent retrenchment in the credit recovery, loan markets at large remain open for business when compared to recent history. According to data from S&P LCD, May represented the third consecutive month of over $20 billion in new issues, a level not reached since June 2008. Specifically, in the middle market, the rebound in the loan markets (typically syndicated cash flow structured products) removed would be volume from the asset-based loan (“ABL”) and club loan markets. Accordingly, as evidenced by ABL spread to Libor of at or below 300 bps for new deals, these more traditional providers of capital are still hungry to put money to work, for now.

What we question most is the source of funds to refinance the wave of maturities looming in late 2011 and 2012. Mid-2000 vintage CLO-backed funds will be largely outside of their five- to seven-year investment window, and unless new CLO vehicles are raised to replace them, it would appear there could be a significant shortage of capital in the market. Accordingly we feel that it is imperative that borrowers take advantage of the credit availability today in order to restructure, recapitalize, and refinance and ensure long-term availability of capital.

Impact on Borrowers and Restructuring Professionals

The Amend to Extend

CLO-backed funds have different motivations than on-balance sheet lenders, which has contributed to their more patient approach when approaching defaults. Given that CLO managers may only have a sliver of equity capital at risk and derive much of their income from the volume of loans under management, their motivations may not always be to sell out of or monetize positions. Additionally many CLO-backed funds are restricted from holding non-cash pay (e.g., equity) securities for prolonged periods. CLO managers have therefore proved more willing than banks to waive defaults or extend maturities as long they are being compensated for the increased risk. Hence, we are witnessing prolific amend to extend volumes ' nearly $60 billion year to date versus a non-existent 2008 market, according to S&P LCD ' despite the recovered capital markets' appetite for providing monetization options.

Although the prevailing “kick the can” mentality has delayed the ultimate day of reckoning for borrowers and lenders, it is not a long-term solution without significant business recovery or deleveraging, and could leave a borrower trying to refinance in an even more difficult market. Instead of seeking the path of least resistance via an extension, now may be the best time to effectuate a fulsome restructuring. With assets marked below par, creative structuring and proper use of the bankruptcy process could end up delivering more value to corporate clients than a simple extension amendment.

Who Holds the Loan?

Based partially on CLO funds' need to maintain ratios of investment grade assets, a much more liquid trading market for loans has evolved. Accordingly, lenders are now able to more readily trade out of troubled credits resulting in diverse bank groups comprised of CLOs, hedge funds and banks. With dramatically different motivations and numerous participants, many bank groups can become paralyzed when needing to react. We see a continuing role for restructuring advisers and insolvency counsel to work on behalf of creditor constituents and negotiate among lender parties to drive the value maximizing result. In addition, for professionals representing borrowers, it has become imperative to address inter-bank group issues expeditiously.

What to Do When You Find Out Who Holds the Loan

When bank groups are more consolidated in distressed situations, it is often due to a handful of hedge fund investors buying up participations in a credit. To a below-par investor, these funds come without the psychological restructuring constraints experienced by banks or CLOs, which are usually par investors looking at sub-par recoveries. Additionally, the distressed loan buyer tends to already have a preconceived plan for extracting value from a loan given that it has elected to purchase the credit based on value rather than loan par dollars.

Having hedge funds as lenders can result in many different outcomes. However, such outcomes are often reached in a more expedited timeline. Borrowers typically fair best when they have taken proactive action and can approach these investors with a plan to deliver value. Accordingly, although engagements for turnaround professionals and insolvency counsel tend to be shorter in duration when hedge funds are involved as lenders, their active presence and experience can prove even more valuable to borrowers when dealing with highly motivated and sophisticated lenders.

Plan to Have a Plan

The rebound in the credit markets and resurgence of the buyout market has been a double edged sword for distressed borrowers. When bank groups have been dominated by more traditional lenders such as banks, the recovery has provided for more realistic options to drive monetization through enterprise sales, divestitures, or liquidations. As such, there will continue to be more of an onus on borrowers and their equity holders to creatively structure other solutions for their lenders that don't involve significant dilution or a wind-down of operations. We expect restructuring professionals and insolvency counsel will continue to prove valuable in counseling borrowers on such solutions.

Conclusion

As the credit markets and their participants have changed, so must the role of restructuring professionals. Legacy CLO-backed funds continue to be the dominant participant in leveraged middle market structures. Their need to adhere with their own funding documents and therefore trade positions has materially changed the market landscape. The proliferation of hedge fund investors in distressed facilities has dramatically changed the attitude of creditors in some restructurings, and the availability of capital has provided lenders seeking monetization with more options than in the past couple years. Taken as a whole, the credit market and its participants have become substantially more complex, which will inevitably lead to a more prominent role for restructuring advisers and counsel in stewarding borrowers and creditors as this cycle continues to progress.

James D. Decker ([email protected]) is the head of Morgan Joseph & Co.'s Financial Restructuring Group. He specializes in representation of both debtor and creditor constituencies as well as the execution of merger & acquisition, financing, and restructuring transactions for troubled companies. James S. Hadfield ([email protected]) is a vice president in the Financial Restructuring Group.

Notwithstanding the market's recent shaky demeanor, the recovery of the credit markets from early 2009 has been nothing short of spectacular. The recovery in the secondary debt markets, which saw yields on first-lien paper decline from equity-like returns in the 20s to traditional single-digit levels, forced capital to return to the primary markets in a quest for yield. Consequently, borrowers were able to tap the new-issue market at greater volumes year to date than during all of 2009. This access to loan dollars fueled the refinancing market and even sparked leverage buyout and recapitalization activity. However, in the last couple of months, capital has begun to once again retreat from the market in the face of uncertainty in Europe and a slower than expected domestic recovery. Correspondingly, loan supply has surged as eager refinancing and buyout borrowers have flocked to a market perceived to be reopened. The impact has been a recent regression from credit recovery trends, calling into question whether the momentum from early this year can be regained.

The dynamics of the credit market, its recovery, and current state have numerous implications for workouts, restructurings, and reorganizations. With collateralized loan obligation (“CLO”)-backed funds accounting for such a substantial portion of credit in existence today, the diversity of interests and number of participants in any one facility has been greatly expanded. When considering the diversity of loan participants (CLOs, banks, hedge funds) and the fact that each might have a different cost basis in the same credit (e.g., some at par, some secondary buyers at premiums or discounts), the prospects of just reaching consensus within a single tranche of a capital structure can become daunting. The resulting outcome of such dynamics is that the role of the restructuring advisor, turnaround professional, and bankruptcy practitioner has continued to evolve in the current cycle.

Before we examine the recovery and current state of the credit market, it's important to understand how much lending (especially in the middle market) has changed in the last 15 years.

Credit Markets: 'The Way We Were'

Once upon a time in the mid-1990s, a group of banks (a/k/a a “Club”) would typically fund the senior tranches of bank debt. If the borrower was of substantial scale, it could also issue bonds either as senior securities or subordinated high yield instruments to finance leveraged balance sheets or buyouts. Smaller non-public borrowers might issue a private placement provided by a handful of insurance companies rather than a bond. Private companies needing additional leverage might have also sought funding from the mezzanine market, but those yields were cost prohibitive with equity-like returns and terms. The common thread between these legacy debt facilities (other than bond indentures), was that a small group of lenders both underwrote and planned to hold their loans over the life of the loan. When a default occurred in a specific loan, the actual economic lenders (banks, insurance companies, etc.) were forced to take action to “workout” the loan in concert with the borrower in order to receive maximum value. Workout actions included hiring of turnaround management, recapitalizations, divestitures, etc, and usually required the retention of one or more restructuring firms and insolvency attorneys.

The Modern-Day Credit Market: The Rise of the 'CLO'

With substantial deregulation of the financial and banking sectors in the late 1990s, banks, insurance companies and other investors were permitted to grow assets and consolidate rapidly. The reinterpretation and ultimate repeal of The Glass-Steagall Act of 1933, passage of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, and the sweeping reclassification of Tier 1 capital requirements during this period provided pathways for even highly regulated entities to decrease capital holding requirements and increase leverage.

With the change in regulatory environment, a popular way to grow assets as a lending institution became shifting loan assets off balance sheet via the CLO. Securitization of assets via bankruptcy remote entities had been around for decades, but for the first time, banks began using CLOs (with the assets being corporate loans) to monetize all but a small equity tranche of low-yielding assets and reduce capital holding requirements. As the use of the CLO structure evolved, so did the variety of institutions taking advantage of the CLO as a funding source. Instead of money-center banks, CLOs structured in the last decade were primarily used by “lending funds” that bought corporate loans originated, but usually not held, by investment banks. Every CLO raised was unique, but the typical loan agreement including the following tenets: 1) an investment period of five to seven years; 2) manager compensation based on outstanding assets and equity tranche participations; and 3) restrictions on non-cash pay and sub-investment grade assets. The basic terms of the CLO structure created unique motivations for CLO-backed funds, which as we will discuss in more detail, have contributed greatly to the difference in restructuring activity during this cycle.

The Great Credit Recovery

The burst of the credit bubble and the resulting shortage of liquidity experienced by the market began to reverse in early 2009. On the backs of numerous government intervention programs designed to increase money supply in the market, capital seized on opportunities for truly outsized returns. First impacting a severely dislocated secondary bond, loan, and equity market, capital soon began to drive demand for new bond and high yield issuances. Demand became so strong that in 2009, the high-yield market set a record for issuance dollars despite being essentially closed until April. Given that most borrowers were highly leveraged, the preponderance of proceeds from the record high yield volumes were used to repay existing corporate loans provided by banks and CLO-backed funds.

CLO managers became awash with cash from these “bond for loan” takeouts. Unlike banks, however, CLO-backed funds did not first use their cash to shore up capital ratios and repay government loans. What CLO funds instead required was yield on their repaid capital. Still within their five- to seven-year investment windows, CLO managers quickly became desperate to put capital to work. With the secondary markets recovered and not providing substantial yield, what ensued was a remarkable rebound in the new issue loan market. By March and April 2010, pricing and terms in the market began to resemble early credit bubble levels. However, and ultimately tempering the market, CLO managers only had the capital returned from bond takeouts to invest, as the market for issuances of new CLO vehicles continued to remain limited.

In late April and May, the capital markets began to show the strains of the sovereign debt issues in Europe. According to Lipper FMI, skittish high-yield investors withdrew $4.3 billion for high-yield mutual funds in May, marking the highest redemption level since September 2001 and erasing all inflows to date in 2010. As the high-yield markets cooled, cash balances at CLO funds begun to decline as “bond for loan” capital was put to work and not replenished with further activity. With liquidity again draining from bond and loan market, the credit market reversed course in May. Secondary loan paper traded two to three points lower (higher yields), and all but the highest-quality new issuances re-priced, downsized or shelved. The retrenchment in demand was ill-timed, as forward loan supply from pent-up refinancing and buyout activity quadrupled 2009 levels in May 2010 at approximately $20 billion, according to S&P LCD. The resulting credit supply/demand dynamics have lead to concerns about the sources of credit to fuel what had appeared to be a recovering buyout and financing market.

Despite this recent retrenchment in the credit recovery, loan markets at large remain open for business when compared to recent history. According to data from S&P LCD, May represented the third consecutive month of over $20 billion in new issues, a level not reached since June 2008. Specifically, in the middle market, the rebound in the loan markets (typically syndicated cash flow structured products) removed would be volume from the asset-based loan (“ABL”) and club loan markets. Accordingly, as evidenced by ABL spread to Libor of at or below 300 bps for new deals, these more traditional providers of capital are still hungry to put money to work, for now.

What we question most is the source of funds to refinance the wave of maturities looming in late 2011 and 2012. Mid-2000 vintage CLO-backed funds will be largely outside of their five- to seven-year investment window, and unless new CLO vehicles are raised to replace them, it would appear there could be a significant shortage of capital in the market. Accordingly we feel that it is imperative that borrowers take advantage of the credit availability today in order to restructure, recapitalize, and refinance and ensure long-term availability of capital.

Impact on Borrowers and Restructuring Professionals

The Amend to Extend

CLO-backed funds have different motivations than on-balance sheet lenders, which has contributed to their more patient approach when approaching defaults. Given that CLO managers may only have a sliver of equity capital at risk and derive much of their income from the volume of loans under management, their motivations may not always be to sell out of or monetize positions. Additionally many CLO-backed funds are restricted from holding non-cash pay (e.g., equity) securities for prolonged periods. CLO managers have therefore proved more willing than banks to waive defaults or extend maturities as long they are being compensated for the increased risk. Hence, we are witnessing prolific amend to extend volumes ' nearly $60 billion year to date versus a non-existent 2008 market, according to S&P LCD ' despite the recovered capital markets' appetite for providing monetization options.

Although the prevailing “kick the can” mentality has delayed the ultimate day of reckoning for borrowers and lenders, it is not a long-term solution without significant business recovery or deleveraging, and could leave a borrower trying to refinance in an even more difficult market. Instead of seeking the path of least resistance via an extension, now may be the best time to effectuate a fulsome restructuring. With assets marked below par, creative structuring and proper use of the bankruptcy process could end up delivering more value to corporate clients than a simple extension amendment.

Who Holds the Loan?

Based partially on CLO funds' need to maintain ratios of investment grade assets, a much more liquid trading market for loans has evolved. Accordingly, lenders are now able to more readily trade out of troubled credits resulting in diverse bank groups comprised of CLOs, hedge funds and banks. With dramatically different motivations and numerous participants, many bank groups can become paralyzed when needing to react. We see a continuing role for restructuring advisers and insolvency counsel to work on behalf of creditor constituents and negotiate among lender parties to drive the value maximizing result. In addition, for professionals representing borrowers, it has become imperative to address inter-bank group issues expeditiously.

What to Do When You Find Out Who Holds the Loan

When bank groups are more consolidated in distressed situations, it is often due to a handful of hedge fund investors buying up participations in a credit. To a below-par investor, these funds come without the psychological restructuring constraints experienced by banks or CLOs, which are usually par investors looking at sub-par recoveries. Additionally, the distressed loan buyer tends to already have a preconceived plan for extracting value from a loan given that it has elected to purchase the credit based on value rather than loan par dollars.

Having hedge funds as lenders can result in many different outcomes. However, such outcomes are often reached in a more expedited timeline. Borrowers typically fair best when they have taken proactive action and can approach these investors with a plan to deliver value. Accordingly, although engagements for turnaround professionals and insolvency counsel tend to be shorter in duration when hedge funds are involved as lenders, their active presence and experience can prove even more valuable to borrowers when dealing with highly motivated and sophisticated lenders.

Plan to Have a Plan

The rebound in the credit markets and resurgence of the buyout market has been a double edged sword for distressed borrowers. When bank groups have been dominated by more traditional lenders such as banks, the recovery has provided for more realistic options to drive monetization through enterprise sales, divestitures, or liquidations. As such, there will continue to be more of an onus on borrowers and their equity holders to creatively structure other solutions for their lenders that don't involve significant dilution or a wind-down of operations. We expect restructuring professionals and insolvency counsel will continue to prove valuable in counseling borrowers on such solutions.

Conclusion

As the credit markets and their participants have changed, so must the role of restructuring professionals. Legacy CLO-backed funds continue to be the dominant participant in leveraged middle market structures. Their need to adhere with their own funding documents and therefore trade positions has materially changed the market landscape. The proliferation of hedge fund investors in distressed facilities has dramatically changed the attitude of creditors in some restructurings, and the availability of capital has provided lenders seeking monetization with more options than in the past couple years. Taken as a whole, the credit market and its participants have become substantially more complex, which will inevitably lead to a more prominent role for restructuring advisers and counsel in stewarding borrowers and creditors as this cycle continues to progress.

James D. Decker ([email protected]) is the head of Morgan Joseph & Co.'s Financial Restructuring Group. He specializes in representation of both debtor and creditor constituencies as well as the execution of merger & acquisition, financing, and restructuring transactions for troubled companies. James S. Hadfield ([email protected]) is a vice president in the Financial Restructuring Group.