Healthcare released from quarantine
–Reuters LPC is a global provider of loan market news, data and analytics to the credit markets worldwide. For real-time news and analytics from LPC’s LoanConnector, sign up here. –As the wider credit markets treat wounds suffered from the current financial crisis, signs of life have emerged in the healthcare industry. Healthcare is typically considered a defensive sector. Many companies have strong balance sheets, predictable cash flows and, most importantly, the ability to repay debtors. So for certain healthcare names, capital has begun to flow again. Some lenders even see the industry as a true growth engine for banks in this time of restrictive lending practices.Despite not being completely inoculated against the crisis, $38 billion of healthcare transactions have been completed thus far in 2009, according to Thomson Reuters LPC data, accounting for almost one-quarter of total U.S. loan issuance. More impressively, 41% ($36 billion) of all investment grade lending to date comes from the healthcare sector (Fig. 1).In fact, while most industries saw declining volumes year over year, 1Q09 healthcare syndicated loan volume outpaced 1Q08 issuance by 150%. M&A was at the forefront of activity with volume up a staggering 7.5 times compared to 1Q08 and already 57% greater than 2008’s total healthcare M&A issuance (Fig. 2). Of course, it should be noted that much of this volume is concentrated in one deal: Pfizer’s $22.5 billion loan, which is the largest U.S. syndicated loan to clear the market since 2007.Positive sentiment in the healthcare sector has also been observed in the secondary loan market. Following signs of a limited recovery in the secondary, healthcare investors have regained some of the losses suffered in 2008. However, healthcare showed more significant signs of an uptick, well ahead of any comparable gains across the broader market. While the overall market has ticked up about 9 points since January to the 70 vicinity, the average bid on healthcare names has gained almost 13 points to the 85 context (Fig. 3).Healthcare’s defensive status in the current recession was an important driver of a speedier recovery in the secondary, as several companies reported solid 1Q09 earnings. Community Health’s $6 billion term loan ticked up about 25 bps after the company reported a 7.6% increase in revenues, in line with market expectations (Fig. 4). The loan is currently bid near 92, up from 78 at year end. And DaVita’s TLB is now trading in the 94 context after jumping about 50 bps when the company posted almost an 8% increase in revenue in the first quarter – creeping closer to par from year-end bids of 86.Secondary trades for HCA Inc. were greatly affected when the largest for-profit hospital chain closed on a $1.5 billion high yield bond issue, the largest deal of its kind so far this year. The company sold the 10-year notes with a yield of 9% and used proceeds to repay a portion of its LBO debt. HCA’s TLA and TLB rose 75 bps ahead of the partial repayment, but after the loans were paid down on April 24, bids settled. The TLB, which began the year at 78, is presently trading in the 91 context.Healthcare’s blockbuster M&A dealsContrary to other sectors where limited loan activity has been focused on refinancings and deleveraging, healthcare has seen significant event-driven financings – specifically in the M&A arena. Although most of healthcare’s primary loan issuance to date comes from Pfizer’s M&A deal, more issuers are expected to make their way to the table this year.Pharmaceutical companies are facing increased pressure to enhance product pipelines in the face of patent expiration, which exposes their products to generic competition. To deal with this issue, larger companies, flush with cash, are looking to acquire small and mid-sized drug companies to increase product lines while reducing overlapping costs.It is estimated that Pfizer, the world’s largest drug maker, could lose approximately $12 billion in annual revenue from the patent expiration of best-selling Lipitor in 2011. To hedge the revenue gap, the company sought out Wyeth. Thanks to the takeover, Pfizer will be able to diversify into vaccines and injectable biologic medicines. Meanwhile, Wyeth also will benefit as its anti-depressant, Effexor XR, loses patent protection in 2010.The takeover, expected to close later this year, was contingent upon Pfizer securing loan financing – not an easy feat in a tumultuous market. But in mid-March, the company secured $22.5 billion of financing for the takeover. The loan was welcomed by lenders due to the lack of high-quality credits with attractive pricing. But capital constraints in the bank market were still evident and the company funded the majority of the $68 billion transaction with $22.5 billion in cash on hand, and $23 billion in stock (Fig. 5).In an effort to entice lenders, highly rated companies such as Pfizer have seen their Libor spreads spike tremendously relative to credits structured prior to the credit crunch (Fig. 6). The company’s $22.5 billion, unsecured 364-day bridge loan was structured much like Verizon’s successful transaction from December 2008 – with a tight ratings grid and duration fees for amounts outstanding.Per the grid, Pfizer’s Aa1/AAA rating set pricing initially at LIB+250 with a 50 bps step-up every quarter, a far cry from prior backstop facilities’ all-in spread of LIB+15. This, in turn, set the benchmark for other investment grade issuers. In conjunction with the new bridge loan, Pfizer also refinanced a $4 billion loan from March 2008, replacing it with a $5 billion, 364-day facility structured with the same pricing grid.Merck & Co. also opted for less funding via the loan market, but nevertheless faced high spreads as an investment grade issuer. Merck’s $41 billion bid for Schering-Plough included only $8.5 billion in loan financing. The remainder was funded by $9.8 billion in existing cash balances, and the rest in stock.The loan portion of the deal is split into a new $3 billion, 364-day bridge term loan, and $5.5 billion in new and amended facilities. Like Pfizer, pricing is based on issuer ratings and includes duration fees and hearty upfront fees. At the current corporate rating of Aa3/AA-, initial pricing is LIB+275. The loan is expected to be paid down by bond offerings and asset sale proceeds in the short term.Schering-Plough was an ideal target for Merck since it has few drugs facing patent expirations, several in the mid- to late stages of development, and the company gains 100% rights to these products post-purchase.On the other hand, pharmaceutical retailer Express Scripts is financing the majority of its acquisition of health insurer WellPoint NextRX’s subsidiaries in the loan market. But at $4.7 billion, it is a comparatively smaller transaction. Express Scripts is currently in market with a $2.5 billion, 364-day bridge loan. Pricing also has been structured similar to Pfizer’s; the initial spread for the BBB rated issuer is LIB+400, stepping up 50 bps every three months until reaching LIB+600. The deal also offers hefty upfront fees of up to 175 bps.Once the loan is completed, the company will finance the remainder of the transaction via cash on hand and up to $1.4 billion in stock. The bridge will likely be refinanced in the bond market and is not expected to be drawn.Bonds back biotech takeoverWhile the aforementioned deals tapped the loan market to various degrees, Swiss drug maker Roche Holding AG primarily financed its hostile takeover of U.S. biotech firm, Genentech Inc., using a combination of bonds, short-term notes, cash and U.S. commercial paper.The investment grade bond market was open for business in 2009, and Roche recognized that the more it could sell there, the less it needed to raise through wary bank lenders. Ultimately, Roche, both an infrequent issuer and a high-quality name with steady cash flows, raised $39 billion in the bond markets, thereby avoiding the loan market altogether.A $16 billion, six-part bond issue sold in the U.S., the largest corporate bond issue ever. And only a week after the U.S. bond offering, a $14 billion, four-part issue in euros and pounds sterling drew $33 billion in commitments, leaving the issue massively oversubscribed.The offering presented generous spreads for a highly rated issuer and even included a coupon step-up clause in pricing, protecting lenders against a downgrade below single-A. After the takeover, Roche’s ratings were cut one notch by Fitch to AA-, and Moody’s Investors Service cut the long-term rating to A2 from Aa1, neither of which triggered the step-up provisions.Roche acquired the 44% of Genentech it did not already own for the winning bid of $95 per share ($46.8 billion total) after a battle that began last summer.Genentech is the world’s largest biotech company by market value with a portfolio of cancer drugs and other medicines. Purchasing the company gives Roche control of all revenues for big-selling cancer drugs Avastin and Herceptin, as well as absorbing an attractive portfolio of new biotech drugs, in turn, helping to round out Roche’s product portfolio.Going forward in 2009, more M&A deals of this kind are expected. Continual breakthroughs in biologic diagnostics and drug therapies have helped create opportunity for small biotech firms, while at the same time posing new financial challenges. Small companies, regardless of their industry, have few financing options due to the credit crunch. And since the economic downturn began, the valuation of biotech companies has declined, possibly sparking further M&A activity in the healthcare sector.Not completely recession proofWhile these few jumbo healthcare deals were successful due to their investment grade profiles and rich spreads, the sector did struggle in the context of overall market trends. Relationship lending remains a priority and smaller deals are still more likely to clear market.According to Thomson Reuters LPC data, over $1.3 billion of middle market healthcare deals have been completed this year, representing 9% of total middle market issuance to date (Fig. 7). Excluding Pfizer, the average deal size diminished to $111 million in 1Q09 from $270 million in 4Q08, highlighting the market’s sweet spot for smaller credits.Thanks to GE Capital’s relationship-based financial support, Vesta Inc. was able to close an $89 million credit facility backing the purchase of ExtruMed LLC in late March. Pharmaceutical retailer Drug Fair Group secured a $40 million debtor-in-possession (DIP) facility provided by Bank of America after filing for Chapter 11 bankruptcy protection.And even a middle market LBO may find success. PharmaNet is in the process of closing a $95 million LBO by JLL Partners, but the bulk of the financing burden has fallen on the sponsor, its equity contribution being over 60%.Putting on some bandagesThrough its new money assets, healthcare has provided some relief to an otherwise ailing loan market. Still, amendment activity was likewise robust. To date, the industry has amended over $42 billion of loans to extend tenors or modify financial covenants to prevent potential events of default. And in a few cases, such as Pfizer and Merck, credit agreements have been modified to allow for acquisitions.In today’s lending environment, refinancing a loan in its entirety is not always an option, even for healthcare issuers. With tightened lending standards and banks short of cash, a new loan puts the existing bank group at risk. But as companies struggle and risk tripping financial covenants, it is in the lenders’ best interest to amend deals by pushing out maturities or loosening covenants. In return, lenders receive hefty amendment fees and much higher spreads.Case in point: Cardinal Health recently loosened covenants on its $1.5 billion revolver from January 2007 in exchange for increased pricing. The grid jumped from a LIB+10-35 range to a much higher LIB +115-275. And in connection with an M&A transaction, Advanced Medical Optics Inc. amended its $300 million revolver to increase the total leverage ratio covenant, while the tender offer by Abbott Laboratories is pending.With a refinancing epidemic set to hit the market in coming years, issuers are unsure where the capital will come from to support that. Thomson Reuters LPC estimates there will be $21.3 billion of healthcare loans maturing for the remainder of 2009, and another $171 billion due in the next three years, peaking at $66.2 billion in 2012 (Fig. 8).Amendments to extend tenor should help maintain some measure of issuer liquidity in the near term. But the bond market may be a more viable long-term substitute to loans given the record-breaking issuance thus far in 2009.The investment grade bond market has natural buyers with a higher risk tolerance, in addition to providing longer tenors on issues. 1Q09 total corporate bond issuance (exclusive of government guaranteed debt) stood at $197.6 billion, up 16% compared to 1Q08. Already, there has been talk of this year’s $25.5 billion in healthcare investment grade bridge loans being refinanced via the bond market (Fig. 9).The prognosisIt remains uncertain whether healthcare can sustain its rally through 2009 since political reform legislation could revamp the industry. Since the recession began, prescription drug prices continue to rise and many unemployed workers cannot afford health insurance. In the near future, roughly 78 million baby boomers in the U.S. will turn 65 beginning in 2011 and will require Medicare coverage. Efforts by the government to extend insurance may negatively impact margins for pharmaceutical manufacturers, but for-profit hospitals are expected to see a decrease in bad debts.Incentives to develop information technology (IT) will improve the overall quality of healthcare while reducing pharmaceutical costs, and healthcare-related technology companies such as Cardinal Health can benefit. But proposals to extend medical coverage into a public plan would shrink the market for private healthcare insurers.In the debt markets, healthcare companies may have access, but with different terms than in the past. All issuers regardless of sector are facing increased pricing and fees, while banks nurse their wounds from the credit crunch.Inverness Medical Innovations Inc. just issued $400 million in high yield bonds, doubling from the expected $200 million. And looking forward, Beckman Coulter intends to finance its acquisition of Tokyo-based Olympus Diagnostics with roughly $500 million in newly issued debt and $300 million in newly issued common stock.As long as lenders see opportunity in healthcare, companies will continue to tap the market.