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A wave of downgrades tied to loan buybacks is igniting debate in the leveraged loan and CLO markets, highlighting the growing tension between CLO managers and rating agencies.

CLO managers are already facing mark-to-market losses resulting from the growing number of loans rated below triple-C in their portfolios. The proportion of CLO portfolios with 15-20% of assets rated CCC+ or below went from about 13% last month to about 37% this month, according to a May 8 research report from Morgan Stanley, which based its calculations on a sample of 527 transactions (Fig. 1).

CLO managers are now dealing with an additional problem arising from rating actions that place issuers that buy back their loans below par in technical default. These technical defaults, managers say, artificially inflate the number of distressed loans in their portfolio, increasing the likelihood that many CLOs will go static.

Loan buybacks - which occur when an issuer buys back its loans in the secondary market - have gained in popularity as issuers look to retire debt in a sub-par market and reduce interest costs.

The buybacks, typically completed via an amendment process, are not coercive in nature, giving investors the flexibility to decide whether or not they would like to tender their paper at the price being offered by the issuer. In some cases, companies use cash on hand or increased equity contributions from private equity sponsors to de-lever.

In many cases, loan buybacks are being executed significantly below par, and, as such, are being viewed as distressed transactions by both Moody’s Investors Service and Standard & Poor’s, which, in turn, have been classifying the buybacks as limited default (LD) and selective default (SD), respectively.

“Given our rating methodology of rating to the original promise to pay, economic losses to investors caused by exchange offerings and similar restructurings are by our rating definition a default,” Mimi Barker, director of communications at S&P, said in an e-mailed statement.

To be sure, both agencies recognize that not all buybacks are distressed. In criteria reports released earlier this year, the agencies said they assess an issuer’s creditworthiness to determine if its buyback is distressed or merely opportunistic.

In Moody’s case, if an issuer rated Caa1 or lower implements a buyback that is at a significant discount to par, the transaction is highly likely to be considered a distressed exchange. When this rating is B1 or higher, the transaction is likely to be considered an opportunistic exchange.

S&P’s rating benchmark for identifying a distressed buyback is an issuer credit rating of B- or lower.

Distressed loan buybacks: A win-win for all?
Broadly speaking, both agencies contend that when a distressed buyback is classified as LD or SD, the agencies make assessments that there is a realistic possibility that the issuer would have filed for bankruptcy or fallen into payment default had the buyback not occurred.

For instance, in April, Moody’s downgraded Emmis Communications‘ corporate family rating to Caa2 from Caa1 and changed its probability of default rating to Caa3/LD from Caa2, while S&P lowered the company’s corporate credit rating to SD from CCC+.

The downgrades came on the heels of the company announcing that it would purchase its term loans at a 45% discount and that it had hired Blackstone Advisory Services LP to explore a possible amendment to its credit facility or a possible restructuring of some of its liabilities.

Subsequently, on May 4, S&P raised the company’s corporate credit rating back to CCC+ from SD after Emmis completed four sub-par Dutch tender offers, ultimately buying back its loans at an average discount of 43%.

The rating agencies’ underlying argument is that a distressed buyback is akin to an out-of-court restructuring and that by buying back its loan at a deep discount to par, a distressed issuer is likely avoiding default and not fulfilling the promise to repay its debt at its original terms.

“Bankruptcy is one way of restructuring your debt and reducing the promise you had made to creditors. A distressed buyback is another,” said Kenneth Emery, senior vice president in the Credit Policy division at Moody’s.

These distressed buybacks “can be beneficial for the company by reducing unsustainable debt levels and can be good for those creditors looking to crystallize losses. But the fact remains that the original promise to pay on this debt was not met,” he added.

But critics say investors themselves could stand to gain from a buyback transaction that is voluntary, especially when an issuer offers to buy back its loans above current market prices but below par. In fact, S&P, in its report, acknowledged that “holders may be very pleased with an offer that is above market prices, especially if they account for the investment on a mark-to-market basis.”

“Pre-offer, sellers have always had the alternative of selling the (loan) in the secondary market for less than the original promise,” wrote Chris Taggert, senior loan strategist at independent research firm CreditSights, in an April 22 report. “Why getting more for the (loan) from the seller’s perspective, and improving the capital structure to boot, is tantamount to a default is highly speculative.”

Old rules for a new market
The rating agencies’ argument has the institutional loan world up in arms because the feasibility of issuers repaying their debt on original terms has changed in light of the deterioration in the credit markets.

For one, today’s market, where the average bid on the 100 most widely held loans was sitting at 78.6 as recently as the end of April, is vastly different from the market that existed two years ago when the average leveraged loan was trading at or near par (Fig. 2).

“If you take a B2 or B3 rated company with a performing loan and you suddenly give it a selective default rating because it bought back its loans at a sizeable discount, you do severe, life-threatening damage to CLO investors,” said a CLO manager.

CLO managers dub the rating agencies’ technical default policies as crime and punishment that are disproportionate, stating that the agencies are exacerbating an already serious problem.

“With buybacks, you get de-leveraging, so why is the punishment so harsh,” said another CLO manager, adding that the rating agencies are using rules that were written for a different market and are applying them too literally now.

“The agencies are trying to prove that they’re purer than pure and a lot of people think it’s self-serving,” said a third manager.

Worsening an already serious problem?
The downgrade problem appears to begin early on in the buyback process. For instance, S&P, in its report, said that it generally lowers the facility and issuer credit rating to CC at the mere announcement or anticipation of a distressed buyback.

An example of this is Cinram International Inc., which announced at the end of the first quarter that it was seeking bank permission to amend its credit agreement to buy back up to $150 million of its term loan at a discount to par using an auction.

Like many other borrowers that have been engaging in buybacks, Cinram’s incentive came from its loan trading at a significant discount to par in the secondary market (Fig. 3).

Following the announcement, S&P said the company’s long-term corporate credit rating would be lowered to CCC+ from B for the duration of the buyback process, which could take up to a year, and that the corporate credit rating would be lowered to SD upon completion of the offer.

“Our downgrade today does not reflect a perceived increase in Cinram’s bankruptcy risk,” S&P said in its March 25 ratings release. “Rather, our downgrade is based on the financial pressure we feel Cinram is under to reduce its debt burden by retiring debt for less than originally contracted,”

Once the buyback is completed, the untendered portion of Cinram’s loan is likely to be upgraded, owing to the company’s de-leveraged capital structure.

The impact this fluctuation in ratings has on the loan market is by no means negligible.

At a time of rising defaults and severe liquidity constraints, downgrades or defaults resulting from buybacks add enormous pressure to ratings - and timing-sensitive investors such as CLOs (Fig. 4).

Due to falling prices on underlying loan assets, CLOs are already being forced to mark them to market and, in many cases, move them into their triple-C or default baskets. That, in turn, is reducing CLOs’ overcollateralization cushion (Fig. 5).

So, downgrades to triple-C or an assignment of SD or LD resulting from a loan buyback inflict even greater pain by triggering overcollateralization (OC) tests for those CLOs that choose to hold onto the loan in question instead of tendering it.

These CLOs are required to mark to market the price of the defaulted or downgraded asset based on its price in the secondary market.

The lesser of two evils
CLOs are having “to choose between two undesirable outcomes,” said one CLO manager. “Should a CLO crystallize a loss by selling back its paper to the issuer for a low price or should it take the hit on its OC test by keeping the paper?”

Market players estimate that over 50% of CLOs have breached their OC tests and that buyback-related defaults are a major contributor to that.

Another problem has to do with the time at which a downgrade or default rating is assigned. CLOs have reporting dates in which they do their OC tests. If the test falls on a day when the loan being bought back is assigned a SD/LD rating, then it has to be marked to market and that impacts the OC cushion.

If a CLO fails its OC test, it must redirect cash flows to its senior note holders, reducing what it can pay its equity investors. This affects CLO managers who either own the CLO equity piece or rely on subordinated fees that are contingent on passing OC tests.

CLO managers also say that by moving issuers to default, the rating agencies are, essentially, trying to measure an unobservable event. In other words, it isn’t always apparent that had it not done a buyback, an issuer that was downgraded to SD would have definitively defaulted on its debt.

“It’s a self-fulfilling prophecy because if companies cannot live to fight another day, it really does increase their chances to default,” said a CLO manager.

The future of buybacks
When asked if the rating agencies are putting additional pressure on the market at a time when the market can ill afford it, Emery from Moody’s said that “Moody’s needs to accurately capture default events and our definition of default has always included distressed exchanges. At the same time, it’s worth noting that Moody’s largely rates through these distressed buyback transactions and understands that the transaction can be beneficial to the capital structure of the company.”

A poll conducted by the Loan Syndications & Trading Association (LSTA) in mid-April asked what the likely outcome from the SD situation would be. Thirty-nine percent said the downgrades would cause more CLOs to trigger their OC tests and go static (Fig. 6).

Twenty-eight percent said borrowers would continue to do economically rational buybacks, while another 28% said CLOs would be forced to vote against buyback amendments, thus ending buybacks. The remaining 5% predicted other outcomes for the situation.

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With the backdrop of a deteriorating economy and continued tight lending conditions, middle market borrowers felt the full effects of the paralysis. Lending capacity deteriorated even further as some lenders were busy dealing with their own liquidity problems or reevaluating their portfolios, while others were lending selectively.

Amendments dominated activity, as issuers sought covenant relief from their lenders, who, in turn, received higher spreads and hefty amendment fees.

However, some signs of life have emerged in the primary market in the last few weeks.

“We have seen some deals coming slowly into the market, and some of the larger middle market players that were on the sidelines seem to be making their way back into the market,” says one lender.

Adds another middle market lender: “But these are just very small signs and don’t signal a recovery; we can only be cautiously optimistic.”

In fact, when asked how close the loan market is to reaching a bottom, 60% of Thomson Reuters LPC Quarterly Middle Market Survey respondents say we are there now. For the rest caution prevails: one-fifth say the market may not reach a bottom for another six months, while another fifth say it might be another year.

Fig. 1: Middle market loan issuance fell below $10 billion

In the primary loan market, lending was almost non-existent as capacity continued to shrink and increasing default rates loomed in lenders’ minds. At just over $9 billion, 1Q09 middle market loan issuance was half of 4Q08 issuance, which was already the lowest issuance registered since Thomson Reuters LPC began tracking the middle market in 2000 (Fig. 1).

1Q09 middle market issuance is down 63% from 1Q08 levels, outpacing the 42% drop in overall market lending. Of course, the overall market’s fall was mitigated by steady activity in the investment grade market, while leveraged loan issuance contracted a more significant 58%.

The lack of liquidity, anemic dealflow, the lack of quality opportunities or M&A activity and the economic downturn – all were obstacles cited by lenders to getting deals done in 1Q09. Lending capacity in the middle market, already at constrained levels, shrank even more in 1Q09. One-quarter of survey respondents say lending capacity shrank more than 75% in 1Q09, while another 13% say lending capacity was down 50-75%. One-third says it shrank less than 25%.

Several market players traditionally active in the middle market were busy solving their own liquidity problems and reorganizing their portfolios, says one lender. Those that have the capital to put to work are being extremely selective.

“We can’t risk adding anything that looks even a little hairy to our portfolios,” says one lender.

Fig. 2: Average deal size shrinks dramatically

It was difficult to find a lender group to put together a deal, says another. Others say smaller deals did garner support and were relatively easier to get done as they were done on a club basis. In turn, middle market deals got smaller. The average middle market deal size dropped to less than $100 million in the first quarter (Fig. 2). The last time it was below that threshold was back in 2004.

Fig. 3: Issuance tumbles across the board

But even smaller deals were a struggle and the traditional middle market, which had seen more tempered falls in issuance last year, fell almost as hard as the larger side of the market. The large middle market saw issuance fall 65% to $6 billion and the traditional middle market fell 61% to just above $3 billion (Fig. 3).

Fig. 4: Sponsored issuance evaporates

Sponsors out of the picture
One of the factors that weighed heavily in the drop in lending activity was almost non-existent sponsored issuance, which topped at just $600 million (Fig. 4). This is 3.5 times lower than its lowest quarterly level back in 2Q02. Only a handful of LBO deals took place and they were very small transactions, all belonging to the traditional side of the middle market.

One of the biggest problems in the sponsored loan market is the gap between buyers’ and sellers’ expectations. In the current economic environment, it is difficult to value an asset, and sellers are not getting what they want.

“The multiples are just not there,” says one specialty finance lender who focuses on the sponsored side of the market.

Lenders have little capacity, and what little they have they are using selectively. One lender says the challenge becomes enticing lenders that have capacity to come into a deal at a spread that is attractive to them, but that is not so attractive that it does not work for the sponsor.

In the smaller side of the middle market, it may be less difficult to obtain financing, says one specialty finance lender. There are pockets of money out there to be put to work, but the problem is that deals do not hold together, he adds. Financing terms and deal multiples that worked a few months ago when the deal was initially planned, no longer work for the sponsor. So they go back to the negotiation table to try to obtain a lower purchase price that makes sense and allows them to lever up the deal. Then, either the negotiations drag on too long or the sponsor drops out of the deal altogether, says a lender that focuses on the sponsored market. Similarly, JLL Partners - currently in market with a $95 million credit - contributed over 60% of equity for the buyout of PharmaNet Development Group.

Given the tough conditions in the lending arena, the bulk of the financing has largely fallen on the sponsors. Deals done today are generally done with a higher equity contribution from the sponsor. Industrial Growth Partners, for instance put equity north of 50% when it acquired O’Brien (Obcorp) in 1Q09, according to sources. Similarly, JLL Partners - currently in market with a $95 million credit - contributed over 60% of equity for the buyout of PharmaNet Development Group.

Fig. 5: Lenders expect sponsors to show higher equity contributions

This is reflected in Thomson Reuters LPC’s survey. A whopping 93% of respondents say the minimum acceptable equity contribution on a sponsored transaction is 40%. None of the respondents in the 2007 survey required such a high contribution, and just 16% did so in the 2002 survey, which was during the last downturn (Fig. 5).

And while mezzanine debt made a comeback last year, some say that as total leverage levels have come in, some sponsors are opting to rely solely on senior debt in order to avoid the difficulties of working with a larger, more diverse group of lenders.

Fig. 6: Institutional issuance negligible

No sign of return from institutional investors
The lack of a B loan market and few signs of its reemergence also has made conditions difficult for sponsors. One of the only deals to be considered this past quarter was a $180 million term loan B for Sbarro, which was part of an amendment done via a 100% vote (Fig. 6).

“The B loan market is just non-existent and with the troubles plaguing the CLOs, and the absence of an investor base to replace them, there is no visibility on when that void will be filled,” says one small specialty finance lender.

Banks and specialty finance companies, while not able to fill that void, have been lending – albeit being extremely selective. As leverage levels have come down, deals are fitting more easily into banks’ risk/return parameters. In some cases, banks have been able to participate in deals that in the prior bull market would have met internal hurdles.

Fig. 7: Bank pro rata lending also suffers

While pro rata lending has not vanished as did institutional lending, capacity has shrunk dramatically. Large middle market institutional issuance fell 93% year over year in 1Q09, while bank pro rata lending fell 60% to $8.98 billion, making up the bulk of issuance. And 1Q08 numbers were already weak for the institutional market – 86% below 1Q07 – whereas they were relatively strong for bank loans, down 13% year over year (Fig. 7).

Fig. 8: Non-sponsored lending down again in 1Q

Non-sponsored lending gets selective
With banks staying slightly more active, the non-sponsored, less levered side of the middle market did not fall as hard as the more leveraged sponsor side. Still, non-sponsored loan issuance reached record lows of $8.6 billion, down 51% from the same year-earlier period (Fig. 8). Banks were lending selectively, with a strong focus on their relationships and their core areas of expertise.

One specialty finance lender says banks are able to be a bit more aggressive because they get ancillary business. But still they are demanding tight structures as their risk-return parameters also have shifted significantly.

Fig. 9: Spreads tick up for non-sponsored market

For one, spreads continued their upward trend in 1Q09. The average spread for large middle market, non-M&A related revolvers jumped from LIB+177.9 in 1Q08 to LIB+233.7 in 1Q09. In the traditional middle market, average spreads for non-sponsored revolvers also spiked, climbing from LIB+180.1 in 1Q08 to LIB+271.4 in 1Q09 (Fig. 9).

On the other hand, tenors have become shorter as banks are reluctant to commit their capital to longer-term transactions.

“We don’t even consider doing a five-year facility, at the most we want to do three years,” says one banker.

In turn, the average tenor for both traditional and large middle market multi-year revolvers dropped significantly in 1Q09. In the large middle market, the average tenor was just above three years in 1Q09, down from 2008’s average of over four years. There was also a marked shift in the traditional middle market. Average maturities on multi-year revolvers sank to less than three years from 2008’s 3.9 years.

Fig. 10: 51% amendments at forefront of activity

Amendments keep lenders busy
While new issue nearly evaporated, many issuers struggled with potential or very real covenant breaches and lenders were kept busy with amendments. Over $15 billion of amendments made it through market in 1Q09, $11 billion of which were done via majority vote (51%) amendments (Fig. 10).

Most of the amendments were done via majority votes to avoid putting an existing lender group at risk.

“Amendments that would traditionally get done with a 100% vote are getting done with just the majority vote,” explains one lender. “In this market no one wants to risk it.”

Fig. 11: Four industris make up half of amendment volume

Lenders say deals belonging to a consumer-driven sector, or sectors that have an industrial base, were hit and companies tripped their covenants. In 1Q09, manufacturing companies grabbed an 18% share of total amendment volume. Real estate-related companies, oil and gas companies and retail and supermarkets also saw heavy amendment activity in 1Q09 (Fig. 11).

Fig. 12: Lenders obtain higher spreads in return for more flexibility

Covenant relief, tenor extensions and increased borrowing bases all were reasons issuers sought amendments in the first quarter. In turn, lenders obtained higher spreads (Fig. 12), an amendment fee, at times reduced commitment sizes and other structural changes.

McCormick & Schmick, for instance, amended a deal put in place in December 2007. The maximum debt-to-EBITDA ratio and fixed-charge coverage ratio were loosened. In return, pricing was increased from a range of LIB+62.5-150 to LIB+125-250. The revolver commitment also was reduced from $150 million to $90 million.

But there is not a formula for amendments. Every amendment presents its own case, and the outcome will depend on many variables, says one source.

“You can get a deal in the same scope with similar companies and their terms will end up being very different,” a lender says. “It becomes a challenge to balance the economics of a deal with the right structure. Sometimes it makes sense to settle for a lower increase in spread, without loosening the structure too much.”

Market sources agree there will be many more amendments this year. Forty percent of survey respondents say the bulk of activity in the second quarter will be from amendments. Companies will need to obtain more flexibility from their lenders, especially if the economic outlook does not improve significantly in the near term.

Fig. 13: Nearly $200B in middle market loans maturing in the next three years

Looking forward, lenders are also concerned about deals coming up for renewal. There are roughly $196 billion of middle market loans maturing in the next three years, $32 billion this year alone (Fig. 13). The traditional middle market has almost $12 billion of loans due this year, while the large middle market has over $20 billion in upcoming maturities for the rest of 2009.

“These deals will most likely get amended,” says one lender. “What other options do we have? We are not getting our money back.”

Even if there is a bad credit story behind the deal, lenders will try their best to keep the deal in place, adds another.

Given the dynamics among bank groups on smaller deals, the situation may not be so dire. Sources say lender groups are friendlier and smaller, so it is easier to reach an agreement. But the asset class attracted non-traditional middle market lenders before the credit crunch – over $29 billion of institutional tranches are due in the next three years – so it remains to be seen how this will play out when the time comes to refinance those tranches.

Down the road
1Q09 offered little relief to a struggling middle market, and most middle market lenders say the rest of the year does not look much better. Market sources expect amendments will continue to make up most activity and new issuance will occur at depressed levels.

“The problem is that we still have deals that are levered at pre-crunch levels and since then some have increased their leverage even more, given the state of the economy,” says one bank. “So now their leverage is out of whack. Until we get through all these deals, there will be very little new issuance.”

And the sentiment resonates through the market. A little over half of survey respondents say they expect issuance to remain flat this quarter. One-third say they expect issuance to go even lower.

The economic outlook was cited as one of the biggest issues affecting middle market lending in 2Q09 as it raises many questions. How does the state of the economy affect companies’ performance for the rest of the year? How do lenders value assets? Does the underlying credit quality of issuers improve?

While market sentiment on the state of the economy has seen some improvement in recent weeks, negative news continues to come in. The most recent data shows an unexpected drop in retail sales in March. This cast a shadow over the prior two months, which showed an increase in retail sales and raised hopes for an end to the plunge in consumer spending.

Fig. 14: Default rates set to soars

Meanwhile, the credit outlook has not shown signs of a significant turnaround. In fact, so far this year, default rates have been on the rise with 55 defaults taking place in the U.S. in 1Q09, according to Moody’s Investors Service. This is a lot higher than the 15 that took place in the same period last year. For the 12 months ended in March, the U.S. speculative-grade default rate rose to 7.4% from a much lower 1.8% a year earlier (Fig. 14). And that is not the end of it. Moody’s now predicts default rates will peak at 14.1% in 4Q09.

Fig. 15: Bids recover for most liquid loans, steady for MM

One bright spot, however, is the rise in secondary bids. After increasing 7.88 points in the first quarter, relative to year-end levels, bids on the SMi100 loans have increased over 5 points so far in April, surpassing the 76 context (Fig. 15). The average bid on the less liquid middle market loans slightly up to the 74 level.

But heading into 2Q09, lenders remain cautious.

“It seems that we are not falling as hard and fast as we were before, but we are still heading down,” says one lender. “With more weakness expected before things turn around, it is all about surviving, to be there and have liquidity when things get better.”