Loan Market Today And What Leveraged Lending Guidance Might Mean Tomorrow

Transcription

1 Welcome

2 Loan Market Today And What Leveraged Lending Guidance Might Mean Tomorrow

3 Leveraged Lending Guidance Overview State of the Market Today Technicals, Fundamentals, Pricing and Terms The Economic Worldview The Regulatory Worldview The Leveraged Lending Guidance Impact on the Loan Market 2

4 Default rate (%) Fundamentals: Credit Outlook Generally Benign Mild Rise in Default Rates Probable Actual Baseline Forecast Pessimistic Forecast Optimistic Forecast Source: Moody s Investors Service 3

5 Net supply/net demand ($Bils) Technicals: Investor Demand Outstrips Net Supply Demand outstrips supply in March, April 2015 Net supply Net visible demand $16B excess demand In Mar 2015, $15B April 2015 Source: S&P/LSTA Leveraged Loan Index, Thomson Reuters LPC 4

6 Avg bid Share of secondary (%) Secondary Loan Prices Rebound Avg. institutional loan bid recovers Par-plus share rebounds 100-plus 101-plus Source: S&P/LSTA Leveraged Loan Index, LSTA/Thomson Reuters LPC MTM Pricing 5

7 All-in new issue yield (%) Primary Loan Yields Contract in March, April 2015 After rising in 2H14, loan yields contract in March, April 2015 Middle Market Large Corporate Source: S&P Capital IQ/LCD 6

8 Views on Leveraged Lending: The Economic Perspective Leveraged lending on the hot seat with regulators: We re looking to deter the origination of criticized or below-standard loans, Martin Pfinsgraff, senior deputy comptroller for large bank supervision at the Office of the Comptroller of the Currency. Bloomberg, November 2013 The impact on private equity, a significant driver of what we see as risky practices, is an intended consequence of our actions, Martin Pfinsgraff, senior deputy comptroller for large bank supervision at the Office of the Comptroller of the Currency. WSJ, January

9 What Does the Research Say About Leveraged Lending? Theory Debt acts as a disciplining device for management; forces managers to hit benchmarks to service debt (Jensen, 1986). Debtholders are better monitors than managers/owners when firm performance is declining (Aghion and Bolton, 1992). LBOs can induce/create optimal governance through disciplining effects of debt, concentrating ownership and sophisticated investors (Jensen, 1989). 8

10 Economic Perspectives on Leveraged Lending: The Tension Regulators: Leveraged lending is bad especially for LBOs because it increases risks of corporate default and bank failure. Financial theorists: Use of leveraged lending could be good for companies. What does the empirical research tell us? 9

11 What Does Empirical Research Tell Us About Leveraged Lending? James (1987): Stock prices of borrowing firms respond positively to announcements of new bank loans. Opposite for public bond offer announcements: stock prices fall. Houston and James (1996): Companies with high growth opportunities rely more on bank debt than public bonds. Cite flexibility in contracts and control through covenants. Nini, Smith, and Sufi (2009): Investment-related loan covenants (capex restrictions) hinder bad investment and improve company performance. Roberts and Sufi (2009): Loan agreements negotiated often to manage borrower-lender relationship. Nini, Smith, and Sufi (2012): Financial covenant violations lead to more conservative firm behavior; improved company performance. 10

12 Mean Median Cumulative Abnormal Return Abnormal return in month Nini, Smith and Sufi (2012): Turnaround in Operating and Stock Price Performance of Covenant Violators Operating Cash Flow scaled by Lagged Assets Equity Abnormal Returns Quarters to violation Months to violation Mean Median Cumulative Abnormal Return Conclusion: Empirical research suggests bank lending, particularly to leveraged borrowers, plays positive financing and governance role. 11

13 What Does Empirical Research Tell Us about LBOs and LBO Financing? LBOs lead to significant operating gains among PE-owned firms. See Kaplan and Strömberg (2009), Lerner, Sørensen, and Strömberg (2011), Davis, et al. (2011), Matsa (2011), Cohn, Towery, and Mills (2013), Harford and Kolasinski (2013), Bernstein and Sheen (2013)... and significant returns to PE investors, see e.g., Harris, Jenkinson, and Kaplan (2014). PE-backed firms are no more likely to default than other borrowers in the leveraged loan market; less likely to default at high-debt levels (Hotchkiss, Smith, Strömberg, 2014). PE-backed firms move through distressed restructurings more quickly (in and out of court) and are less likely to liquidate than other distressed leveraged borrowers (Hotchkiss, Smith, Strömberg, 2014). Conclusion: Empirical research counters idea that LBOs add to excessive risktaking; limiting LBOs could have downside. 12

14 Views on Leveraged Lending: The Regulatory Perspective We re looking to deter the origination of criticized or below-standard loans, Martin Pfinsgraff, senior deputy comptroller for large bank supervision at the Office of the Comptroller of the Currency Bloomberg, November [A] poorly underwritten leveraged loan that is pooled with other loans or is participated with other institutions may generate risks for the financial system. Leveraged Lending Guidance (78 F.R ). "The impact on private equity, a significant driver of what we see as risky practices, is an intended consequence of our actions," Martin Pfinsgraff, senior deputy comptroller for large bank supervision at the Office of the Comptroller of the Currency. WSJ, January Since the issuance of the 2001 guidance, the agencies have observed periods of tremendous growth... in the participation of unregulated investors. Leveraged Lending Guidance (78 F.R ). "We do not see any benefit to banks working with alternative asset managers or shadow banks to skirt the regulation and continue to have weak deals flooding markets," said Martin Pfinsgraff, senior deputy comptroller for large bank supervision at the Office of the Comptroller of the Currency. Reuters, January

15 Leveraged Lending Guidance Background Banks should not originate* loans to companies that cannot show the ability to repay all of their senior secured debt or half of their total debt in five to seven years from base cash flows Leverage > 6x raises concerns** Is this a way for regulators to squeeze leverage from the system; reduce bubbles/perceived systemic risk? Last year, people said banks weren t complying But the market is changing. * Originate means originate, refinance or modify; it s not clear the leeway banks have in refinancing or amending special mention loans that are performing well; Regulators have also said that banks should not originate non-pass credits ** But only 54 percent of recently originated loans with leverage > 6x were criticized 14

16 Share of loans 6X (%) Leverage Levels Have Backed Off 2014 Highs Share of LBOs with leverage 6x begins to drop There are fewer deals with leverage of 6x or more Almost all deals show the ability to repay debt from base cash flows But other structural softening is appearing/may be accelerating Source: S&P Capital IQ/LCD 15

17 Share of respondents Lender Views on Leveraged Lending Guidance are Changing TR-LPC Survey: Impact of LLG: Views evolving Big: Noticeable drop in bank participation Modest: Banks more selective None: Banks continue to buy lev loans Market participants now see LLG as a significant limiting factor Source: Thomson Reuters LPC 16

18 LBO Loan Bookrunner Vol. ($Bils.) Leveraged Lending Guidance: Who is Leading LBO Loans? LBO Bookrunner League Tables 1Q14 1Q15 Bookrunners have been changing for LBO deals Non-bank market share is up to 22% for 1Q15 Source: Thomson Reuters LPC 17

19 Criticized loans ($Bils.) But What About Refinancing Non-Pass Inst TLs? Maturity profile: Higher/lower estimates of outstanding criticized TLs Low end est (ratings-based) High end est (33% of index) A key issue is how to refinance criticized institutional TLs Unfortunately, without transparency, we simply don t know how many criticized TLs are outstandings Thus, we created high and low estimates High estimate: 33% of all non-defaulted institutional loans are criticized (based on SNC comment that 33% of lev loans were criticized) Low estimate: Assumes CCC+ and below cos are criticized; 75% of B- cos are criticized; excludes NR and defaulted loans Source: LSTA, S&P/LSTA Leveraged Loan Index 18

20 List of Academic References Bernstein, S. and Sheen, A., 2013, The Operational Consequences of Private Equity Buyouts: Evidence from the Restaurant Industry. Stanford University working paper. Cohn, J. B., Mills, L. F., and Towery, E. M., 2014, The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts: Evidence from U.S. Corporate Tax Returns. Journal of Financial Economics 111(2), Davis, S.J., Haltiwanger, Jarmin, J.C, R.S., Lerner, J. and Miranda, J., 2011, Private Equity and Employment. Center For Economic Studies working paper. Hotchkiss, E., Smith, D. and Strömberg, P., 2014, Private Equity and the Resolution of Financial Distress. University of Virginia working paper. Houston, J., James, C., 1996, Bank information monopolies and the mix of private and public debt claims. Journal of Finance 51, James, C., Some evidence on the uniqueness of bank loans. Journal of Financial Economics 19, Kaplan, S. N. and Strömberg, P., 2009, Leveraged buyouts and Private Equity. Journal of Economic Perspectives, 23(1), Lerner, J., Sørensen, M. and Strömberg, P., 2011, Private equity and long run investment: the case of innovation. Journal of Finance 66(2),

21 List of Academic References (continued) Matsa, David A, 2011, Running on empty? Financial leverage and product quality in the supermarket industry. American Economic Journal: Microeconomics 3, Nini, G., Smith D. and Sufi, A., 2009, Creditor Control Rights and Firm Investment Policy. Journal of Financial Economics 92: Nini, G., Smith, D. and Sufi, A., 2012, Creditor Control Rights, Corporate Governance, and Firm Value. Review of Financial Studies 25: Roberts, M., and Sufi, A., 2009, Control Rights and Capital Structure: An Empirical Investigation. Journal of Finance 64:

22 The Costs Of Chapter 11 Reform A Discussion about the Report of the ABI Commission to Study the Reform of Chapter 11 21

23 I. Introduction: The Commission and its Report On December 8, 2014, the ABI Commission to Study the Reform of Chapter 11 released its Final Report and Recommendation on reform of Chapter 11. The report is 397 pages, with more than 200 recommendations. The report contains some proposals that target secured creditors and would limit or reduce their rights in bankruptcy. 22

24 ABI Commission Mission Statement In light of the expansion of the use of secured credit, the growth of distressed-debt markets and other externalities that have affected the effectiveness of the current Bankruptcy Code, the Commission will study and propose reforms to Chapter 11 and related statutory provisions that will better balance the goals of effectuating the effective reorganization of business debtors with the attendant preservation and expansion of jobs and the maximization and realization of asset values for all creditors and stakeholders. 23

25 The Commission s View of the Current Bankruptcy Regime Greater complexity of capital structures, increased reliance on secured credit, shift toward intangible assets and the rise of claims trading have left the 1978 Code obsolete in many respects. Anecdotal evidence suggests that Chapter 11 has become too expensive and is no longer capable of achieving certain policy objectives such as stimulating economic growth, preserving jobs and bases or helping to rehabilitate viable companies that cannot afford a Chapter 11 reorganization. As compared to the early years of the Bankruptcy Code (the Code) there are now more and quicker sales of a debtor s assets, fewer stand-alone reorganizations, lower recoveries to unsecured creditors and higher costs associated with Chapter 11. The original balance the Code struck between preserving troubled businesses and maximizing value for creditors is now askew. Changes are necessary to shift power back to the debtor and the unsecured creditors. 24

26 The ABI s Narrative About Secured Credit s Effect on Chapter 11 Cases Debtors come into bankruptcy with more secured credit and little unencumbered value. Most DIP loans are provided by prepetition lenders who impose extraordinary terms that give secured lenders substantial control over bankruptcy process. Debtors thus have far less flexibility to run a traditional reorganization process. Secured creditor control increasingly leads to liquidations and quick 363 sales which may undervalue the enterprise, rather than traditional reorganizations. Unsecured creditors are increasingly out of the money, and receive little or no benefit from the bankruptcy process. 25

27 The LSTA s View The empirical data and the academic evidence and research demonstrate that the U.S. bankruptcy regime continues to be effective and efficient. It is the envy of the world and the model for many countries that are struggling to find a better way to rehabilitate their companies. The Commission s view that the Code is broken relies in large part on anecdotal evidence, rather than data. The Commission s philosophy of the bankruptcy code is misguided; rather than focusing on maximization of the value of the estate and protection of creditors, they are more concerned with distribution issues. Some of the Commission s specific proposals add uncertainty and complexity to the bankruptcy process, would slow down that process and would be very harmful to secured creditors. If enacted, the likely results of these proposals would be lower recoveries for secured creditors and higher costs for leveraged loans and DIP loans. As cases such as Momentive demonstrate, the adoption by courts of some of the Commission s proposals could be very harmful, even without legislative action. 26

28 What Does the Data Show? 27

29 Academic Perspective: Theory Why secured debt could be bad for Chapter 11 debtors and other parties: Push for quick liquidations or sales, and fewer reorganizations; Seek outcomes that maximize their own recoveries at expense of junior creditors; Make DIPs difficult and uncompetitive because of lack of unencumbered assets. Usurp Chapter 11 control from judges and debtor. 28

30 Some Implications From Theory Why secured debt could be good for Chapter 11 debtors and other parties: Use early triggers (e.g., financial covenants) to restructure company earlier Provide financing when others will not Provide credit insurance for unsecureds (letters of credit) Sophisticated players understand workouts 29

31 What Can the Data Tell Us? 1. Over the last 20+ years, direct costs of bankruptcy (fees paid to professionals) have likely fallen by an enormous amount. 30

32 Median Days in Chapter 11 (Lopucki) 31

33 What Can the Data Tell Us? 2. Over the last years, the proportion of debt of Chapter 11 filers that is financed by secured debt has increased a lot. 32

34 Use of Secured Debt by Chapter 11 Filers (Moody s) Fraction debt secured, median filer Fraction 100% secured Fraction 100% unsecured 33

35 What Can the Data Tell Us? 3. How does this increase in use of secured debt correlate with Chapter 11 outcomes? Filers more likely to be liquidated today than prior to the rise in secured debt? More likely to be sold through a Section 363 sale? Less likely to emerge through a reorganization? 34

36 Bankruptcy Outcomes (Lopucki) Fraction emerge reorganized Fraction liquidated Fraction emerge 363 sale 35

37 What Can the Data Tell Us? 4. Direct costs have fallen as a result of shorter times in Chapter 11. But at what cost? Have total recovery rates fallen during this period? How about recoveries to unsecured creditors? 36

38 Recovery Rates For Defaulted Firms (Moody s) Total family recovery rates Unsecured recovery rates 37

39 38

40 Secured Credit and Asset Sales: Academic Evidence Westbrook (2014): Examines the relation between level of secured credit and likelihood of observing 363 sale among relatively small bankruptcy cases. Collects data on 424 randomly selected bankruptcy cases filed in nine districts (including DE and SDNY) during Findings: Less than ½ of firms file with more than 50 percent of assets financed by secured debt, implying large equity cushion in majority of cases. Substantial 363 sales are observed in < 30 percent of cases; no evidence that quick sales dominate. No statistical relation between amount of secured debt at filing and likelihood of sale. 39

41 The Academic Studies Jenkins and Smith (2014) Studies incentives for secured creditors to force inefficient liquidations or sales in bankruptcy Develops a simple model that mirrors characteristics of U.S. Chapter 11 and allows for estimation of efficiency of outcomes Estimates model using 721 Moody s U.S. bankruptcies from Findings: Inefficient sales/liquidations occur in 8% of cases; typically occur when collateral market value near level of secured claim Average cost of inefficiency is small: 0.28% of reorganization value 40

42 The Academic Studies Gilson, Hotchkiss and Osborne (2015) Examines the relation between level of secured credit and likelihood of observing bankruptcy asset sales in large bankruptcy cases Collect data on 350 public firms that file for bankruptcy during period Findings: Higher levels of secured credit correlated with sales of firm as a going-concern, but not with increased liquidations Sales as going-concerns have survival rates and post-bankruptcy recovery rates that are similar to reorganizations Conclusion from three studies: No relation between secured credit and value-decreasing inefficient sales 41

43 References Gilson, S., Hotchkiss E., and Osborne, M., 2015, Cashing out: The rise of M&A in bankruptcy. Harvard University working paper. Jenkins, M. and Smith, D., Creditor conflict and the efficiency of corporate reorganization. University of Virginia working paper. Westbrook, J., 2015, Secured creditor control and bankruptcy sales: An empirical view. University of Illinois Law Review

44 The Principles of Bankruptcy Corporate bankruptcy exists to provide a forum in which to vindicate creditors and shareholders state-law entitlements in an orderly and equitable fashion and to enable the reorganization of financially distressed businesses, if doing so is feasible and in creditors best interests. Bankruptcy law alters non-bankruptcy rights only to the extent necessary to vindicate some overriding principle of law. Otherwise, bankruptcy takes all constituencies rights and obligations essentially as it finds them. Making bankruptcy serve a redistributional purpose necessarily gives parties whose non-bankruptcy rights are being altered perverse incentives to invoke (or attempt to evade) the bankruptcy process for reasons that have nothing to do with bankruptcy's core function. Reorganization of businesses is a goal of corporate bankruptcy but only up to a point: the Code does not permit businesses to be reorganized if doing so is detrimental to creditors, even if keeping the business alive might have other beneficial consequences. 43

45 The Commission s View Balances competing interests based on subjective perceptions of fairness; Assumes that reorganizing debtors is an independent goal of Chapter 11 that can be balanced against the goal of maximizing value for creditors. Would effectively require secured creditors to subsidize debtors reorganization efforts at the expense of creditors right to the full value of their collateral; Does not provide a predictable legal regime or a forum to maximize value; Lacks analytical coherence; and Provides no principled basis for resolving new questions as they arise. 44

46 The Commission s Proposals 45

47 Adequate Protection Adequate protection would be based on the Foreclosure Value of the collateral, rather than the reorganization value. Foreclosure value means the net value that a secured creditor would realize upon a hypothetical, commercially reasonable foreclosure sale of the secured creditor s collateral under applicable nonbankruptcy law. There can be a substantial difference between foreclosure value and reorganization value. Pinning adequate protection to foreclosure value significantly disadvantages secured creditors by taking away much of the protection against depreciation in the value of their collateral caused by bankruptcy and the automatic stay. 46

48 Redemption Option Value Under a Chapter 11 plan, or in a Section 363 sale, secured creditors will be entitled to the reorganization value of their collateral (subject to the redemption option ). Reorganization value means (i) if the debtor is reorganizing, the enterprise value attributable to the reorganized business entity, or (ii) if the debtor is selling all or substantially all of its assets under section 363 or a Chapter 11 plan, the net sale price for the enterprise. Thus, two different valuations of collateral will be necessary: one to ascertain the foreclosure value for adequate protection purposes at the beginning of the case and one to ascertain the reorganization value for purposes of distribution at the end of the case. 47

49 Redemption Option Value The Redemption Option is intended to address the fact that valuation in bankruptcy necessarily occurs at a particular time, which may be during an economic downturn and may thus undervalue the enterprise. It is intended to compensate junior creditors for any unfairness resulting from that. Example: If a senior secured creditor with a blanket lien on the debtor s assets is owed $100, a junior creditor is owed $20, and the enterprise value of the debtor at confirmation or sale is $90, the senior creditor will receive $90 and the junior creditor $0. But what if, during the next few years, the enterprise value of the debtor proves to be much higher, such that the junior creditor could have been in the money? 48

50 The Redemption Option The Redemption Option expands the timeframe for valuation of the enterprise by conceptualizing junior creditors as having an option on the potential increase in value. The option is an option to purchase the enterprise, with a strike price equal to the full amount of the senior creditor s claim (in this example, $100), expiring three years after the petition date. Under either a plan or a 363 sale, the junior class is entitled to the value of that hypothetical option. The option may have no value at all; the value will be greatest if the junior class is only slightly underwater. The option typically will not be an actual option, but some other kind of compensation for the option value. The upshot is that, in most scenarios, the senior secured creditor will have to carve out some amount for the junior creditor, even if the senior creditor is not paid in full; ironically, this is already common place in Chapter

51 363 Sales Creates a new provision, 363x, for sales of substantially all of the debtor s assets that: Establishes a 60-day moratorium on 363x sales within the first 60 days of a case, unless a party can show by clear and convincing evidence a high likelihood that the value of the debtor s assets will decrease significantly during such 60-day period and; Requires courts to find that the sale is in the best interests of the estate and satisfies certain provisions required in the Chapter 11 plan process. 50

52 DIP Financing The report imposes several new restrictions on DIP financing: No roll-ups unless the postpetition lender is not affiliated with the prepetition lender or the postpetition lender pays prepetition debt in cash and extends substantial new credit on terms better than any alternative, and court finds it s in best interest of estate No liens on estate s avoidance actions No milestones or benchmarks or representations regarding validity of liens within 60 days of petition or in an interim financing order Provisions of intercreditor agreements restricting junior creditors ability to provide postpetition financing are unenforceable (but senior creditors would have the option to provide financing at the same terms) 51

53 Next Steps The Commission presented the report to Congress Congressional hearings possible in 2015 Any legislation is most likely well down the road the Commission has been throwing out 2018 as a possible date The LSTA is drafting a comprehensive response that will present our view of the empirical evidence, the report s overall philosophy and its specific recommendations, which we hope to produce in June or July

54 Cramdown Interest Rate Debate Formula rate approach vs. market rate approach o o Formula rate approach applies a base rate (generally the national prime rate or Treasury rate) plus a risk premium (generally 1 percent to 3 percent). Market rate approach looks to whether an efficient market exists for the loan in question. If so, the market rate is applied; if not, the formula rate is applied. Till, the seminal Supreme Court case on cramdown interest rates, applied the formula rate approach in a Chapter 13 case, but left the door open for application of the market rate approach in the Chapter 11 context. Since Till, courts have been divided in their approaches. o Most recently, a district court in the Southern District of New York affirmed the bankruptcy court s holding in Momentive, which rejected the market rate approach and applied the formula rate approach. Interestingly, the ABI Commission s report, which specifically responds to Momentive, advocates for application of the market rate approach. 53

55 Thank You