DDJ CAPITAL MANAGEMENT, LLC SPECIALISTS IN HIGH YIELD AND LEVERAGED CREDIT INVESTMENTS NOVEMBER 2017 VOLUME 4 ISSUE 4 Second-Lien Loans: Increased Use in LBO Financing > Favorable call profile typical of leveraged loans relative to bonds is driving this trend > Second-lien loan market is a small, niche segment with intricacies that differentiate it from the broader leveraged credit market Andrew Ross, CFA Director, Portfolio Specialist Mr. Ross joined DDJ in 2016 as a member of the Business Development and Client Service team. He works to communicate DDJ s investment philosophy and strategies with clients, consultants, and prospects. Mr. Ross is a CFA charterholder. Stony Brook Office Park 130 Turner Street Building 3, Suite 600 Waltham, MA 02453 Phone 781.283.8500 Web ddjcap.com
leveraged buyouts ( LBOs ) were the largest driver of second-lien loan volume growth Introduction Total institutional leveraged loan new issuance in the first nine months of 2017 has already surpassed the previous calendar year record set in 2013. However, with refinancing and repricing transactions accounting for over 70% of such volume, on a net basis, new issuance volume is less extreme. Examining second-lien loans specifically, issuance has increased significantly this year, more than doubling calendar year 2016 total volume during the first three quarters. However, unlike total institutional leveraged loans (which comprise approximately 95% first-lien loans), leveraged buyouts 1 ( LBOs ) were the largest driver of second-lien loan volume growth. We do not believe this is a one-off development, but rather the continuation of a trend that began a few years ago and more recently has picked up steam. More specifically, the trend we are referring to is a change in the funding structure that Private Equity ( PE ) firms are using to fund LBOs. Historically, it was common for such buyouts to be financed with a first-lien (senior secured) leveraged loan, an unsecured bond, and an equity contribution from the acquiring PE firm. More recently, however, many PE LBO sponsors are replacing the unsecured bond piece in the funding structure with a second-lien leveraged loan, resulting in all-loan debt financing. In this paper, we will discuss why we believe this development has occurred and whether it is likely to continue; compare and contrast the characteristics and new issuance process for bonds vs. second-lien loans; and summarize the pros and cons of each financing structure from an investor perspective. In addition, we will highlight certain key attributes that we believe are important to be successful investors in the second-lien loan market over the long term. What is driving this change? Exhibit 1 below compares second-lien loans to high yield bonds, highlighting the major differences between the two debt instruments. In addition, when referring to bonds, unless otherwise noted, we are referring to senior unsecured high yield bonds, which are commonly issued. Furthermore, it is important to emphasize that in many cases, because of the private nature of second-lien loans, investors typically gain greater access to information when compared to what is available in most high yield bond deals a feature of second-lien loans we will reference throughout this paper. Exhibit 1: Typical Characteristics Second-lien leveraged loan High Yield Bond (Unsecured) Coupon Floating (based off 3-month LIBOR); generally higher Usually fixed; generally lower Secured Yes - second priority claim on issuer s assets Not typically Private Yes Not typically Liquidity Less liquid More liquid Issue Size Typically smaller Typically larger Callable Issuer (borrower) friendly call profile Investor (lender) friendly call profile The move by many PE firms to utilize second-lien loans rather than unsecured bonds to finance LBOs has contributed to a meaningful increase in second-lien leveraged loan issuance thus far in 2017. While the increased second-lien loan issuance has caused many market participants to call attention to this change more recently, the trend has actually been underway for the last few years. As one can conclude from Exhibit 2 below, the percentage of total second-lien loan 1. A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company. DDJ CAPITAL MANAGEMENT 2
issuance used in LBO transactions is on pace to meaningfully exceed the longer-term average for a third consecutive year. Exhibit 2 also displays the actual dollar amount of LBO-related second-lien loan issuance by calendar year. We believe the reason for this change is the favorable call profile typical of leveraged loans relative to bonds, which provides issuers with significant flexibility to address their capital structure in the future. In general, leveraged loans can be called after a shorter time frame has passed post issuance, and the premium paid by the issuer to call the loan is significantly lower than that of a bond. We believe that PE firms are willing to pay a higher interest rate, and thereby increase their exposure to rising interest rates which would increase the interest cost for the issuer in exchange for the ability to refinance the loan sooner and less expensively than a bond. The PE sponsor views this flexibility very favorably as it could reduce the issuer s borrowing costs considerably in the event that the issuer can refinance the loan at a lower rate should either the overall market and/or the issuer s fundamental profile improve prior to maturity. We expect the use of second-lien loans rather than unsecured bonds to finance LBO transactions to continue and possibly to increase unless demand for second-lien loans declines significantly and/or the call protection of bonds declines and begins to resemble that of leveraged loans (an outcome that we believe to be unlikely). Exhibit 2: Historical LBO Driven Second-Lien Issuance (Annual Calendar Year Volume 2003 - YTD 2017*) 70% LBO % of Second-lien total new issue volume $14 Second-lien loan annual issuance $BN (LBOs) 60% $12 50% $10 40% $8 30% $6 20% $4 10% $2 0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017* $0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017* LBO 16-yr Avg Source: S&P Leveraged Commentary and Data;* 2017 YTD through 9/30/17 Bonds vs. second-lien loans the new issue process The second-lien loan market is a small, niche segment within the overall leveraged credit market that has some characteristics that differentiate it from the broader high yield bond market. These differences are especially evident in the new issue market. Below we provide a high level overview of the new issue process for high yield bonds and second-lien loans, highlighting some of the attractive features of second-lien loans, in particular, a longer period of time to research and better access to information regarding the issuer prior to making any commitment to invest. DDJ CAPITAL MANAGEMENT 3
The syndication process for second-lien loans, on the other hand, is more involved and can take weeks to complete In a typical LBO driven transaction process, both high yield bonds and second-lien loans usually go through a syndication process. The process for most high yield bond new issues typically follows a somewhat standard template: potential investors receive an offering memorandum for the bond deal usually via email with only a few days time to decide whether to participate or not. The financial information accessible to potential bond investors is generally limited, and contains only pro forma financial data with no forecasts or detailed historical financial information. The syndication process for second-lien loans, on the other hand, is more involved and can take weeks to complete. The process usually begins with a pre-marketing phase, in which potential investors sign a confidentiality agreement, generally resulting in such investors being restricted from trading any securities of the issuer. Upon execution of the confidentiality agreement, potential lenders are given access to significantly more information relative to bond offerings, especially historical company financial information as well as management projections for future financial performance. Furthermore, likely as a result of the second-lien loan new issuance process (i.e., longer time from start to finish and fewer number of investors involved), DDJ s experience is that its research analysts typically obtain greater access to company management when analyzing a second-lien loan issuance relative to a bond issuance. DDJ believes that the additional financial information on the issuer (both historical and forecasted) and greater access to management provided in the second-lien loan process is especially beneficial to firms that perform extensive bottom-up fundamental analysis and due diligence with respect to each individual investment opportunity. Distinguishing factors of the second-lien loan market Given the relatively small size of the overall second-lien loan market and the intricacies of such market, DDJ believes that certain less tangible factors, such as relationships, reputation, infrastructure, and legal expertise, play an outsized importance in this market. For example, both cultivating relationships and establishing a well-regarded reputation typically take time and are correlated with a firm s level of experience investing in the second-lien loan segment of the market. The universe of second-lien loan investors and market participants is relatively limited. Relationships oftentimes drive knowing whom to call when you are looking to trade, whether you receive a call from a broker when another firm is looking to sell, or whether you are informed of an upcoming second-lien loan new issue before the launch of the syndication process. Similarly, developing a reputation as an honest and professional investor with significant assets dedicated to investing in second-lien loans can go a long way. For example, if sponsors, brokers, or underwriters know from experience that your firm may be interested in serving as an anchor holder in a new issue, you may be more likely to receive that first call for a preferential allocation when a new deal is coming to market. In addition, another important aspect for firms investing in second-lien loans is the need to develop and maintain an appropriate compliance and operational infrastructure to trade secondlien loans. Because the second-lien loan process often involves investors receiving confidential, potentially material non-public information, firms evaluating a second-lien loan opportunity need to implement comprehensive and effective policies and procedures to safeguard the confidentiality of such information, including appropriate restrictions on trading any securities issued by the subject firm until the transaction is complete. These compliance requirements may deter larger investment managers who invest across multiple asset classes from investing DDJ CAPITAL MANAGEMENT 4
in second-lien loan new issues, as the broad trading restrictions associated with the receipt of confidential information could negatively affect the management of other investment strategies offered by such firms. Furthermore, trading of second-lien loans is not as straightforward as bonds, particularly as it pertains to trade settlement. While high yield bonds typically settle on a T+2 (trade date plus two business days) basis, usually via the Depository Trust Corporation (DTC), leveraged loans can and typically do take in excess of two weeks to settle. Trading on an extended settlement basis can result in frictional issues associated with various investment management functions, such as pre and post-trade compliance, order management, accounting, and cash management (as a firm may need to maintain sufficient cash to fund a loan trade that was executed weeks prior). Not only does this require systems that can effectively facilitate trading on an extended settlement basis, it often requires employees from various departments within the firm to coordinate the monitoring and management of the settlement process to prevent disruptive delays or other more significant consequences. Furthermore, loan trading is especially manual, and requires the preparation of assignment agreements for each trade that need to be executed by the counterparty as well as the administrative agent for the particular credit prior to settlement. Although the loan trading process has become more standardized and streamlined in recent years, it remains significantly less efficient than trading a traditional bond. In addition, when investing in high yield debt instruments including second-lien loans the importance of performing rigorous legal due diligence cannot be overstated. The ultimate goal of such due diligence is to identify and understand the legal risks associated with such investment so that any potential downside can be fully assessed. In the new issue process, an important distinction between high yield bonds and second-lien loans is in the degree to which the underlying legal agreements are standardized. As a generalization, high yield bond indentures are more standardized, while the credit agreements governing second-lien loans have historically, at least in part, been the result of negotiations between lenders and borrowers. An experienced legal team can add considerable value in an environment where lenders have the leverage to negotiate protective legal terms for second-lien loans. By understanding the proposed legal terms, in particular as it pertains to negative covenants, a firm is better equipped to negotiate changes that benefit lenders, though the likelihood of successfully negotiating such changes is highly market dependent. For example, in the current market where investor demand for leveraged loans is high, borrowers generally have the upper hand in negotiating the terms of a new loan issuance (legal related or otherwise). However, this dynamic is not always the case, and DDJ has found it a best practice to attempt to negotiate prudent and reasonable legal changes whenever possible. Ultimately what is most important, however, is to recognize when to walk away from a deal, regardless of how attractive the basic economic terms appear, if the lack of adequate legal protections presents too much downside risk. DDJ CAPITAL MANAGEMENT 5
For other investors, the higher coupon/ yield typically offered by second-lien loans relative to unsecured bonds serves as the main attraction Pros and cons of each asset type Any discussion regarding this trend would be incomplete if it did not include the pros and cons, or trade-offs, investors make when investing in a second-lien loan relative to an unsecured high yield bond. Exhibit 3 below highlights the main trade-offs, which should be viewed as generalizations that do not apply in all situations, but are typically the case. Exhibit 3: Investor perspective - pros and cons of second-lien loans (relative to unsecured bonds) Pros Higher coupon Floating coupon rate - less interest rate exposure Secured by second-priority claim on assets of issuer Access to greater issuer information (e.g., management projections) Historically more ability to customize terms and legal documents Source: DDJ Capital Cons Less call protection Less liquid (trade less frequently) Longer settlement - both at initial issue and in secondary markets Not included in high yield indices; guideline restrictions may limit second-lien loan exposure for traditional high yield managers Potential for restrictions on trading other securities of issuer Investors are attracted to second-lien loans for a number of reasons. The floating-rate coupon, which reduces exposure to rising interest rates, is attractive to those looking to reduce interest rate risk. For other investors, the higher coupon/yield typically offered by second-lien loans relative to unsecured bonds serves as the main attraction. In addition, for leveraged credit managers that perform bottom-up fundamental research and individual security selection, the access to greater issuer information particularly as part of the new issue process combined with lower overall investor participation in the second-lien loan market, creates a less efficient (and oftentimes mispriced) market in which discerning investors can add value for their clients. Many of the drawbacks of second-lien loans listed above, such as the longer settlement process, the off-index nature for many high yield bond managers, and common guideline restrictions that limit or altogether prohibit leveraged loan exposure for traditional high yield bond managers, reduce the overall number of participants in the second-lien loan market. These factors contribute to the less liquid nature of second-lien loans, which may present a potential problem if an investor needs to sell holdings to fund redemptions or in the event that the issuer s financial condition has deteriorated and a sale is warranted. Market participants generally attribute the higher yield typically offered by second-lien loans relative to unsecured bonds as compensation for the reduced liquidity in the secondary market together with the lack of significant call protection. Conclusion For as long as current market conditions persist, we expect that the use of second-lien loans to fund LBO transactions will continue. While there are both positives and negatives for investors associated with this development, as an investment manager committed to bottom-up fundamental analysis of each investment opportunity, we believe that successful investing in second-lien loans ultimately comes down to an investor s ability to perform methodical individual DDJ CAPITAL MANAGEMENT 6
credit research and diligent security selection. To this end, the level of financial information available in second-lien loan new issuances relative to high yield bonds enables investors to conduct more thorough, bottom-up fundamental research and due diligence, thereby resulting in more informed investment decisions. However, as a result of the intricacies of the secondlien loan market and the additional resources required to build the necessary infrastructure to successfully trade these instruments, the universe of investors that participate in the secondlien loan market will likely remain more limited than those seeking to invest in the broader high yield market. DDJ believes that this lower level of participation contributes to inefficiencies that can be exploited by investors with both sufficient experience investing in second-lien loans together with superior credit selection ability. Skilled investors will accordingly target such second-lien loans that offer a more attractive risk/reward profile as compared with unsecured high yield bonds. Especially in a market where PE-driven LBO transactions remain prominent, the issuance of second-lien loans may present intriguing investment opportunities for those investors that participate in such market. DDJ CAPITAL MANAGEMENT 7
Appendix BPS: Stands for basis points. A basis point is one one-hundredth of one percent (0.0001). Callable: A callable debt instrument (e.g., bond or loan) is one that can be redeemed by the issuer of such instrument prior to its maturity Call Protection: is a protective provision of a callable security prohibiting the issuer from calling back the security for a period early in its life. Coupon: The stated interest rate paid on a bond. Coupon payments for high yield bonds are typically made semi-annually. High Yield Bond: A high yield bond is a debt security issued by a corporate entity where the debt has lower than investment grade ratings. It is a major component along with leveraged loans of the leveraged credit market. Investment Grade: investment grade are those securities rated Baa3/BBB-/BBB- or above by Moody s, S&P, and/or Fitch, respectively. LBO: A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. Negative Covenant: A negative covenant is a clause in a bond indenture or loan credit agreement that prohibits the borrower from an activity. For example, a negative covenant may restrict the payment of dividends or the issuance of new debt. Second-lien Loans: Second-lien loans have a junior (second in priority) claim, following senior debt, on the collateral of an issuer in the event of a default. Yield: The yield is the income return on an investment, such as the interest or dividends received from holding a particular security. Disclosures ALPS Distributors, Inc. Member Firm. DDJ Capital Management and ALPS Distributors, Inc. are not affiliated. Information in this document regarding market or economic trends or the factors influencing historical or future performance reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Diversification does not guarantee against investment loss. Past performance is no guarantee of future returns. Investing involves risk, including potential loss of principal. DDJ000176 11/30/2018 DDJ CAPITAL MANAGEMENT 8
NOVEMBER 2017 VOLUME 4 ISSUE 4 Second-Lien Loans: Increased Use in LBO Financing ABOUT DDJ CAPITAL MANAGEMENT DDJ Capital Management s goal is to consistently produce attractive long-term investment returns, while minimizing downside risk for our investors, which include: > Corporate pension accounts and public retirement plans > Endowments and foundations > Insurance companies > Other institutional clients The underpinning of DDJ a disciplined investment philosophy, coupled with a commitment to exhaustive credit research has remained constant since our founding in 1996. Our highly skilled team is steadfast and focused on executing our strategy to identify strong risk-adjusted investment opportunities in the leveraged credit markets. For information on DDJ s investment capabilities, please contact: Jack O Connor Head of Business Development and Client Service joconnor@ddjcap.com Phone 781.283.8500 Web ddjcap.com Jack O Connor, head of business development and client service at DDJ, is a representative of ALPS Distributors, Inc. DDJ CAPITAL MANAGEMENT 9