Credit Market Research Credit Quality Weakens for Loan- Financed LBOs Analysts William H. May +1 212 98-32 william.may@fitchratings.com Silvia Wu +1 212 98-598 silvia.wu@fitchratings.com Mariarosa Verde +1 212 98-791 mariarosa.verde@fitchratings.com Leveraged Finance Eric Tutterow +1 312 368-3218 eric.tutterow@fitchratings.com Related Research Credit Market Research, Fitch Global Corporate Rating Activity: Credit Quality Takes Negative Turn in 27, published March 6, 28. Credit Market Research, Developments in the US Leveraged Loan and CLO Markets, published Feb. 7, 28. Credit Market Research, Stock of Covenant-Weak Loans Could Affect Recovery Rates, published Nov. 19, 27. Credit Market Research, Loan Issuance Boom Shifts Refinancing Risk Strongly to Loan Market, dated July 26, 27. Credit Market Research Report, US Leveraged Loan Covenant Decline Accelerating in 27, dated June 2, 27. Credit Market Research Report, Speculative Grade Balance Sheets Becoming More Loan-Heavy Recovery Prospects at Risk, dated May 7, 27. Introduction When Linens n Things, Inc. (Linens n Things) filed for Chapter 11 bankruptcy protection in early May, it highlighted the difficulties faced by firms laden with leveraged buyout (LBO) debt in an environment of deteriorating market and economic conditions. Companies that in recent years were taken private through LBOs are now burdened with aggressive capital structures designed in a period of robust liquidity and supportive macroeconomic growth. In the difficult environment that has emerged since the summer of 27 credit quality among this group of companies has visibly eroded and the risk of default is rising, as demonstrated by negative rating and outlook trends combined with tight credit conditions. While LBO issuance activity is largely absent this year, with first-quarter 28 sponsored LBO-related loan issuance, for example, down 88% compared with the first quarter of 27, the stock of outstanding LBO debt is large. Between 24 and 27, fueled by declining credit spreads and relaxed lending standards, approximately $45 billion of sponsored US LBO related leveraged loans came to market. Now as the US economic environment softens and below investment grade debt markets remain largely closed, these LBO-related credits have and will likely continue to come under pressure. In this report, Fitch examines 29 loan-financed LBOs launched over the 24 27 period with associated leveraged loan debt of approximately $293 billion and finds evidence that in addition to the headline bankruptcy by Linens n Things, other signs of stress have emerged for these credits, including the following. From the time of their LBOs through the end of May 28, the ratio of downgrades to upgrades among these firms was 3.3 to 1. and the average downgrade was 2.3 notches, compared with an average of just 1.1 notches on upgrades. Weak operating performance and an inability to generate sufficient cash flows to service post-lbo debt loads were the primary drivers behind about 8% of the downgrades. A secondary driver was the issuance of additional debt, post-lbo, to fund a dividend payment to the equity sponsors, which accounted for about 15% of the downgrades. Almost one-quarter of LBO credits examined by Fitch consisted of firms in consumer cyclical sectors, evidence that a meaningful share of the LBOs brought to market in recent years are particularly sensitive to the type of macroeconomic weakness and consumer retrenchment the US economy is currently experiencing. In fact, through May, consumer cyclicals, which accounted again for roughly one-quarter of LBOs examined, recorded a disproportionate 36% of the LBO downgrades and two of the four defaults. While seasoning certainly plays a role in the distribution of downgrades through time, one indication of the toll current economic and credit market conditions are taking on these credits is that more than one-quarter of the downgrade actions and three of the four recorded defaults occurred during the first five months of 28. www.fitchratings.com June 12, 28
Looking ahead, Fitch constructed composite Rating Outlooks or Watches on 199 of the LBO credits and found that 44% of them had a composite Negative Rating Outlook or Watch as of May 28, versus only 3% with a Positive Outlook or Watch. As LBO Volumes Surged, Risks Rose Between 24 and 27, roughly $45 billion of sponsored LBO issuance poured into the leveraged loan market, more than three times the issuance volume of the prior nine years according to Reuters/LPC (see the US-Sponsored LBO Issuance chart below). With default rates low and economic conditions supportive, market participants such as CLOs (collateralized loan obligations) and hedge funds drove increasing demand for this paper. As a result, the leverage levels on LBOs rose while the loans financing them carried lower spreads and weaker structural protections (see the LBO Spreads and Leverage chart below). Some large deals were even financed with loans that carried no financial covenants at all. In fact, in 26 and 27, respectively, $7 billion and $44 billion of these covenant-lite LBO-related loans were issued. The stock of outstanding LBO debt that was building in the market therefore became riskier, carried fewer structural protections, and provided smaller risk premiums. US Sponsored LBO Issuance ($ Bil.) 7 6 5 4 3 2 1 1Q96 4Q96 3Q97 2Q98 1Q99 4Q99 3Q 2Q1 1Q2 4Q2 3Q3 2Q4 1Q5 4Q5 3Q6 2Q7 1Q8 Source: Reuters/LPC. LBO Spreads and Leverage 7 6 5 4 3 2 1 (x) Avg. Debt /EBITDA Level (Left Axis) Spread (Right Axis) (Basis Points) 1H2 2H2 1H3 2H3 1H4 2H4 1H5 2H5 1H6 2H6 1H7 2H7 4 35 3 25 2 Source: Reuters/LPC. 2 Credit Quality Weakens for Loan-Financed LBOs June 12, 28
Data Description To conduct the analysis presented in this report, Fitch examined a sample of 29 LBO transactions, completed between 24 and 27, for which it was possible to create and track a composite issuer-level credit rating. These deals were financed by approximately $293 billion of leveraged loan debt. a The composite rating construction follows standard market convention and the same methodology is used to arrive at composite Outlooks and Watches. b Because the ratings and outlooks used in this report are composites from the three major rating agencies (Standard & Poor s, Moody s and Fitch), rating changes (either upgrades or downgrades) may not necessarily result from a ratings change by all three of the major rating agencies and could reflect a change by only one or two. Initial Ratings Reflect the High Degree of Risk Associated with LBOs LBOs are frequently described as a way to liberate company management (often new company management put in place by the LBO s sponsors) from the short-term demands of disparate stockholders and allow it to focus on longer-term value generation. Under the post-lbo structure, the theory asserts, the value of the firm should grow while cash flows are generated sufficient to meet scheduled payments on the new, post-lbo, debt burden. LBO Default Risk Ratings Initial Post-LBO Rating Rating at End of May 28 12 1 8 6 4 2 BB+ BB BB- B+ B B- CCC to C D WR One risk is that the LBO saddles the company with debt levels that while appearing manageable in the economic and credit market environment prevailing when the deal was consummated become a financial albatross if conditions, and earnings, suffer. Even highly skilled management may then find it difficult, if not impossible, to meet the higher interest costs and to operate with the reduced financial flexibility associated with a post-lbo capital structure. In addition, many firms, post-lbo, are expected to distribute dividend returns to the deal sponsors, either from internally generated funds a Issuance data according to Reuters/LPC. b If there are three ratings available the median rating is taken, if there are two ratings available the lower of the two ratings is taken, and if there is only one rating available that rating is taken. Credit Quality Weakens for Loan-Financed LBOs June 12, 28 3
or from borrowings in the credit market, and this can further strain their capital structures. These are among the reasons why the post-lbo issuer default risk rating is typically set fairly low. In fact, the vast majority (97%) of the initial post-lbo default ratings assigned to issuers in our study were found to be B+ or lower, with a full 82% rated B or below (see the LBO Default Risk Ratings chart on page 3). Industry Concentration Indicates Exposure to Consumer Retrenchment Almost one-quarter of the LBOs in our sample were in cyclical consumer industries, such as retail, evidence that a meaningful share of the LBOs brought to market in recent years are particularly sensitive to the type of macroeconomic weakness and consumer retrenchment the US economy is currently experiencing (see the Distribution of LBOs by Broad Industry Category chart below). Retail firms can be particularly vulnerable to negative liquidity shocks in the credit markets as they rely a great deal on inventory and trade financing for their operations. The industrial sector also recorded a large number of LBOs in our sample. While this encompasses a wide range of industries, here too a slowing economy is problematic. Distribution of LBOs by Broad Industry Category 7 6 5 4 3 2 1 Basic Materials Communications Consumer, Cyclical Consumer, Non-cyclical Other Energy Financial Industrial Technology Utilities Rating Trends Indicate Weakness in LBO Credits Fitch finds that since their completion, rating trends on LBO credits have been net negative with the initial low non-investment grade ratings assigned to LBOs migrating further down the rating scale (see the LBO Default Risk Ratings chart on page 3). In addition and perhaps even more revealing, a strong excess of negative to positive outlooks on the credits suggests more credit deterioration going forward. Downgrades Exceed Upgrades by a Significant Margin Comparing the composite issuer default ratings assigned post-lbo to the composite ratings as of the end of May 28 reveals that the ratio of downgrades to upgrades was 3.3 to 1. (see the LBO Issuer Rating Changes chart on page 5). In an indication that the impact of the credit deterioration may be more severe than that suggested by the raw count of downgrades versus upgrades, the average downgrade was 2.3 notches, versus the average upgrade of only 1.1 notches (see the chart, Average LBO Issuer Rating Changes, on page 5). To get a sense of whether the rating performance of the LBO credits was typical of the broader high yield market, Fitch constructed a sample of 259 non-lbo high yield credits that issued unsecured debt over the same 24 27 period and examined their composite rating performance through the end of May 28. For these firms, upgrades outpaced downgrades by a ratio of 1.1 to 1., indicating that the LBO credits had significantly weaker 4 Credit Quality Weakens for Loan-Financed LBOs June 12, 28
Cumulative LBO Issuer Ratings Changes 24-May 28 (By Year of Issue) Upgrades Downgrades 35 3 25 2 15 1 5 24 25 26 27 Overall Average LBO Issuer Ratings Changes 24 May 28 (By Year of Issue) (No. of Rating Notches) 3.5 3 2.5 2 1.5 1.5 Upgrades Downgrades 24 25 26 27 Overall credit performance than similarly rated non-lbo credits (see the charts, Cumulative Non- LBO Ratings Changes, on page 6). Taking into consideration that the bulk of the LBO credits had an initial composite rating of B+, B, or B, Fitch examined a sub-sample of 132 of these firms that had initial ratings in the same range and found that the upgrade to downgrade ratio among these credits was also about 1.1 to 1.. c Consumer Cyclicals Had Most Downgrades A total of 33 credits in our sample were downgraded subsequent to completing their LBOs, a 15.8% rate, and four have defaulted so far, a 1.9% rate. d Consumer cyclicals, which accounted for 23% of the LBOs, recorded 36% of the downgrades and two of the four defaults: Linens n Things and Recycled Paper Products, which both defaulted in May 28 (see the Distribution of LBOs Downgraded chart on page 7). In all, 24% of the cyclical consumer credits have been downgraded since their LBOs were completed. c A full 88% of the LBO credits had initial ratings in this range. d On an issuer-count basis. However, some of the downgraded credits experienced either multiplenotch downgrades and/or were downgraded multiple times. In addition, a defaulted entity also counts as a downgrade. Credit Quality Weakens for Loan-Financed LBOs June 12, 28 5
Cumulative Non-LBO Ratings Changes 24 May 28 (By Year of Issue) 8 7 6 5 4 3 2 1 Upgrades Downgrades 24 25 26 27 Overall Cumulative Non-LBO Ratings Changes 24 May 28 (Single 'B' Rating) (By Year of Issue) 4 35 3 25 2 15 1 5 Upgrades Downgrades 24 25 26 27 Overall Other sectors have seen credit deterioration as well. Industrials, for example, which comprised only 15% of the LBOs in our sample, accounted for 27% of the downgrades, as a full 28% of the industrial LBOs have been downgraded. Not surprisingly, consumer non-cyclicals have fared somewhat better. While these accounted for 28% of the LBOs in our sample, they comprised only 18% of the downgrades, as only 1% of the consumer non-cyclicals experienced downgrades. (One of the other defaults in our sample, however, Leiner Health Products Inc., a pharmaceutical company that filed for Chapter 11 bankruptcy on March 1, 28, was a consumer non-cyclical LBO.) The downgrade and default patterns indicate that the credit deterioration, while reaching across industry sectors, is more severe in those sectors most vulnerable to an economic downturn such as consumer cyclicals. Downgrades Driven by Poor Operating Performance The primary driver of downgrades of the LBO credits in our sample was poor operating performance, which put significant pressure on the firms credit metrics. In fact, about 8% of the entities downgraded suffered from weak cash flows that threatened their ability to make timely interest payments and, in many cases, significantly increased the risk of a covenant breach. The next-largest driver of downgrades was the issuance of additional debt to fund a dividend to be paid to the equity sponsor. The further leveraging-up of an already highly leveraged capital structure accounted for about 15% of the downgrades. The remaining downgrades were attributable to the issuance of additional debt to fund an acquisition or other disappointing, but non-operating, results. 6 Credit Quality Weakens for Loan-Financed LBOs June 12, 28
Distribution of LBOs Downgraded by Broad Industry Category 14 12 1 8 6 4 2 Basic Materials Communications Consumer, Cyclical Consumer, Non-cyclical Other Energy Financial Industrial Technology Utilities Outlooks Point to More Downward Pressure on Credit Quality More than one-quarter of all rating downgrades and three of the four defaults have occurred in the first five months of 28 (see the Year of Downgrade chart and the Rating Downgrades table below). Looking ahead, it appears that further downward pressure on ratings is likely. From our sample of 29 firms, it was possible to construct a composite Rating Outlook or Rating Watch for 199 of them. Of these, 44% of the LBO credits had a Negative Outlook or Watch at the end of May 28, versus only 3% with a Positive Outlook or Watch. In contrast, the distribution of Fitch s US highyield industrial Outlooks at the end of May 28 had 25% with a Negative Outlook and 13% with a Positive Outlook. Year of Downgrade 27 44% By major industry sector, we see negative outlooks dominating positive outlooks across the board (see the chart, Distribution of LBOs Outlooks by Broad Industry Category, on page 8). However, consumer cyclicals again leads the way in pointing to downward pressure on ratings. It is not alone, however, as consumer non-cyclicals and industrials also show the likelihood of additional rating downgrades going forward. 26 21% 25 8% 28 (through end of May) 27% Rating Downgrades by Year of Action Year of Downgrade Year of LBO No. of LBOs 25 26 27 28 (Through May) 24 27 3 6 7 2 25 42 1 5 8 3 26 54 7 6 27 86 1 3 Grand Total 29 4 11 23 14 Credit Quality Weakens for Loan-Financed LBOs June 12, 28 7
Distribution of LBO Outlooks and Watches by Broad Industry Rating Category 3 25 2 15 1 5 Positive Negative Basic Materials Communications Consumer, Cyclical Consumer, Non-cyclical Other Energy Financial Industrial Technology Utilities Conclusion Tremendous amounts of leveraged loans were absorbed by market participants to finance the LBO boom of the past few years. CLOs, in particular, were avid acquirers. As competition to bid on this paper heightened, leverage ratios rose while structural protections and spreads fell. Now, as economic conditions soften and credit markets remain tight, these debt-laden credits may come under increased pressure. A review of LBO credits issued over the 24 27 period indicates that these companies have already started to show signs of strain with downgrades exceeding upgrades. In addition, the disproportionate share of Negative Outlooks on these credits points to further credit deterioration in the coming year and heightened risk of default. Copyright 28 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 14. Telephone: 1-8-753-4824, (212) 98-5. Fax: (212) 48-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit or verify the truth or accuracy of any such information. As a result, the information in this report is provided as is without any representation or warranty of any kind. A Fitch rating is an opinion as to the creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax-exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from USD1, to USD75, (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from USD1, to USD1,5, (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2 of Great Britain, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers. 8 Credit Quality Weakens for Loan-Financed LBOs June 12, 28