Outlook 2006: LBO, M&A deals expected to dominate issuance as refis drop

By Sara Rosenberg

New York, Dec. 30 - Leveraged buyouts and acquisition financing are expected to generate a lot of loan activity in 2006 but a decline in refinancing is expected to leave total issuance staying flat compared with 2005 levels, market sources agree.

But while overall volume will be little changed from the year before, the amount of loans outstanding is expected to rise as new money deals take a bigger share of the primary pie.

M&A and LBO activity is seen rising because of the amount of cash corporations and sponsors have to put to use and - since the leveraged loan market proved in the second half of 2005 that it is willing to absorb large amounts of this new issue paper - the primary environment has become more inviting to potential issuers.

"We're feeling that there could be more corporate activity," a primary professional said. "A lot of corporates have a lot of money. and M&A activity probably is going to be in reasonably good shape next year. [And] the sponsors obviously have a lot of money."

"The LBO wave will continue," a buyside source said in agreement. "Starting with SunGard and continuing through Hertz, the bank loan market has proven it will take down really, really large deals. Sponsors clearly have a heck of a lot of cash and to the extent that they can do really, really large deals, they'll do it. They are encouraged to believe correctly that the bank loan market will happily sponsor and pay for big deal after big deal to the extent that it makes sense.

"Sungard came [around June 2005]. We hadn't proven that we could do really big deals before and that got the ball rolling. You have in 2006 at least a full year in which people truly believe big deals are going to get done. It only takes a few $2 billion deals to make up for a lot of $200 million deals. And a few $2 billion deals tend to encourage the smaller sponsors to go for the $200 million deals so I would think that net new issuance could easily be up in 2006."

"[Also issuance could go up] if the high-yield market rebounds and the early signs of that rebound are here now. Starting in the middle of November that turnaround started to happen in high yield and it's continued so far through December, so that could change peoples' moods. The quest for yield never ends in the low yielding environment and high yield clearly is tempting there," the buyside source said.

Meanwhile, in terms of refinancing, and even dividend deals, many seem to agree that the numbers are likely to fall off since spreads are thought to have gotten as low as they could possibly get, making this type of transaction less attractive than it was over the past two years or so.

"The refinancing business is always a staple," the primary professional said. "You're going to see it but spreads are kind of drifting upwards so it's going to be tougher to do more refinancing business. That was a big chunk of business in the last two years. Spreads have come in so much so it's pretty tough for spreads to be coming in a whole lot more and therefore generate a lot of refinancing business."

"Everything has been pushed to the limit as far as pricing. I don't think guys can price any lower. They tapped that market out and got the lowest pricing available," the sellside source said.

"I would assume less dividends as well. If you wanted to pay yourself a dividend, you should have done it already over the last two years. If you haven't done it, you're not going to get it done now," the sellside source added.

"The refi wave definitely has crested," the buyside source said, putting the trio of interviewees in full agreement. "We're starting to see things go back the other way. A lot more deals are being issued at 250 and 300 now."

In 2005, total issuance was $379 billion, with acquisitions and LBO financing accounting for $121 billion of that amount, refinancings accounting for $127 billion, general corporate purposes $64 billion, dividend/recapitalizations $24 billion, capital expenditures $9 billion, exit financing $5 billion and "other" or multiple purposes $29 billion, according to data compiled by Prospect News.

Second-lien fate in question

The destiny of the second-lien loan in 2006 is hazy as some believe that these types of loans will not be as prevalent in capital structures because potential economic weakness will scare off investors, while others disagree, saying that there's more and more interest for these type of loans both on the investor and on the issuer side, which in turn will continue to make them a strong part of the market.

"The trouble with second liens is that market historically has come and gone because true banks don't want to do second liens; they only want to do first," the buyside source explained. "When institutions were stretched, second liens came out, and when the market got a little concerned, second liens went away again. Now they're really, really booming thanks in part to hedge funds, thanks in part to primary funds reaching for yield and to a very small extent, CLO's reaching for yield.

"In the next recession I suspect that second liens are going to be in very low demand and they're going to trade like high-yield bonds, 40 cents on the dollar instead of 80 cents on the dollar when they're facing default.

"If you look at any kind of economic weakness I think primary funds will back off of second liens. Even today the buckets allowing for second liens in a CLO are not very big [and] I don't think they're going to get bigger," the buyside source continued.

"Second liens sort of filled a nice gap when the high-yield market stepped back. If the high-yield market gets strong again, second liens will definitely go down a lot because I don't think there are as much natural buyers for them.

"I feel like the second-lien wave has peaked and it's going to be going down until we get to the other side of the next recession," the buyside source concluded.

On the flip side, a sellside source argued that second liens offer too many benefits to all parties involved for them not to be a big part of capital structures in 2006.

"It's going to be a part of the landscape again this coming year. We're seeing more and more deals where there's first, second lien. I think investors like it. A lot of high-yield accounts will take a piece. There's bigger and bigger baskets for non-registered deals; so, whether it's a security or whether it's a loan, if it's got the yield and it's got the structure, they're willing to take it," the primary professional countered.

"The sponsors love it because it's a cheaper call [when compared to bonds]. Deals where there's an IPO on the horizon or where they can flip it pretty quickly, they love this paper. If you do a 10 non-call five [bond] in today's interest rate environment, and then tomorrow you want to call them for whatever reason, the tender will probably cost you 20 to 25 points, whereas in the second-lien market, it's usually two to three points. There's a lot more flexibility," the primary professional added.

Defaults on the rise?

The consensus seems to be that default rates will be on the rise; however, whether that will play out in 2006 or hold off until 2007 is up for debate. with many pointing to the overall economy as a key factor in determining the trend.

"I definitely think defaults are going to be up from last year," the sellside source said. "From what I'm seeing on the par side and the way a lot of credits are performing, I'm fairly confident that defaults will increase. The appetite is still out there. Cash is still out there. CLO's continue to develop. Guys will want to keep paper and want to work with the company, but defaults will go higher.

"With the last six months we saw a lot of amendments and a lot of lightening of covenants. Going forward, you're going to see a lot of the stuff that got done hiccup. You'll see deals that were done very aggressively six or 12 months ago coming for amendments.

"And, what's the next step after amendments and covenant relief? Bankruptcies," the sellside source added.

"The wild card obviously is the state of the economy," the primary professional pointed out. "Inflation is still kind of in hand. Growth is not out of control. Defaults are ... probably heading up. It takes a long time for the economy to turn and it feels like you're going to have to go pretty far in '06 before you see a pretty big uptick in default rates.

"If you do a deal, the normal rule of thumb is that it usually takes a good 12 months for the company to run into problems because amortization kicks up or covenants start to come in. So even if the economy starts to really suck, back half of next year, you're probably in '07 before you start to see a lot defaults."

"I think most of the high-yield capital structures took advantage of low cost financing in the last two or three years and fixed their balance sheets the best they could to dates a lot later than 2006," the buyside source responded. "The whole maturing debt problem shouldn't be there so you're going to need a big downturn in demand to create the kind of situation that makes people think about defaults. And, until we get the consensus that we're going into recession I don't think people should be incredibly concerned about that."

Spreads seen as widening out

Based on everything that is being predicted for 2006 - economic uncertainty, the need for amendments and defaults rising - loan spreads are expected to go up, although the difference in pricing between 2005 and 2006 is not anticipated to be earth shattering.

"Some spread widening is definitely warranted to the extent that I'm focused on the housing bubble breaking and some people think 2007 is the year that a recession may start," the buyside source said. "Spreads need to widen in anticipation of that.

"I don't feel like it's anywhere close to falling off a cliff and I won't feel that way until I get some conviction that a recession is going to happen in 2007 as opposed to the classic worry warts always predicting it's a year or so away.

"On a macro level, the one thing to mention in any article where Libor rates are kind of important is the affect of the [Ben] Bernanke change. If it had been [Alan] Greenspan we would have known what to expect but [with] Bernanke, they're going to give him perhaps one more rate increase and not worry about it, but if he then goes one more than they think he should, they're going to get all freaked out. Sort of a weird technical there by changing the Fed chairman," the buyside source continued.

"If you look at comparative projections for return in 2006 it looks a fair amount like return projections in 2005 with some increase in interest rates and some fear of economic problems starting 2007 weighing on both the high-yield and the corporate bond market," the buyside source concluded.

"Spreads have to go up," the sellside source said in agreement. "Amendments, defaults - if I believe that, then I believe that prices are going to go up too because guys are going to say you got to pay me.

"I think the power is going to continue to go back to the investor instead of the borrower," the sellside source added.

Secondary break levels should remain strong

Deals that have freed for trading in the last couple of months of 2005 have done so in the high par to 101 type context, and this trend is expected to continue for the most part into 2006 as market technicals should remain strong with investors flush with cash, sources explained.

"There's more institutional money going into bank loans than there was a couple of years ago," the buyside source said. "Primary funds have done OK. And, we're still facing rising Libor rates, so that's good for their customers.

"CLO's get done constantly. As soon as you start getting pick up in coupon you tend to encourage CLO's to start coming back to market.

"Yeah, we lose a little bit of hedge fund money, which is more important to the second-lien market than the first-lien market, but the technicals of bank loans are clearly very strong, which is not surprising given that when the high-yield market went away [in 2005] the bank loan market pretty much said OK, fine we'll take over, and it really didn't change the break prices that much," the buyside source continued.

"I always feel like there's a lot of money on the sidelines waiting for the right collateral to be available.

"I tend to think that the market, until it starts to feel gloomy, is going to slop around in this par 1/2, 101, 101¼ type break range. Based on sentiments of the week and what CLO's need to ramp up and reach for certain kinds of diversification, certain kinds of ratings will control that trading range and whether it's par ½ or 101 or 101¼ doesn't make a great difference, doesn't reflect a great variation," the buyside source added.

Real estate worth watching

Although the overall secondary loan market is expected to stay in good shape in 2006, one sector that may be worth keeping an eye on is the consumer/homebuilding/real estate group, sources said.

"If the housing market turns down then housing-related loans might be under pressure and secondarily to that will be loans that are related to the consumer," the buyside source said.

"There's no individual sector other than anything highly real estate oriented that seems to have the potential to perform notably differently," the source added.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.