Outlook 2007: LBO/M&A deals expected to dominate issuance, refis seen taking the sideline

By Sara Rosenberg

New York, Dec. 29 - The leveraged loan market in 2007 is expected to continue to be all about leveraged buyout and acquisition financing deals, maybe even more so than in 2006 now that market tolerance toward enormous deals has been tested, while refinancings/repricings are expected to play a diminished role in terms of issuance, market sources agree.

"If you look at the thing that's been driving issuance, it's been to a large extent new issue LBO activity, acquisition related financings and the like. Given the development of the market to be able to accommodate some of these jumbo deals, it's kind of opened the door for the sponsors to look at a lot of situations that previously they wouldn't have thought they could raise the capital to go after," a sellside source said.

"A few years [back] you weren't seeing $10 billion bank loans, jumbo bonds and these sort of double-digit LBO's being done all that commonly. That's really been very recent where people got comfortable with the higher numbers.

"So what constrained it? I guess there were a couple of things. One was the ability of the sponsors themselves to commit enough equity capital to finance them and they solved that problem generally by forming these consortia and going after them in packs. [Also] lately they've been in pretty active fund raising mode themselves. Some of them have gone public. So they're available capital to put in as the equity component has increased.

"The other thing that was constraining was the market capacity on the debt side. If you were taking a survey a couple of years ago about what's market capacity in the bank loan market, you might have heard a lot of $2 to $3 billions. It changes so quickly. Now, HCA is off at $8.8 billion," the sellside source continued.

"You have these different LBO shops running around, chasing different opportunities generally for companies that have enterprise values $5 billion and below, and now all of a sudden they have the ability to look at some of these take-private situations. They're not really picked over because it's only been recently that the markets have accommodated transactions of that size.

"The availability of capital to complete large deals, as well as just the general health of the markets, and it's a reasonable favorable interest rate environment, default rates are pretty low, etc. you should probably continue to see the trend that we've seen this year with pretty large new issuance levels," the sellside source added.

More mergers ahead

"One of the themes you'll see [in 2007] continued is more mergers," a market professional said in agreement. "It's been a record year in mergers. You've had a record year in buyouts. And, and I would think, with private equity money where it is, and the stock market where it is, you'll see much more of that."

The market professional went on to say that all you have to do is look at the already building 2007 calendar to know it's going to be a big year, as a number of large deals have already popped on the radar, including Aramark Corp.'s $4.605 billion senior secured credit facility, Kinder Morgan Inc.'s $8.6 billion credit facility, Univision Communications Inc.'s $8.25 billion credit facility and Freeport-McMoRan Copper & Gold Inc.'s $11.5 billion senior secured credit facility.

"The backlog for January is at an all time high relative to other Januaries. We haven't seen the biggest yet. More and more of these big deals I think will be tried. I read someplace that equity either raised or has on its books $175 billion. Multiply that by five or six, which is what they can leverage these things - not that they'd spend all that in one year - [and] it's a lot of money. And, that's not talking about their continued desire and the market's ability and willingness to finance dividends. That will continue either through bonds or loans," the market professional continued.

"The market has shown an amazing resilience of supporting these bigger deals, as you can see with the price on HCA, SunGard...all right around par [in trading right now]. There's enough liquidity and demand for this.

"Another issue is where's all the demand coming from, because if you do all the numbers, it's not coming entirely from CLO's, it's not coming from bank mutual funds, it's coming from other sources be it hedge funds, be it other types of mutual funds, etc., and that's the big unknown. Where's that money coming from, how permanent is it, are they big relative value players. If Libor is cut in half just because interest rates come down, where does all that hedge fund money go if Treasuries stay the same where they are today. Libor is higher than Treasuries and the spreads are about the same. If Libor goes to where it was 21/2-years ago, then the relative value might tilt you the other way," the market professional added.

"[There's] no reason for LBO activity to go down as long as the economy is OK and the private equity guys have not run out of money," a buyside source remarked. [An] interesting technical question is whether private equity will get conservative before the loan market does. If they stop sponsoring deals because they're afraid of a downturn, the lack of implied supply may drive loan prices up. Probably, they'll be late to turn down deals, however.

Refinancings may dwindle

In terms of refinancing and repricing activity in 2007, sources seem to agree that they have the potential to fall in numbers being that spreads have gotten incredibly low and most issuers who could have taken advantage of that trend have already done so.

"Refinancings typically are driven by a change in the spread environment or a rebalancing of the markets between more favorable bonds or more favorable bank markets. You had the repricing wave that precipitated a lot of refinancing, but now that that's largely behind us. Spreads have been fairly stable. The bond market has been in good shape but has been for a while. I guess I'm not really seeing what's going to drive a lot of refinancing activity," the sellsider remarked.

"I would think that [refinancings] might be more of a challenge. Repricings will maybe not be as prevalent because so many of the pricings now are at the tight end. Spreads are pretty much at historical lows. You'll see some, but that will not be one of the drivers [next] year. On refinancings, if you mean using more bank [debt] to buy maturing bonds, maybe, because it looks like people are seemingly comfortable with higher leverage numbers perhaps than they have in the past," the market professional said.

And, the buyside source, agreeing with the others, simply stated "refinancings might step down as a lot of companies are at minimum coupons for their credit quality, in my opinion."

Spreads expected to stay neutral

Based on the strength of the loan market and the expected economic stability, sources agree that spreads will likely stay in line with those seen in 2006, however, one source did point out that loan spreads are becoming a little more credit specific and a little less ratings driven.

"I don't really see much of anything happening with spreads. It's kind of been this 250 to 300 single-B type of market. Despite how positive everyone is feeling about the market the average single-B index has actually been creeping up lately. Not a lot but a little bit. I would say that your single-B's [will be] at 275 with kind of 25 basis points on either side of it and should bounce around in that area. I'm kind of neutral as far as that goes," the sellside source said.

"Unless there's some exogenous event, some awful terrorist thing, some oil shock, something that you can't model in, there seems to be nothing on the horizon that would suggest that much is going to change. I really don't see spreads moving up. I don't know if I see them moving down much, probably a better chance to move up then down and the reason I say that is because they're pretty damn low now," the market professional remarked.

"It's much more situational versus coming up with a universal theme like all spreads are widening or everything is flexing down," the market source continued. "You're seeing that the bank market is beginning to act a little bit more like the high-yield market. Yes, it may be a B2/B, but some B2/B's can get done at 250 and others are going to get done at 375. Some deals will be flexed up; some deals will be flexed down. [The deals are] much more specific to the credit now. [There will be a] much more diverse outcome. I would think that would continue."

There is no reason for pricing to change until deals get too big or too many, the buyside source added. And according to the source, that has not happened yet.

Second liens to stay in landscape

The fate of the second-lien loan seems to be a good one, as sources believe that they will continue to flourish in the loan market based on the desire of equity shops to use them and the ability to find enough investor demand to support them.

"I think you're going to continue to see [second liens] gain traction as they have for the last several years. There are two sides to the argument. On the on hand, the yield curve is pretty flat so there's not a big premium for going out and locking in rates long term. That would argue for less second liens," the sellside source said.

"But, I think the thing that's driving it, particularly amongst the deal shops, LBO sponsors and the like, is that what they value the most is flexibility in their capital structure. Think about the lifecycle of these transactions for the LBO guys. They buy them and sometimes weeks or months later they're recapping them, issuing new bonds. They do quick flip transactions. I think they in particular put value on flexibility and the better call terms that are available from the second-lien market relative to the fixed-rate bond market.

"I think you're going to continue to see a desire on the part of financial sponsors to do a lot of second-liens.

"As far as the corporates go, you don't really have the same argument," the sellside source continued. "These guys look at interest rate management, long-term capital. You don't pay much of a premium to lock in your rate for 10 years; [so] why not do that? Corporates aren't really motivated by financial engineering. Not thinking about drastically modifying their capital structure in the next year to 18 months. [For] deal shops, [there is a] totally different mentality."

"I think second lien will continue to explode to be a more significant part of the market because it is by far [the] issuer preference. You're finding more and more people who buy that, both the regular guys as well as hedge funds, as well as other mutual funds be it high yield or equities. So, I think that will continue showing up. The issuers love it," the market professional said in agreement.

"Second liens are like high yield in disguise. If high yield is doing OK, low defaults, good economy, second liens will do OK," the buyside source added.

Covenant-light loans to be opportunistic

Covenant-light transactions are also anticipated to continue to be sought after in 2007, sources said, as equity sponsors love that particular structure; however, whether these particular loans will flourish will primarily be driven by demand.

"That trend is increasing. It was getting fairly common place, the market cracked it over the summer, you stopped seeing it altogether, and, then a few transactions started to test it," the sellside source said.

"I see the front end of it, which is what the sponsors are asking for today on deals that the market won't see until next year. I got to tell you, they're all over it. They want everything to be covenant-light.

"I would say that we will see a big pick up in covenant-light transactions in the first part of next year. How long that continues is largely a function of how the market responds to them, but based on the sampling of transactions that have come this year in the fall, deals like Momentive, Aleris and Freescale, the tea leaves look pretty positive in terms of the market being willing to lend to those situations," the sellside source remarked.

"I think [that in the] the covenant-light market you'll see certainly that everybody wants that on the issuer side. It will be kind of opportunistic. There were three months in '06 where no covenant-light deals were done. And other months there was only one deal done. That market's going to be open and shut," the market professional said.

"Maybe what you'll see is much more on the covenant-low side, even one covenant, and very far backed off from projections - very opportunistic, very much of an indicator of a strong market because certainly the buyers don't like that. [Equity sponsors] love it because they don't want to ever have to negotiate with these banks. It basically gives them further options not to fix anything.

"The challenge on that is to see what happens to the recovery rates. You won't know that until the cycle is finished. Are they going to have any different recovery patterns, anything different from now on a macro basis," the market professional added.

Defaults may rise

The amount of defaults in the loan market may see a small increase, but most seem to think that this upswing will most likely take place toward the end of 2007 or even in 2008, rather than anytime soon.

"My observation on defaults would be that when you hit these leverage peaks you tend to see default rates pick up with maybe a couple year lag. So the one thing you probably want to keep an eye on when you're thinking about defaults is what is your average leverage multiple and what's been happening with it over time. Leverage clearly has gotten pushed to some pretty lofty levels," the sellside source remarked.

"That said, I don't think we're looking for an interest rate environment where interest rates are going to be increasing dramatically over the next year.

"Could you see some pick up in defaults?" the sellside source continued. "Yeah, you might, off of levels that are kind of at historical lows, but I'm not really seeing a lot of it happening near term. I would suspect that if you're looking for when default rates might pick up in a significant way it might be toward the end of next year, possibly into the following year - probably a very modest pick up in default rates."

"If it does pick up, maybe [it would be] during the end of next year," the market professional said in agreement.

"You're in the middle of a presidential race now so the Congress will want to keep things going. I don't think they'll raise interest rates. Maybe they'll lower interest rates so there will be plenty of money around. Money will be cheap. They're not going to change the taxes because obviously Republicans aren't and the Democrats aren't going to be tasked with raising taxes going into an election year. So, the economy is kind of OK.

"And, the thing that will solve a lot of these defaults, as it has in the last couple of years, is there's a lot of liquidity. So if somebody has a problem, they can't meet interest or they can't meet amortization, basically they just refinance it," the market professional added.

"I will be shocked if defaults do not increase in 2007. The question is whether they get scary, 3.5% or more, or just rebound to typical floor levels, 2%," the buyside source said.

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