Risk overhang from funded bridge loans threatens to push back bank loan, junk bond calendar

By Paul A. Harris

St. Louis, Aug. 23 - Although the calendar reads late summer, in the leverage markets it is "nuclear winter," according to one observer.

In the month to Aug. 23, the junk bond market has seen just three issuers combine to raise slightly more than $2 billion of proceeds, by far the lowest amount of issuance for the Aug. 1 through Aug. 23 period in the past five years.

Likewise, in the bank loan new issue market, the first 23 days of August produced the lowest amount of issuance seen for that period in the past half decade, according to Prospect News data.

Sources attribute this "nuclear winter" to risk aversion sparked by what is shaping up to be a catastrophic collapse in subprime mortgages.

And it has left a heavy cloud of fallout in the form of "hung bridge loans."

Those bridge loans were set in place as backstop funding for a parade of multi-billion dollar leveraged buyout deals that began lining up during the latter half of 2006 and continued to build through the first half of the present year.

As the subprime scare began to spread in earnest, during late June and July, those bridge loans had to be funded by underwriters who were unable to place junk bonds or syndicate leveraged loans.

Sources say that the "risk overhang" on the balance sheets of the investment banks, resulting from the hung bridge loans, is expected to continue to build and may serve to push back massive forward calendars in both the high-yield and leveraged loan markets.

$300 billion in the wings

Sources have estimated that the combined junk and bank loan forward calendars amount to $300 billion.

On Wednesday night a senior high-yield syndicate official conceded visibility on $100 billion of high-yield bonds and $230 billion of bank loans.

One sellside source, who focuses on both junk bonds and loans, told Prospect News that about seven deals make up nearly half of that amount, and the source added that the investment banks are starting to see some significant signs of trouble in distributing that debt.

And until there is some clarity as to the displacement of the existing risk overhang, the calendar may have to wait, this source said.

"Banks are going to look for some sign that they are going to be able to distribute some paper before they are willing to reload."

Price discovery

Beginning in mid-August sources from both the buyside and the sellside began telling Prospect News that hedge funds, as well as funds formed by some of the private equity firms, were beginning to submit bids on the risk overhang of the big investment banks, with an eye to participating in that risk at steep discounts.

One high-yield syndicate official characterized the unfolding interaction between the bargain-hunting hedge funds and the risk-laden investment banks as "price discovery."

Sources continue to maintain that, with few exceptions, none of the big bids have been hit.

One exception, sources say, is the Metals USA Holdings $300 million bridge, backing an issue of five-year senior floating-rate payment-in-kind notes (Caa1/CCC). Sources say that the bridge loan was offloaded at 90.00, even though on June 29 the notes were reported to have been priced at 97.00 with a Libor plus 600 basis points coupon.

A market source also told Prospect News that a "big part" of the Dollar General Corp. subordinated notes tranche was sold at 88.00.

Bid-offer: narrow or wide

One high-yield syndicate official said recently that there has been conversation but no action on the risk overhang resulting from the hung bridges.

"The bid-ask spread is a little wider than the banks are willing to take at this point," the source said.

However another syndicate official recently suggested that in certain cases the bid-ask spread is actually quite narrow, while in other cases it is understandably quite wide.

"On certain deals there are real buyers coming out of the woodwork, putting in real bids for massive amounts of this paper," the source said, and added that presently rumors are running rife, with buyers calling three and four times a day, whenever rumors of a counterbid are circulating.

This source also asserted that if the investment banks discount the risk too steeply, in the name of getting it off of the books, it would end up taking the entire market down.

Meanwhile a source from a hedge fund said that some prospective buyers are bidding on select portions of this "huge" overhang in the low 90s, and added that the hedge funds and private equity investors expect the underwriters to be sellers ahead of the massive calendar for the debt markets through the rest of 2007.

Elsewhere a trader who focuses on both the high-yield and leveraged loan markets told Prospect News that the private equity firms and the hedge funds want to buy down around 90, and the sellers want to be around 97.

"If you take into consideration that the Street makes approximately two points off of a transaction, anything they sell below 98 is a loss for them," the trader added.

"So to sell it at 90 would be a pretty big hit."

This source added that the buzz on the Street is that some of the dealers are looking at "material adverse conditions" clauses in some of the LBO deals, grappling with whether it would be cheaper to pay legal fees and the breakup fees than to sell some of the risk at 90 or perhaps even lower.

"Either way it will be expensive because the private equity guys will sue, contesting any assertions of material adverse conditions," the source added.

Apt to disappear

Earlier this week, Prospect News asked one senior high-yield syndicate official whether it was reasonable to expect some of the funded bridges to resurface in the form of bonds and loans repriced and restructured to accommodate investors with diminished appetites for risk in the wake of the bond and loan market sell-offs.

This official expects very little of that risk overhang to resurface in the form of bonds and bank loans, however.

Also sources have warned Prospect News not to expect much flow of information with regard to the eventual distribution of the risk overhang.

One sellsider said that these transactions won't happen on high-yield or bank loan trading desks and added that there is not an active secondary market in the risk overhang.

"It's risk participation, so there won't be a lot of visibility on it," the source said.

Another sellsider concurred.

"There won't be a lot of fanfare.

"Basically this stuff is just going to disappear."

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