Outlook 2009: Larger deals may return in back half of the year, but need stable secondary first

By Sara Rosenberg

New York, Dec. 31 - Issuance for 2009 is expected by some to go down in 2009 versus 2008, and others are just not sure what to expect at this point, but most seem to agree that activity in the broad market won't likely pick up until the second half of the year and until trading levels have improved and stabilized.

"It's got to go down," a sellside source remarked about new deal action in 2009. "Some of this year you got legacy '07 deals that got executed in '08. If you're counting on when it's brought to market versus when it was funded, I think things will go down. I would say that 28% of the 2008 issuance was LBOs that were committed to in 2007. Like Clear Channel is a 2008 deal. You had some decent size deals in 2008. You had Wrigley, you had Clear Channel, Lyondell. We're looking at about $100 billion [in 2009]. I have us around $150 [billion] for [2008]."

The sellside source went on to say that he expects the bulk of the new issuance to happen in the second half of 2009, and that the trend will be for much smaller deal sizes, not multi-billion dollar deals. He estimated that $300 million to $700 million will probably be the ideal size for term loan Bs, although there will be some larger than that as well.

"If your loan market is trading at yields of 15%, you're not going to get any refinancing activity. There will be very little LBO activity, if anything. The only people going to market are those that have to. You'll see more restructuring activity [such as exchanges that extend maturities], amendments, people postponing capital projects till the market gets better - and I don't think that happens in the first half of the year," the sellside source continued.

"The question of where are we in the deleveraging cycle is a poignant question, but it's one that's difficult to answer. Our best guess is that we're probably at 50% of the leverage that we were at, at the peak. I don't think that has to go to zero. We're probably in the later stages of it, but we still have some more to go," the sellside source added.

Middle market deal issuance may go up

According to one sellside source, the amount of middle market deals in 2009 may actually increase as deals are coming up on their maturities and they will need to be handled.

"I would think that the volume just got to such a low level, especially in the second half of the year, that it will have to be higher, and part of it's going to be because of refinancings," the sellside source said regarding the middle market. "There are loans maturing that lenders are going to have to figure out. The refinancing activity is going to increase, the general volume is going to increase.

"As far as M&A, it's so dead. Sellers have valuation expectations and it takes them a long time to make the adjustment to a lower multiple. But I think that will happen, so I think M&A activity from a really depressed level in '08 is also going to be up. We think that the activity is going to increase just because it's coming from such low levels in 2008, especially during the second half of the year," the sellside source continued.

"There's such a shock factor to what occurred in the financial markets after the Lehman bankruptcy and the stock market crash and everything. I would expect things to pick up almost immediately but certainly by the end of the first quarter.

"There's still a lot of private equity. A lot of them are kind of reorienting a little bit toward troubled companies that need equity. They're looking for opportunistic stuff as opposed to their regular auctions. But the main point is that they still have a lot of equity to put to work and they're going to put it to work one way or the other. There's been such a lull in the market that valuation expectations are going to get much more realistic and people with equity are going to find a way to deploy it. It takes a while for people to adjust to doing things a different way, but I think that the deadness in the market in the fourth quarter is going to be enough to push people to get a little bit more creative just at the turn of the year," the source added.

Larger deals slower to come back

The sellside source that expects middle market deals to be on the rise in 2009, possibly early on in the year, went on to say that he doesn't expect larger deals to be able to come back quite that quickly.

"It's going to be a while before a [large deal] can get done other than an investment grade or a near investment-grade deal that can get a lot of bank support, just because the CLOs, the hedge funds, the credit opportunity funds, they're just not there," the source said.

"As stuff matures, you're going to say to the existing lenders you're not getting paid off, so let's just redo the terms and push out the maturity. But as far as actual new deals, there's just not enough capital to do a big deal. There hasn't been a new deal of any size done in months and I think it's going to be a while into 2009 before a deal of any kind of size can get done. There's just going to be a lot of middle market stuff.

"There's no liquidity in the market. If the economy really starts spiraling down and the default rate continues to climb and downgrade activity continues - all of that is going to have to stop before the bigger deal market comes back.

"We think it's going to be a kind of a crappy year, but it's not going to be a depression or a disaster. We think that stuff is going to level off. The government is putting so much money into the economy to support companies, banks, maybe even state budgets, that it's going to limit the amount of the downturn. We could be halfway through 2009 before you start to feel that things are leveling off and are not going to deteriorate anymore and I think that's what it's going to take for big deals to get done again," the sellside source added.

Secondary needs to improve for new deals to come

Sources explained that in order for new deals to really have a fighting chance in the market, secondary levels are going to have to come up from where they were at the end of 2008.

"The problem with issuance is price - cure price and you cure issuance. Get the S&P/LSTA index up to 85-90 and you can issue at 95 with a higher coupon and higher quality. An 85 price with a 230 coupon, higher than index quality, translates to an 839 36-month spread. Historic average difference between 36-month spread and high-yield option adjusted spread is 134, so an 839 spread suggests around a 1000 option adjusted spread for high yield. That is not a heroic rebound assumption when considering fair value and history, even with relatively high default assumptions," a buyside source said.

"You need to have a secondary that's stable so that people who come in are not afraid of just a freefall," a sellside source remarked. "The freefall kind of feeds itself because then you have more forced selling. We're maybe half way through the forced selling. Some of the BWICs that came to market didn't trade, so the lenders are holding the loans and are looking for opportunities to sell them. People know that that's out there. The primary backlog has virtually become non-relevant. But, [people] do care about assets that are sitting on bank balance sheets that need to be moved.

"You're going to need some period of time where bottoms get tested a couple of times, I think that's starting to happen. You can't really have a primary market until the secondary market is at least in the 80s. Mid-80s certainly, because at mid-80s you're talking about yields that are around 10%, 11% and I think there is promise of appetite from issuers to get that kind of paper out there," the sellside source added.

Forced selling major factor in issuance

A buyside source told Prospect News that the loan market will not see a rebound in secondary levels until forced selling is done, and as noted above, without the rebound, issuance is likely to stay sparse.

"When will forced selling be done? When hedge funds have finished liquidating, hoping CLOs don't have to unwind, and average investors don't capitulate completely and go to cash, so sometime around when the stock market starts going up for good would be my guess. Let's call that June 30, 2009. That could allow a new issuance window to open up in second half 2009 that might have enough volume to rival all of 2008's," the buyside source explained.

"Depends how many BB [Libor] plus 500 at a discount loans need to be made. Are the [private equity] firms still going to be ready to do deals? Will there be many strategic acquisitions funded with debt? Will there be high-yield maturities that can be refinanced with bank debt at [Libor] plus 500? Anybody making a bold prediction on issuance levels should have a view on these questions, and odds are they do not," the buyside source added.

Second-liens likely to fade away

Second-lien bank debt is not anticipated to be a big part of the new deal landscape in 2009, if at all, as banks aren't currently keen on providing second-lien commitments and lenders are unlikely to want to invest in them.

"Second-liens are down more than high yield in 2008. They are high yield with less liquidity, and were mostly useful in CLOs and hedge funds, two buying bases that are not there too much anymore. I expect second-liens to be largely off the table in 2009 other than for exchange offers for unsecured bonds," a buyside source told Prospect News.

"Not really, very little if any," a sellside source said in agreement. "It's hard to get a second-lien off when your high-yield bond market is trading at 20%. It's going to be the higher credit profile companies that can get things done. It's not going to be the single-B stretch for as much leverage as possible by going first-and second-lien. You'll have generally less leverage deals so the second-lien kind of gets squeezed out."

"With second-liens having an average bid in the low 50s it will be difficult to coax people to commit to new second-lien issuance with the secondary having such attractive yields. In addition, CLOs will avoid them like the plague, especially ones with triple-C ratings," another sellside source remarked.

"I'm thinking more about middle market deals now, but we're not accepting second-liens," a third sellside source said. "As a refinancing strategy or when somebody is stuck with a deal possibly, but on a new deal, partly because the banks are a bigger part of the market again, we're insisting on subordinated debt. We're not going to do a senior deal with a second lien underneath it. It's going to have to be subordinated debt."

Mezzanine to replace second liens?

With many predicting the demise of the second-lien loan in 2009, the question was raised as to whether mezzanine financing will act as sort of a filler for that second-lien debt, and opinions on this issue varied quite a bit.

"If you have mezzanine appetite, why would you not want collateral? Maybe if you get an equity-kicker instead. Mezzanine financing was always designed for small deals with less than ideal equity proportions and lenders willing to take some equity-like risk for fixed income returns. That need will remain, but the willingness to provide it will be lower in a more conservative credit culture for the next several years," a buyside source said.

"There's plenty of mezzanine money. There's plenty of mezzanine lenders. They have a lot more liquidity to do business than the classic hedge funds, second-lien providers. And, the first-lien lenders are generally rejecting second-liens as part of a structure. They're saying it's got to be subordinated debt," a sellside source remarked.

"I don't know. I think it's going to be dictated by where unsecured paper is trading. You're going to need some reduction in yields on the unsecured for the mezzanine guys. Going to illiquid paper for the most part. If you can buy more liquid paper for the same types of returns, wouldn't you prefer that? I think both the second-lien and the mezzanine markets will be down," a second sellside source added.

Default rate expected to rise

Sources agreed that the default rate will most likely be on the rise during the 2009 calendar year, with some projecting it will go to the 6% to 8% type of range and others projecting it might reach as high as 10%.

"It's definitely going to keep going up," one sellside source said about defaults. "It's right under 4% now [prior to Tribune Co. filing for bankruptcy in December]. It will keep going up for a while before it comes down. It's lower than everybody was predicting at the beginning of this year. Most of the predictions I saw [for 2008] were for 6% and some of them were higher. By the end of [2009], I think 6% to 8%, something like that. That's where it's going to kind of top out."

"Expect it to go up," another sellside source remarked. "It's going up pretty rapidly right now. Hopefully not the same rate throughout the year, but it will go up. Probably up over 4% now [including Tribune]. Our research guys are saying 9% to 10% by the end of the year. There could be a lot of factors that impact that obviously, like if the government will continue to provide stimulus and liquidity, [and if] the economy starts to recover in the second half of the year."

"Although things seem abysmal, defaults are slightly over 4% after Tribune filed. With a recent slew of downgrades, it seems that this number has only one place to go, up. Defaults are a lagging indicator. You don't default until things are already really bad," a third sellside source said.

"Up, for lack of financing and bad results," a buyside source chimed in. "Many loans are now trading below their recovery value, so there may be an increased incentive to get the recovery process going through default."

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