Outlook 2007: Strong year ahead seen after LBOs, hedge funds pushed 2006 to a record

By Paul A. Harris

St. Louis, Dec. 22 - High yield is expected to see another strong year of new deals, market sources said, as the forces that propelled issuance to a record in 2006 look set to remain in place.

The past year saw issuers sell $157.26 billion of new junk bonds into a market which sources now value, in round numbers, at $1 trillion.

Hence 2006 goes into the record books. And the margin is by no means a narrow one.

The 2006 issuance total was just slightly less than $15 billion over the previous record, 2004's $142.38 billion.

As the exiting year wound down in the high yield primary market Prospect News surveyed syndicate sources, traders, investors and other market observers.

We asked sources to characterize the record-breaking year, highlight its trends and select a "deal of the year."

And we prevailed upon those sources to look toward the horizon and advise us as to what they foresee in the year ahead.

2006, a huge finish

Sell-side sources recounted that heading into the fourth quarter 2006 did not have the appearance of a conspicuous year for the primary market.

"July was a poor month," recalled a senior syndicate official. "August was not great. Neither was September."

However, this source and others added, a pair of deals loomed on the horizon that promised to transform what was looking like a "so-so" year in the junk market into a record-breaker.

And those deals delivered on that promise.

On Nov. 9 HCA Inc. set a new single-day issuance record in the junk market by pricing $5.70 billion of bonds in three tranches.

That record stood for all of one week.

Then on Nov. 16 Freescale Semiconductor Inc. priced its landmark $5.95 billion four-part transaction which one high yield syndicate official characterized at the time as "the biggest single amount of issuance placed at one time by a U.S. issuer."

Those two deals with their combined $11.65 billion total set in train a month of November which saw a staggering issuance total of $29.8 billion in a fourth quarter that would end up cranking out $62.6 billion.

The preceding three quarters had seen an average of $31.55 billion, with the biggest of the first three quarters of 2006 being the second, which saw slightly less than $38 billion.

November 2006 topped the $9.77 billion monthly average for Novembers going back to 2001 by more than $20 billion! The largest November among the previous five years was, not surprisingly, November 2004 at slightly more than $16 billion. The smallest, again not surprisingly, was November 2001 at just above $5 billion.

The 2006 fourth quarter topped the $25.7 billion average for fourth quarters going back to 2001 by just under $37 billion. The largest fourth quarter among the previous five years was, again, the fourth quarter of 2004 at just above $38.6 billion. The smallest, by a hair, was the fourth quarter of 2001 at $14.511 billion (the 2002 fourth quarter was only slightly larger at $14.537 billion).

The deal of the year

When asked to select a "deal of the year" primary market sources were all but unanimous.

"It was the HCA deal," one high yield syndicate source said, with no hesitation whatsoever.

"Every tranche is now trading over 106," the source added, speaking in the middle of the Dec. 18 week (other sources subsequently confirmed that the HCA tranches are indeed better than 106 bid, with one source adding that the HCA bank loan is also trading above par).

"HCA has traded like a gem," the synidicate source added.

"And it had the PIK toggle feature."

More on the "PIK toggle feature" below.

To recap HCA's LBO deal, the company priced $5.70 billion of bonds (B2/BB-) in three tranches.

A $1 billion tranche of eight-year senior secured second-lien notes priced at par to yield 9 1/8%, on the tight end of the 9¼% area price talk.

In addition a $3.2 billion tranche of 10-year senior secured second-lien notes priced at par to yield 9¼%, 12.5 basis points below the 9 3/8% to 9½% price talk.

Finally, a $1.5 billion tranche of 10-year senior secured second-lien PIK toggle notes priced at par to yield 9 5/8%, in the middle of the price talk that had the second-lien notes coming 25 to 50 basis points behind the 10-year secured notes.

Citigroup, Bank of America Securities, JP Morgan, Merrill Lynch, Deutsche Bank Securities and Wachovia Securities were joint bookrunners.

Freescale...the big guy

One sell-sider asserted that the deal of the year nod ought to rightfully go to Freescale.

"It came on the heels of HCA, and there was uncertainty as to whether the market would still be there," this official recalled.

"And Freescale was an absolute blowout. They didn't even end up having to use European markets.

"Doing $5.95 billion, all in dollars, was a real success story."

To recap the Freescale deal, the Texas semiconductor company priced $5.95 billion in four tranches:

• A $2.35 billion tranche of eight-year senior notes (B1/B) priced at par to yield 8 7/8%, at the wide end of the 8¾% to 8 7/8% price talk, which had been revised from initial talk of 9% to 9¼%;

• A $1.5 billion tranche of eight-year senior PIK toggle notes (B1/B) priced at par to yield 9 1/8%, on top of talk;

• A $500 million tranche of eight-year senior floating-rate notes (B1/B) priced at par to yield three-month Libor plus 387.5 bps, on the wide end of talk; and

• A $1.6 billion tranche of 10-year senior subordinated notes (B2/B) priced at par to yield 10 1/8%, on top of price talk.

Credit Suisse had the physical books for the LBO deal.

Having it both ways

Interestingly, two senior high yield syndicate officials from different institutions insisted that the deal of the year had to be the HCA deal in tandem with the Freescale transaction which just a week later displaced HCA as the biggest-ever junk deal.

"HCA was the first mega-high yield financing that was quickly followed with Freescale," one of the senior syndicate officials recounted.

"Those two transactions established that there was a high yield market that can take $5 billion to $7 billion of paper, take it well and take it at one time.

Looking at $7 to $10 billion

"They paved the way for a lot of the LBO players to look at some of these mega-LBOs, and say to themselves 'If a $5 billion to $7 billion deal can get done, maybe we can do $7 billion to $10 billion.'

"The liquidity is there for the right company to do pretty big things in the high yield market," the official concluded.

The other senior syndicate source also said that HCA and Freescale, in tandem, generated phenomenal momentum.

"Given that they set and reset the record in successive weeks, and that they both had in excess of $20 billion of orders, they merit the most attention," the official asserted.

"The specter of those two deals coming got the ball rolling in the fourth quarter. A lot of issuers realized that the high yield market is a big market, and made the decision to come.

"They created a tremendous push."

A dissenting voice

One sell-side source did provide an alternative selection for deal of the year.

This official dialed that calendar back to early October, when NXP BV and NXP Funding LLC, formerly Philips Semiconductor, priced approximately €4.5 billion equivalent of bonds in a five-tranche transaction representing the largest amount of new high-yield issuance from a European issuer.

The bonds came in €3.0 billion equivalent of senior secured notes (Ba2/BB+) in three tranches, and €1.5 billion equivalent of senior unsecured notes (B2/B+) in two tranches.

The secured tranches priced as follows:

• $1.535 billion of seven-year floating-rate notes priced at par to yield three-month Libor plus 275 basis points, on top of price talk;

• €1.0 billion of seven-year floating-rate notes priced at par to yield three-month Euribor plus 275 basis points, also on top of price talk; and

• $1.026 billion of eight-year fixed-rate notes priced at par to yield 7 7/8%, on top of price talk.

The unsecured tranches priced as follows:

• $1.250 billion of nine-year notes priced at par to yield 9½%, at the wide end of the 9¼% to 9½% price talk; and

• €525 million of nine-year notes priced at par to yield 8 5/8%, at the wide end of the 8½% area price talk.

Morgan Stanley, Deutsche Bank Securities and Merrill Lynch & Co. were joint bookrunners for the debt refinancing related to the acquisition of 80.1% of Philips Semiconductors by Kohlberg Kravis Roberts & Co. with Bain Capital, Silver Lake Partners, Apax and AlpInvest Partners.

The source who selected it said that the NXP deal featured a unique structure: all secured notes with no bank debt.

"It was good use of the high yield market and a great deal for all parties," the source commented.

However another sell-side official mulled the NXP deal and questioned its qualifications.

"Most of NXP was secured, first-lien bank loan paper in disguise," the source contended.

"The reason that the bond was so big is because they didn't want maintenance covenants. So a lot of it was sold to banks and secured lender accounts."

The toggle feature

Sources also remarked upon the toggle features contained in some of the year-end PIK note deals.

The feature involves a coupon step-up - 75 basis points, typically - should an issuer elect to pay in kind instead of in cash.

Sources say the toggle feature was first seen in the early fall of 2005 when, as part of a $1.2 billion overall two-part transaction led by Credit Suisse, Banc of America Securities, Deutsche Bank Securities and Goldman Sachs, The Neiman Marcus Group Inc. priced a $700 million issue of senior notes due in 2015 (B2/B-) at par to yield 9%.

The toggle feature gave the company the option to pay the coupon in cash or to pay it in kind plus 75 basis points.

From fall 2005 until the fourth quarter of 2006 the toggle feature remained dormant, sources said.

Then on Nov. 9, HCA, as part of its overall $5.70 billion three-part deal, priced a $1.5 billion tranche of senior secured second-lien toggle notes due Nov. 15, 2016 (B2/BB-) at par to yield 9 5/8%.

On Nov. 14 Freescale priced its landmark $5.95 billion four-part transaction which included a $1.5 billion tranche of senior PIK toggle notes due Dec. 15, 2014 (B1/B). Those notes priced at par to yield 9 1/8%.

On Nov. 29 Momentive Performance Management (General Electric's advanced products business) priced a $1.925 billion equivalent offering of high yield notes in a four-part transaction. It included a $300 million tranche of senior toggle notes due Dec. 1, 2014 (B3/B-) which priced at par to yield 10 1/8%.

On Nov. 30 VWR International priced a $350 million issue of three-month Libor plus 450 basis points five-year senior floating-rate toggle notes (Caa1/CCC) at 98.50.

Finally, as part of its overall $1 billion two-part deal, Aleris International, Inc. priced a $600 million tranche of senior PIK toggle notes due Dec. 15, 2014 (B3/B-) at par to yield 9%.

"The toggle notes are probably the big innovation of 2006," one sell-side source said, adding that it will be interesting to see how they trade in the long run.

Sources tell Prospect News that toggle features seem genearlly to be well received among investors.

More than one sell-side source mentioned that the toggle deals apparently work for hedge funds.

"Hedge funds are big into the toggle notes," one senior syndicate official asserted.

"Hedge funds may be taking a bigger piece of the toggle in order to get a better allocation on the fixed-rate tranches."

Another sell-side source, when pressed by Prospect News, conceded that the toggle feature may be a vestige of the so-called "hot market deal," but went on to say that competition for paper among the accounts late in 2006 was especially intense for some of the deals in the market.

And a buy-side source asserted that the recent toggle deals are merely "whistles-and-bells" variations on the garden variety PIK note, which, the investor added, is a well-known hallmark of a hot market.

However sources from both the buy side and the sell side expect these deals to keep coming in 2007, especially as the new year gets underway.

A senior sell-side official said that issuance in toggle PIK notes would likely keep up in 2007.

"The holdco PIK market is going to be selective," the source said.

"Some of these deals have been getting done very well, while others get done very poorly.

"The market will be very discriminating - deal-by-deal, structure-by-structure - and very pricing-dependent.

"However, for the right credit the market seems to like the pick-up in yield."

This source went on to forecast that most of the large LBO deals of 2007 will have toggles."

2007 issuance forecasts

Among sources surveyed in the run-up to the holidays the consensus was that 2007 issuance is apt to fall short - although most said not too far short - of the record-setting $157.26 billion seen in 2006.

One senior syndicate official expects $145 billion of issuance.

"It's all about how many LBOs are going to get done," said this source, sounding a theme that was picked up by other sell-siders who spoke to Prospect News.

"We don't think it's going to be a huge refinancing year, as you look at the relevant dates of issuance and call dates," the source added.

This official's institution went into the Christmas break having visibility on $50 billion of new issuance, the source said, adding "that number is considerably higher than it was last year at this time."

Very few of those surveyed professed to have numbers for issuance projections, and one or two professed to have numbers but declined to share them.

Another senior syndicate official said that the first three or four months of the year could see $30 billion, but conceded that late-year LBO announcements could boost that number.

"The first quarter appears to be on a par with 2006, and possibly the second quarter. But there is a little uncertainty beyond that."

Another syndicate source said that the primary market saw approximately $100 billion in 2005 and $150 billion in 2006, and professed the expectation that 2007 should come in somewhere between those two, adding that refinancing figures to slow down, and the first quarter of the new year figures to be very strong.

Interestingly, the one dissenting voice with regard to 2007 issuance forecasting departed not on the low side but on the high side.

This sell-side source said that given the flurry of leveraged acquisitions announced during mid-December, 2007 will probably come in ahead of 2006 "by a fair margin, assuming conditions stay good."

This official said that the market could see as much as $200 billion, but added that a median estimate would be $170 billion to $180 billion.

The source added that the Freescale $5.95 billion single-issuance record will be broken in 2007.

As 2006 wound down, however, there were no deals being marketed, as is customary in the high yield market at the close of the year.

Aramark seen launching 2007

However sources are expecting primary market activity to ramp up quickly when business resumes on Jan. 2.

Various sell-siders professed the expectation that Aramark Corp. will be among the first deals out the gate in 2007.

The Philadelphia-based professional food, hospitality and facility management services company is expected to start a roadshow in early January for a $2.270 billion notes transaction that will involve senior and senior subordinated notes.

JP Morgan and Goldman Sachs & Co. will be joint bookrunners for the LBO deal, with JP Morgan on the left.

The liquidity picture

Beginning in early 2005 market sources started telling Prospect News that one of the traditional measures of the junk market's liquidity, namely the weekly and monthly reports of the high yield funds' cash inflows and outflows, from AMG Data Services, were perhaps an indicator of the market's sentiment, but were less and less a picture of the market's overall liquidity.

That trend continued in 2006, sources said.

In a year that saw a record breaking $157.26 billion of issuance, in new deals that in large part were reported to have played to "phenomenal liquidity," AMG's measure of year-to-date aggregate fund flows among the funds that report on a weekly basis ended in the red: slightly less than $3 billion of net outflows for the year to Dec. 20.

AMG's numbers told an altogether different story, however, among the funds that report to it on a monthly basis - funds that saw slightly less than $5 billion of inflows through 2006 to Dec. 20.

Hence the 2006 aggregate flows, tallying both the weekly and monthly reporting funds, were squarely in the black, at slightly under $2 billion, with just 11 days remaining in the year.

The hedge funds

With the high yield mutual funds showing aggregate flows of $2 billion, in a market that churned out $157.26 billion of issuance during the year, where, Prospect News wanted to know, is all the cash coming from?

According to several market observers on both the buy-side and the sell-side a good deal of it is coming from the hedge funds.

One senior syndicate source characterized the hedge fund community's growth in importance to the high yield market as one of the "big dynamics" of 2006.

"In 2005 the market may have been somewhat skeptical, and the hedge funds may have been treated a little less fairly with regard to allocations than the tried-and-true high yield accounts," the official reflected.

That perception changed in 2006, the source continued.

"Hedge funds have been instrumental in getting some of the tougher, lower-rated credits done. They came into some of those deal in size.

"They obviously have quite a bit of cash to put to work," the source asserted, adding that hedge funds are lately becoming involved in bridge syndications.

They are doing so, the source added, not merely for the relatively easy money there is to be made if the bridge loan does not get funded, but also to try to guarantee themselves allocations when the bridge loans are taken out by bonds.

Euro issuance

The year 2006 saw slightly less than €29.6 billion of euro-denominated issuance in 74 tranches.

Because of the NXP deal, October was the biggest single month.

A senior high yield syndicate official in the United States recounted that on the first of December one of the market's serial issuers, Chesapeake Energy Corp., priced an upsized €600 million sale of 6¼% senior notes due 2017.

This source said that companies such as Chesapeake Energy, which come to the market nearly every year and sometimes even more frequently than that, will continue to explore issuing more euro denominated bonds as the American accounts become more saturated with the paper of those companies.

The syndicate official added that accounts in Europe continue to struggle to find liquid issues from known names, helping a company such as Chesapeake Energy to raise cash at an interest rate level which outweighs the expense of issuing in a foreign currency, even when the exchange rate is not favorable.

The source forecasted more growth overall in the European market in 2007, and added that there is likely to be a larger Asian component to the high-yield market in the year ahead, as well.

"A lot of people have been building up syndicate and originations desks in Asia," the official said.

"There are plenty of participants who want to put money to work. But there are a lot of regulatory issues to deal with, certainly in Australia, China and Japan.

"Everyone is working together to address those regulatory issues."

This source also looks for action in the Australian corporate sector, with deals featuring dollar, euro and Australian dollar tranches.

The official added that Australian airline, Qantas, is expected to come with a big deal in 2007.

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