Colbeck Capital discusses the rise of the leveraged loan market
Today’s leveraged loan market is an indispensable asset class and a vital part of global finance. Like a strategic lending partner companies in transition, Colbeck Capital Management is at the forefront of the phenomenon, imagining creative solutions and tailor-made credit structuring.
Despite its critical and ever-growing role in the industry, the leveraged loan market is not always well understood.
History of LBOs
To better understand the emergence of the leveraged loan market, it makes sense to start with the leveraged buyout (LBO). In this type of deal, an investor – usually a private equity firm – buys a business with a mix of equity and debt (not that different from how a homebuyer gets a 30-year mortgage, with the bank providing the majority of the initial funds Capitale).
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Outside financial circles, LBOs have had a negative connotation and have been seen as predatory for the acquired company or as a hostile or unwanted takeover. But that’s actually not really the case. Today, private equity teams typically prioritize partnering with management teams and optimizing operations over selling the business for its parts.
Previously known as a “bootstrap” acquisition (the acquired company is expected to provide a stream of revenue, thereby getting off the hook), LBOs have existed at least since the 1940s, although they were rarely employed until in the 1980s. Financier Michael Milken is widely credited with inventing high-yield ‘junk bonds’, which served as essential financing during the period. However, poorly constructed borrowing terms, bad press and risky businesses led to the collapse of the high yield bond market. The LBO market in the 1990s was more evenly distributed, with the equity/debt ratio often approaching 50/50, dropping from 30/70 – or even more – a few years earlier.
It wasn’t until the era of mega-takeovers in the early 2000s that the next LBO boom really began. Unlike in the past, private equity deals have now seen large institutional investors, such as giant global banks, take on the role of lenders. Propelled by lower taxes and reduced regulation, things were going well…until the global financial crisis of 2008.
For many people outside the industry, the crash was their first introduction to the leveraged credit market, and it was not a good sight, as huge unsinkable institutions went bankrupt. The United States government has approved a record $700 billion bailout to shore up and streamline the country’s financial system. It worked: with interest rates kept low, liquidity increased.
The United States, still soft from the crash (and under pressure from Main Street), has seen regulation reverse the course of liberalization seen over the past two decades. In 2010, the Dodd-Frank bill put in place rules prohibiting banks from using their own money to speculate and obliging CLO (Collateralized Loan Obligation) managers to keep at least 5% of their funds. The market has changed again. Investors began trading loan shares themselves, with this market eventually evolving into its own mature asset class, offering even greater liquidity.
In the decade since 2008, the market for leveraged loans has more than doubled. Before the COVID-19 pandemic upended nearly every facet of everything, the United States (the largest leveraged loan market) exceeded $1.2 trillion in 2019, the highest ever.
Generally, leveraged loans are loans where lenders consider the borrower to be at a higher risk of default than higher quality loans. In the majority of cases, the borrower has significant debt on the books and a credit rating below investment grade (think below BBB- on the S&P rating scale).
The terms of these leveraged loans often come with higher interest rates and more restrictive covenants than higher quality loans. These terms provide a bit of a cushion for the lender. And with more risk comes more potential reward, which makes the profit margin all the more attractive to lenders.
There is no hard and fast set of rules for the loan. Some are based on a spread. Many involve a floating rate, often based on the London Interbank Offered Rate (LIBOR), and a spread over LIBOR (LIBOR is expected to be phased out by the end of the year).
Arrangers – usually one or more commercial or investment banks (more investors mean risk is spread across lending institutions, should the borrower default) – round up cash from investors for issuers who need of capital. The issuer pays the arranger for, well, arranging the loans, and fees can range from 1% to 5% of the total commitment.
After being arranged and structured, the loans are syndicated and the arrangers can sell their leveraged loans to all kinds of players, including other banks, institutional investors, mutual funds and hedge funds. If the interest on a loan is lower than expected, arrangers may find themselves with more restraint than they had in mind. Over the past 25 years, arrangers have increasingly used the language of “flexible to market”, where they can change the price of the loan in coordination with investor demand.
At any time, these flexes are a good indication of the state of the leveraged loan market. An abundance of issuer-friendly flexibilities suggests that market demand exceeds supply.