A Guide To The European Loan Market

January 2010

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January 2010 Published by Standard & Poor's Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. Executive and Editorial offices: 55 Water Street, New York, NY 10041. Subscriber services: (1) 212-438-7280. Copyright © 2009 by Standard & Poor’s Financial Services LLC (S&P). All rights reserved. No part of this information may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of S&P. S&P, its affiliates, and/or their third-party providers have exclusive proprietary rights in the information, including ratings, credit-related analyses and data, provided herein. This information shall not be used for any unlawful or unauthorized purposes. Neither S&P, nor its affiliates, nor their third-party providers guarantee the accuracy, completeness, timeliness or availability of any information. S&P, its affiliates or their third-party providers and their directors, officers, shareholders, employees or agents are not responsible for any errors or omissions, regardless of the cause, or for the results obtained from the use of such information. S&P, ITS AFFILIATES AND THEIR THIRD-PARTY PROVIDERS DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE. In no event shall S&P, its affiliates or their third-party providers and their directors, officers, shareholders, employees or agents be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs) in connection with any use of the information contained herein even if advised of the possibility of such damages. The ratings and credit-related analyses of S&P and its affiliates and the observations contained herein are statements of opinion as of the date they are expressed and not statements of fact or recommendations to purchase, hold, or sell any securities or make any investment decisions. S&P assumes no obligation to update any information following publication. Users of the information contained herein should not rely on any of it in making any investment decision. S&P’s opinions and analyses do not address the suitability of any security. S&P does not act as a fiduciary or an investment advisor. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of each of these activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process. S&P’s Ratings Services business may receive compensation for its ratings and credit-related analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), www.globalcreditportal.com and www. ratingsdirect.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees. S&P uses billing and contact data collected from subscribers for billing and order fulfillment purposes, and occasionally to inform subscribers about products or services from S&P, its affiliates, and reputable third parties that may be of interest to them. All subscriber billing and contact data collected is stored in a secure database in the U.S. and access is limited to authorized persons. If you would prefer not to have your information used as outlined in this notice, if you wish to review your information for accuracy, or for more information on our privacy practices, please call us at (1) 212-438-7280 or write to us at: [email protected]. For more information about The McGraw-Hill Companies Customer Privacy Policy please visit www.mcgraw-hill.com/privacy.html. Privacy Notice Last Updated: 23 September, 2008. Permissions: To reprint, translate, or quote Standard & Poor's publications, contact: Client Services, 55 Water Street, New York, NY 10041; (1) 212-438-9823; or by email to: [email protected]. To Our Clients

tandard & Poor’s Leveraged Commentary & Data (LCD) and Standard & Poor’s Ratings Services are pleased to publish the fourth edition of our European Guide STo The Loan Market, which provides commentary on the European leveraged loan market covering a gamut of topics, including secondary trading, default, restructurings, and recovery. As usual, we have also updated and amended our primer on the European leveraged loan market. After a tumultuous end to 2008, during which successive waves of forced selling had taken secondary prices to extremely distressed levels, 2009 has seen secondary prices recover to pre-Lehman levels, with the market differentiating far more based on credit fundamentals, as well as reflecting the relative value of security provided to support senior and subordinated debt instruments in the capital structure. At the beginning of September 2008, the average bid within the Standard & Poor’s European Leveraged Loan Index for senior loan issuers rated ‘BB’ was 89.98 and 86.40 for single ‘B’s. In contrast, as of the end of September 2009, double ‘BB’s had an average bid of 91.94 while single ‘B’s had an average bid of 79.90. As we look ahead to 2010 what we can confidently predict is that little is predictable. The high-yield bond market is outpacing the loan market for now in Europe in terms of issuance, yet judging from the pick-up in primary market activity recently in the U.S., it would probably be a mistake to rule out European banks starting to underwrite transac- tions as the next year unfolds. The last two years have severely tested the leveraged loan market in Europe. Many mar- ket assumptions and established practices about market, credit, and legal risk have had to be reassessed in light of recent events. Whether it is the volatility in loan pricing, forbear- ance from lenders keen to avoid addressing overlevered balance sheets, or using pre-pack administration in the U.K. to cram down dissenting minority interests in a restructuring, there have been many material developments that loan market participants now have to factor into their future lending and investment decisions. These are all issues that Standard & Poor’s strives to incorporate into our loan, high yield bond and recovery ratings as well as through the market leading research and commentary that Standard & Poor’s LCD provides to the leveraged loan, distressed, and high-yield mar- kets in Europe. In addition, Standard & Poor’s continues to work with 15 of the most active European leveraged loan institutions to pool their default and recovery experience. The European Leveraged Loan Study, now its fifth year, is starting to generate, really for the first time given the severity of this default cycle, some robust data around default and post- default recovery that over time will better inform investors about the risk characteristics of this asset class. If you want to learn more about our loan market services, all the appropriate contact infor- mation is listed in the back of this publication. We welcome questions, suggestions, and feed- back of all kinds on our products and services, including this annual Guide. You can access this report and other relevant articles on LCD’s website, www.lcdcomps.com, as well as Standard & Poor’s loan rating website that includes a link to all our current loan and recov- ery ratings: www.bankloanrating.standardandpoors.com or www.sandprecoveryratings.com.

Sucheet Gupte Paul Watters

Standard & Poor’s ● A Guide To The European Loan Market January 2010 3

Contents

A Primer For The European Syndicated Loan Market 7

Loans Limp Along, High-Yield Strides Out As Europe Moves Into Recovery Mode In 2009 31

Western European Leveraged Loan Defaults Should Have Peaked In Q3 2009, But Only Gradually Fall In 2010 37

LBO Performance In Europe Falls Behind Expectations As Recession Bites 43

Is History Repeating Itself In The European High-Yield Market? 50

Charting The Evolution Of Post-Default Recovery Prospects At U.K.-Based Countrywide 54

Key Contacts 58

Standard & Poor’s ● A Guide To The European Loan Market January 2010 5

A Primer For The European Syndicated Loan Market

Robert Polenberg orporate lending is the primary route that European compa- New York (1) 212-438-2717 Cnies use to access the debt markets, unlike in the U.S., where Marina Lukatsky New York high-yield bond issuance plays a significant role. Since the euro (1) 212-438-2709 Sucheet C. Gupte launched in 1999, the syndicated loan market in particular has London (44) 20-7176-7235 become the dominant way for European issuers to tap banks and other institutional capital providers for loans.

A syndicated loan is one that is provided by a above Euribor or LIBOR, depending on the group of lenders and is structured, arranged, currency) sufficient to attract investor appe- and administered by one or several commer- tite for this relatively risky asset class, typi- cial or investment banks known as arrangers. cally Euribor + 200 or higher. They are less expensive and more efficient to The “retail” market for a syndicated loan administer than traditional bilateral, or indi- consists of banks and, in the case of leveraged vidual, credit lines. transactions, finance companies, hedge funds, At the most basic level, arrangers raise and institutional investors. The balance of investor funds for an issuer in need of capi- power among these different investors groups tal. The issuer pays the arranger a fee for this is different in the U.S. than in Europe. The service, and, naturally, this fee increases with U.S. has a capital market where pricing is the loan’s complexity and riskiness. In the linked to credit quality and institutional U.S., corporate borrowers and private equity investor appetite. In Europe, although institu- sponsors fairly even-handedly drive debt tional investors have increased their market issuance. Europe, however, has far less cor- presence over the past few years, banks porate activity and its issuance is dominated remain a key part of the market. Conse­ by private equity sponsors, who, in turn, quently, although market-flex language has determine many of the standards and prac- become standard, pricing is not yet fully tices of loan syndication. driven by capital market forces. High-quality, or investment grade, compa- Banks have historically dominated the Euro­ nies pay lower fees for loans than do specula- pean debt markets because of the intrinsically tive-grade, or leveraged, borrowers. However, regional nature of the arena. Regional banks investment-grade companies generally require have traditionally funded local and regional just a plain-vanilla loan, typically an unse- enterprises because they are familiar with cured revolving credit instrument that is used regional issuers and can fund in the local cur- to provide support for short-term commercial rency. Since the Eurozone was formed in 1998, paper borrowings or for working capital. the growth of the European leveraged loan Leveraged borrowers carry riskier credit market has been fuelled by the efficiency pro- profiles and thus pay higher fees for more vided by this single currency as well as an complex loans. These loans, which are gener- overall growth in merger and acquisition ally secured, also require spreads (premiums (M&A) activity, particularly leveraged buyouts

Standard & Poor’s ● A Guide To The European Loan Market January 2010 7 A Primer For The European Syndicated Loan Market

(LBO) due to private equity activity. Regional loan is undersubscribed, the credit may not barriers (and sensitivities toward consolida- close—or may need major surgery to clear tion across borders) have fallen, economies the market. have grown, and the euro has helped to bridge currency gaps. Club deal As a result, more and more leveraged buy- A “club deal” is a smaller loan (usually E150 outs have occurred over the past few years million or less, but determined by the and, more significantly, they have grown in regional banks’ appetite for risk) that is pre- size as arrangers have been able to raise big- marketed to a group of relationship lenders. ger pools of capital to support larger, multi- The arranger is generally a first among national transactions. To fuel this growing equals, and each lender gets a full cut, or market, a broader array of banks from multi- nearly a full cut, of the fees. Club deals are ple regions now funds these deals, along with traditionally rare from the perspective of European institutional investors as well as transactions syndicated across regions, but U.S. institutional investors. they are common regional plays in Europe, The European market has taken advantage where regional banks provide the funding. of many of the lessons from the U.S. market Club deals became much more prominent while maintaining its regional diversity. In during 2008/2009 as the credit crunch side- Europe, the regional diversity allows banks lined the bulk of institutional investors, and to maintain a significant lending influence banks scaled back their lending. During this and fosters private equity’s dominance in period club deals of more than E150 million the market. became common.

Types Of Syndications The Syndication Process Globally, there are three types of syndications: an underwritten deal, a “best-efforts” syndi- Purpose and preparation in leveraged lending cation, and a “club deal.” The European lev- Leveraged transactions fund a number of eraged syndicated loan market almost purposes. They provide support for general exclusively consists of underwritten deals, corporate purposes, including capital expen- whereas the U.S. market is mostly best-efforts. ditures, working capital, and expansion. They refinance the existing capital structure Underwritten deal or support a full recapitalization including, An underwritten deal is one for which the not infrequently, the payment of a dividend arrangers guarantee the entire commitment, to the equity holders. Their primary purpose, and then syndicate the loan to other banks however, is to fund M&A activity, specifi- and institutional investors. If they cannot fully cally leveraged buyouts, where the buyer uses subscribe the loan, they absorb the difference the debt markets to acquire the acquisition and may later try again to sell to investors. target’s equity. This is easy, of course, if market conditions or The core of European leveraged lending the credit’s fundamentals im–prove. If not, the comes from borrowers owned by private arranger may be forced to hold a larger posi- equity funds. In the U.S., these are called tion on its balance sheet than originally “sponsored transactions.” In Europe, all planned. Alternatively, they may have to sell at sponsor-related activity, including refinancings a discount and, potentially, even take a loss on and recapitalizations, are referred to as LBOs. the paper. Of course, with flex-language now The transaction originates well before lend- widely accepted, underwriting a deal does not ers see the transaction’s terms. In an LBO, the carry the same risk as it did when the pricing company is first put up for auction. A com- was set in stone before syndication. pany that is for the first time up for sale to private equity sponsors is a primary LBO. A Best-efforts syndication secondary LBO is one that is going from one A best-efforts syndication is one for which sponsor to another sponsor (and a tertiary the arranger group commits to underwrite LBO is one that is going for the second time less than the entire amount of the loan, leav- from sponsor to sponsor). A public-to-private ing the credit to market vicissitudes. If the transaction (P2P) occurs when a company is

8 www.standardandpoors.com going from the public domain to a private been gathered, the agent will formally market equity sponsor. the deal to potential investors. As prospective acquirers are evaluating tar- The executive summary will include a get companies, they are also lining up debt description of the issuer, an overview of the financing. A staple financing package may be transaction and rationale, sources and uses, on offer as part of the sale process. By the and key statistics on the financials. time the auction winner is announced, that Investment considerations will be, basically, acquirer usually has funds lined up via a management’s sales “pitch” for the deal. financing package funded by its designated The list of terms and conditions will be a mandated lead arrangers (MLA). preliminary term sheet describing the pricing, Where the loan is not part of a competitive structure, collateral, covenants, and other auction, an issuer usually solicits bids from terms of the credit (covenants are usually arrangers before awarding a mandate. The negotiated in detail after the arranger receives competing banks will outline their syndication investor feedback). strategy and qualifications, as well as their The industry overview will describe the view on the way the loan will price in the company’s industry and competitive position market. In Europe, where mezzanine funding relative to its industry peers. is a market standard, issuers may choose to The financial model will be a detailed pursue a dual track approach to syndication model of the issuer’s historical, pro forma, whereby the MLAs handle the senior debt and and projected financials including manage- a specialist mezzanine fund oversees place- ment’s high, low, and base case for the issuer. ment of the subordinated mezzanine portion. Most new acquisition-related loans are kicked off at a bank meeting at which poten- The information memo, or “bank book” tial lenders hear management and the spon- Once the mandate is awarded, the syndica- sor group describe what the terms of the tion process starts. The arranger will prepare loan are and what transaction it backs. an information memo (IM) describing the Management will provide its vision for the terms of the transactions. The IM typically transaction and, most important, tell why will include an executive summary, invest- and how the lenders will be repaid on or ment considerations, a list of terms and con- ahead of schedule. In addition, investors will ditions, an industry overview, and a financial be briefed regarding the multiple exit strate- model. Because loans are not securities, this gies, including second ways out via asset will be a confidential offering made only to sales. (If it is a small deal or a refinancing qualified banks and accredited investors. If instead of a formal meeting, there may be a the issuer is speculative grade and seeking series of calls or one-on-one meetings with capital from nonbank investors, the arranger potential investors.) will often prepare a “public” version of the Once the loan is closed, the final terms are IM. This version will be stripped of all con- then documented in detailed credit and secu- fidential material such as management finan- rity agreements. Subsequently, liens are per- cial projections so that it can be viewed by fected and collateral is attached. accounts that operate on the public side of Loans, by their nature, are flexible docu- the wall or that want to preserve their abil- ments that can be revised and amended from ity to buy bonds or stock or other public time to time. These amendments require differ- securities of the particular issuer (see the ent levels of approval (see Voting Rights sec- Public Versus Private section below). tion below). Amendments can range from Investors that view materially nonpublic something as simple as a covenant waiver to information of a company are disqualified something as complex as a change in the col- from buying the company’s public securities lateral package or allowing the issuer to stretch for some period of time. out its payments or make an acquisition. As the IM (or “bank book,” in traditional market lingo) is being prepared, the syndicate The loan investor market desk will solicit informal feedback from Loans are “launched” to the market in a potential investors on what their appetite for series of steps. The roles of each of the play- the deal will be and at what price they are ers in the each of those phases are based on willing to invest. Once this intelligence has their relationships in the market and access to

Standard & Poor’s ● A Guide To The European Loan Market January 2010 9 A Primer For The European Syndicated Loan Market

paper. On the arrangers’ side, the players are equity tranche, but the equity tranche is usu- determined by how well they can access capi- ally not rated. CLOs are created as arbitrage tal in the market and bring in lenders. On the vehicles that generate equity returns through lenders’ side, it’s about getting access to as leverage, by issuing debt 10 to 11 times their many deals as possible. equity contribution. There also are market- There are three primary phases of syndica- value CLOs that are less leveraged—typically tion. During the underwriting phase, the spon- three to five times—and allow managers sor or corporate borrower designates the MLA more flexibility than more tightly structured (or the group of MLAs) and the deal is ini- arbitrage deals. CLOs are usually rated by tially underwritten. During the sub-under- two of the three major ratings agencies and writing phases, other arrangers are brought impose a series of covenant tests on collat- into the deal. In general syndication, the trans- eral managers, including minimum rating, action is opened up to the institutional inves- industry diversification, and maximum tor market, along with other banks that are default basket. CLOs traditionally were the interested in participating in the transaction. dominant institutional investor vehicle in There are two primary investor consti­ Europe. Over the past few years, other vehi- tuencies in Europe: banks and institutional cles, such as credit funds, have begun to investors. appear in the market. Banks in the U.S. can be a commercial Credit funds are open-ended pools of debt bank, a savings and loan institution, or a investments. Unlike CLOs, however, they are securities firm that usually provides invest- not subject to ratings oversight or restrictions ment-grade loans. In Europe, the banking regarding industry or rating diversification. segment is almost exclusively made up of They are generally lightly levered (two to commercial banks. For leveraged loans, three times) and allow managers significant European banks fund and hold all tranches freedom in picking and choosing investments within the credit structure. U.S. banks typi- and are subject to being marked to market. cally provide any unfunded revolving credits Mezzanine funds are also investment pools, and letters of credit (LOC); it is becoming which traditionally focused on the mezzanine increasingly less common for them to fund market only. However, when second lien amortizing term loans under a syndicated entered the market, it eroded the mezzanine loan agreement. market; consequently, mezzanine funds Institutional investors in the loan market are expanded their investment universe and principally structured vehicles known as col- began to commit to second lien as well as lateralized loan obligations (CLO). In the U.S., payment-in-kind (PIK) portions of transac- a large part of the institutional investor market tions. As with credit funds, these pools are funds loan participation mutual funds (known not subject to ratings oversight or diversifica- as “prime funds” because they were originally tion requirements, and allow managers signif- pitched to investors as a money-market-like icant freedom in picking and choosing fund that would approximate the prime rate). investments. Mezzanine funds are, however, Although U.S. prime funds do make alloca- riskier than credit funds in that they carry tions to the European loan market, there is no both debt and equity characteristics. European version of prime funds. Prime funds allow U.S. retail investors to Additionally, private equity funds, hedge access the loan market. They are mutual funds, high-yield bond funds, pension funds, funds that invest in leveraged loans and are insurance companies, and other proprietary sold only in the U.S.—there is no European investors do participate opportunistically equivalent. How­ever, U.S. prime funds have in loans made significant allocations to investments in CLOs are special-purpose vehicles set up European loans; an estimated 10% of some to hold and manage pools of leveraged loans. of the largest funds in the U.S. are available The special-purpose vehicle is financed with for funding European loans. several tranches of debt (typically a ‘AAA’ rated tranche, a ‘AA’ tranche, a ‘BBB’ tranche, and a mezzanine tranche) that have Public Versus Private rights to the collateral and payment stream In Europe, the line between public and pri- in descending order. In addition, there is an vate information in the loan market is far

10 www.standardandpoors.com simpler than in the U.S. European loans are public version of the bank meeting and dis- strictly on the private side of the wall and tribute to these accounts only scrubbed any information transmitted between the financial information. issuer and the lender group is considered con- • Buy-side accounts. On the buy side there fidential. High-yield bonds are public instru- are firms that operate on either side of the ments. However, because most European debt public-private fence. Accounts that operate is in the form of loans, privacy reigns. on the private side receive all confidential In the U.S., since the late 1980s, that line materials and agree to not trade in public has begun to blur as a result of two market securities of the issuers for which they get innovations. The first was more active sec- private information. These groups are often ondary trading that sprung up to support part of wider investment complexes that do (1) the entry of nonbank investors in the have public funds and portfolios but, via market, such as insurance companies and Chinese walls, are sealed from these parts loan mutual funds and (2) to help banks sell of the firms. There are also accounts that rapidly expanding portfolios of distressed are public. These firms take only public and highly leveraged loans that they no lon- IMs and public materials and, therefore, ger wanted to hold. This meant that parties retain the option to trade in the public that were insiders on loans might now securities markets even when an issuer for exchange confidential information with which they own a loan is involved. This traders and potential investors who were can be tricky to pull off in practice because not (or not yet) a party to the loan. The sec- in the case of an amendment the lender ond innovation that weakened the public- could be called on to approve or decline in private divide was trade journalism that the absence of any real information. Or, focuses on the loan market. In Europe, the the account could either designate one per- same trends began to emerge, thanks in part son who is on the private side of the wall to a period of rapid growth in the institu- to sign off on amendments or empower its tional investor base. trustee or the loan arranger to do so. But Nonetheless, there has been growing con- it’s a complex proposition. cern among issuers, lenders, and regulators in • Vendors. Vendors of loan data, news, and the U.S. and Europe that this migration of prices also face many challenges in manag- once-private information into public hands ing the flow of public and private informa- might breach confidentiality agreements tion. In general, the vendors operate under between lenders and issuers and, more impor- the freedom of the press provision of the tantly, could lead to illegal trading. The mar- U.S. Constitution’s First Amendment and ket has contended with these issues through: report on information in a way that any- • Traders. To insulate themselves from violat- one can simultaneously receive it—for a ing regulations, some dealers and buyside price of course. Therefore, the information firms have set up their trading desks on the is essentially made public in a way that public side of the wall. Consequently, trad- doesn’t deliberately disadvantage any party, ers, salespeople, and analysts do not receive whether it’s a news story discussing the private information even if somewhere else progress of an amendment or an acquisi- in the institution the private data are avail- tion, or it’s a price change reported by a able. This is the same technique that invest- mark-to-market service. This, of course, ment banks have used from time doesn’t deal with the underlying issue that immemorial to separate their private invest- someone who is a party to confidential ment banking activities from their public information is making it available via the trading and sales activities. press or prices to a broader audience. • Underwriters. As mentioned above, in most Another way in which participants deal primary syndications, arrangers will pre- with the public-versus-private issue is to ask pare a public version of an information counterparties to sign indemnity (“big-boy”) memo that is scrubbed of private informa- letters acknowledging that there may be tion like projections. These memos will be information they are not privy to and they distributed to accounts that are on the pub- are agreeing to make the trade in any case. lic side of the wall. In addition, underwrit- They are, effectively, big boys and will accept ers will ask public accounts to attend a the risks.

Standard & Poor’s ● A Guide To The European Loan Market January 2010 11 A Primer For The European Syndicated Loan Market

Credit Risk: An Overview private “credit estimates” from ratings agen- Pricing a loan requires arrangers to evaluate cies, rather than full public ratings. the risk inherent in a loan and to gauge It is important to note that default risk is investor appetite for that risk. The principal much harder to quantify in Europe than in the credit risk factors that banks and institu- U.S. because distressed transactions tend to tional investors contend with in buying loans privately restructure rather than publicly are default risk and loss-given-default risk. default. Due to the nature of the U.S. bank- Among the primary ways that accounts judge ruptcy courts, their transparency and focus on these risks are ratings, credit statistics, indus- restructuring versus liquidation, both borrow- try sector trends, management strength, and ers and lenders are comfortable with public sponsor. All of these, together, tell a story defaults. In Europe, both parties are subject to about the deal. the vagaries of the array of bankruptcy Brief descriptions of the major risk regimes; as a result, they are more likely to factors follow. come to a private restructuring and the influ- ence and support provided by sponsors in these events cannot be underestimated. Default risk Up until the end of 2008, ratings in Default risk is simply the likelihood of a Europe were still primarily private, but as of borrower’s being unable to pay interest or December 2008, Standard and Poor’s will no principal on time. It is based on the issuer’s longer give credit estimates on deals where financial condition, industry segment, and the debt is worth more than E750 million, conditions in that industry and economic signaling a shift toward a greater role for variables and intangibles, such as company public ratings in Europe. management. Default risk is most visibly expressed by a public rating from Standard Loss-given-default risk & Poor’s Ratings Services or another ratings agency. These ratings range from ‘AAA’ for Loss-given-default risk measures how severe a the most creditworthy loans to ‘CCC’ for loss the lender would incur in the event of the least. The market is divided, roughly, default. Investors assess this risk based on the into two segments: investment grade (loans collateral (if any) backing the loan as well as rated ‘BBB-’ or higher) and leveraged (bor- the amount of any priority debt and other rowers rated ‘BB+’ or lower). Default risk, claims that may affect the likely level of recov- of course, varies widely within each of these eries. Lenders will also look to covenants to broad segments. provide a way of coming back to the table In the U.S., public loan ratings are a de early—that is, before other creditors—and facto requirement for issuers that wish to tap renegotiating the terms of a loan if the issuer the leveraged loan market, which, as noted fails to meet financial targets. Investment-grade above, is now dominated by institutional loans are, in most cases, senior unsecured investors. Unlike banks, which typically have instruments with loosely drawn covenants that large credit departments and adhere to inter- apply only at incurrence, that is, only if an nal rating scales, fund managers rely on issuer makes an acquisition or issues debt. As a agency ratings to bracket risk and explain result, loss given default may be no different the overall risk of their portfolios to their from risk incurred by other senior unsecured own investors. creditors. Leveraged loans, by contrast, are, in The European market is less transparent virtually all cases, senior secured instruments because public ratings are not commonly with tightly drawn maintenance covenants, i.e., required to get a deal syndicated. This is a covenants that are measured at the end of each by-product of the bank dominance of the quarter whether or not the issuer carries out investor market as well as the strong relation- any additional fund raising. Loan holders, ship that exists between lenders and sponsors. therefore, almost always are first in line among Investors rely on their own understanding of prepetition creditors and, in many cases, are default risk and their own assessment of the able to renegotiate with the issuer before the credit, rather than relying on independent loan becomes severely impaired. It is no sur- credit analysis. CLO managers need ratings prise, then, that loan investors historically fare on the credits they invest in, to comply with much better than other creditors on a loss- their internal tests, but they usually obtain given-default basis.

12 www.standardandpoors.com Credit statistics • Pro rata debt consists of the revolving Investors use credit statistics to help calibrate credit and amortizing term loan (TLa), both default risk and loss-given-default risk. which are packaged together and, usually, These statistics include a broad array of syndicated to banks. In some loans, how- financial data, including credit ratios measur- ever, institutional investors take pieces of ing leverage (debt to capitalization and debt the TLa and, less often, the revolving to EBITDA) and coverage (EBITDA to inter- credit, as a way to secure a larger institu- est, EBITDA to debt service, operating cash tional term loan allocation. Why are these flow to fixed charges). Of course, the ratios tranches called “pro rata?” Because arrang- investors use to judge credit risk vary by ers historically syndicated revolving credit industry. In addition to looking at trailing and TLas on a pro rata basis to banks and and pro forma ratios, investors look at man- finance companies. agement’s projections and the assumptions • Institutional debt consists of term loans behind these projections to see if the issuer’s structured specifically for institutional game plan will allow it to pay its debt com- investors, although there are also some fortably. There are ratios that are most banks that buy institutional term loans, geared to assessing default risk. These include especially in Europe. (European structures leverage and coverage. Then there are ratios usually include two bullet term loans, that are suited for evaluating loss-given- called a TLb and a TLc.) These tranches default risk. These include collateral cover- include first-lien TLb and TLc facilities, age, or the value of the collateral underlying second-lien loans, as well as rare prefunded the loan relative to the size of the loan. The letters of credit. Traditionally, institutional ratio of senior secured loans to junior debt in tranches were referred to as TLbs because the capital structure is also used. Logically, they were bullet payments and lined up the likely severity of loss-given-default for a behind TLas. loan increases with the size of the loan as a With institutional investors playing an percentage of the overall debt structure. After ever-larger role, by 2006 many executions all, if an issuer defaults on E100 million of were structured as simply revolving credit/ debt, of which E10 million is in the form of institutional term loans, with the TLa falling senior secured loans, the loans are more by the wayside. likely to be fully covered in bankruptcy The mechanism of structural flex allows than if the loan totals E90 million arrangers to adapt the overall distribution of debt between first lien, second lien, and mez- Industry sector zanine to current market conditions. Under highly liquid market conditions, arrangers Industry is a factor, because sectors, natu- can structurally “flex” the deal by moving rally, go in and out of favor. At times, defen- debt from the more expensive tranches, such sive loans (like consumer products) can be as mezzanine, to less expensive tranches, like more appealing in a time of economic uncer- second or first lien. Likewise, in more diffi- tainty, whereas cyclical borrowers (like cult times, arrangers can do the opposite and chemicals or autos) can be more appealing move debt from first lien into second lien during an economic upswing. The European and second lien into mezzanine to complete market is not as industry diversified as the syndication of the debt. U.S. market, and is primarily dominated by a handful of industries such as cable, telecom, services, and chemicals. Pricing A Loan In The Primary Market Syndicating A Loan By Facility As mentioned earlier, pricing loans in the U.S. is a capital market negotiation that bal- Most loans are structured and syndicated to ances the needs and interests of the different accommodate the two primary syndicated players in the market at the given time. lender constituencies: banks (domestic and Institutional investor pricing is a straightfor- foreign) and institutional investors (primarily ward exercise based on simple risk/return structured finance vehicles, mutual funds, and consideration and market technicals. Pricing insurance companies). As such, leveraged a loan for the U.S. bank market, however, is loans consist of two parts: more complex. Indeed, banks often invest in

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loans for more than pure spread income-- Types Of Syndicated they are also driven by the overall profitabil- Loan Facilities ity of the issuer relationship, including There are four main types of syndicated loan noncredit revenue sources. U.S. pricing also facilities: takes into account other market technicals, • A revolving credit (within which are such as supply relative to demand. If there options for swingline loans, multicurrency- are a lot of dollars chasing little product, borrowing, competitive-bid options, term- then, naturally, issuers will be able to com- out, and evergreen extensions); mand lower spreads. If, however, the oppo- • A term loan; site is true, then spreads will need to increase • An LOC; and for loans to clear the market. • An acquisition or equipment line (a Pricing loans in Europe is a simpler, but delayed-draw term loan). less efficient, process because pricing is not A revolving credit line allows borrowers as flexible and market-driven as it is in the to draw down, repay, and reborrow as often U.S. For many years, the European market as necessary. The facility acts much like a had a well-established pricing “standard” corporate credit card, except that borrowers where most deals started out. The pro rata are charged an annual commitment fee on tranches usually began general syndication at unused amounts, which drives up the over- Euribor + 225. The institutional tranches all cost of borrowing (the facility fee). In were each usually priced up by about 50 bps the U.S., many revolvers to speculative- so the TLb was at Euribor + 275 and the grade issuers are asset-based and thus tied TLc at Euribor + 325. to borrowing-base lending formulas that Until the market turned in July 2007, a limit borrowings to a certain percentage of rapidly decreasing number of deals opened at collateral, most often receivables and inven- the old “standard” levels, and these were tory. In Europe, revolvers are primarily des- mainly more difficult or less liquid credits. ignated to fund working capital or capital The majority of mainstream deals launched expenditures (capex). There are a number at the slightly lower level of Euribor + of options that can be offered within a 200/250/300, in response to heavy demand revolving credit line: for assets. However, once the market slowed • A swingline is a small, overnight borrowing down, the opening spread level on deals line, typically provided by the agent. began to rise back up to, as well as above, • A multicurrency line may allow the bor- the old “standard” levels. rower to borrow in several currencies. During the credit crunch of 2008/2009, • A term-out will allow the borrower to con- opening spreads increased to between Euribor vert borrowings into a term loan at a given + 400-500 across the TLa, TLb, and TLc, in conversion date. This, again, is usually a response to the higher return requirements feature of investment-grade loans. Under of investors. the option, borrowers may take what is Market flex language has also played a big outstanding under the facility and pay it part in adjusting spreads to market liquidity off according to a predetermined repay- levels. Over the past few years, Europe ment schedule. Often the spreads ratchet adopted the U.S. practice of using market flex up if the term-out option is exercised. language to adapt pricing during general syn- • An evergreen is an option for the dication a little more to market conditions. borrower—with consent of the syndicate Until the liquidity crunch, the vast majority group—to extend the facility each year of flexes were downward, allowing borrow- for an additional year. ers to take advantage of the current hyper-liq- A term loan is simply an installment loan, uid market conditions by reducing pricing such as a loan one would use to buy a car. and only a handful of upward flexes had The borrower may draw on the loan during a occurred to make transactions struggling in short commitment period and repays it based syndication more appealing to investors. on either a scheduled series of repayments or However, once the market turned bearish, a one-time lump-sum payment at maturity market flex language allowed arrangers to (bullet payment). There are two principal upward flex pricing in an effort to reengage types of term loans: reluctant investors.

14 www.standardandpoors.com • An amortizing term loan (A-term loans, or ranks of mezzanine as a financing alternative TLa) is a term loan with a progressive for private equity backed transactions, repayment schedule that typically runs six including buyouts and recapitalizations and years or less. These loans are normally syn- for a time it became almost an intrinsic part dicated to banks along with revolving cred- of an LBO financing. its as part of a larger syndication. In the Although they are really just another type U.S., A-term loans have become increas- of syndicated loan facility, second-lien loans ingly rare over the years as issuers bypassed are rather more complex. As their name the bank market and tapped institutional implies, the claims on collateral of second- investors for all or most of their funded lien loans stand behind those of first-lien loans. Recently, the European market has loans but ahead of bonds and mezzanine. seen an increase in number of transactions Unlike the U.S. (where second-lien loans also without the A-term loan as the presence of typically have less restrictive covenant pack- institutional investors has risen. ages in which maintenance covenant levels • An institutional term loan (B-term, C-term, are set wider than the first-lien loans), or D-term loans) is a term-loan facility with European second-lien credits share the same a portion carved out for nonbank, institu- covenant package as first-lien facilities. tional investors. These loans become more Due to its secondary ranking in the priority common as the institutional loan investor line, second-lien deals carry a spread pre- base grows. These loans are priced higher mium over its first-lien counterparts. For than amortizing term loans because they example, while the TLb/TLc tranches have an have longer maturities and bullet repayment average spread of anywhere from Euribor + schedules. This institutional category also 275 to Euribor + 325, the average second lien includes second-lien loans and “covenant- is priced in the Euribor + 500 area. But pric- lite” loans, which are described below. ing varies widely depending on the complex- LOCs differ, but, simply put, they are guar- ity and riskiness of the underlying credit. antees provided by the bank group to pay off Second-lien loans became much less com- debt or obligations if the borrower cannot. mon in 2008, and all but disappeared from Acquisition/equipment lines (delayed-draw the market in 2009, as investor appetite for term loans) are credits that may be drawn these tranches evaporated. down for a given period to purchase specified assets or equipment or to make acquisitions. The issuer pays a fee during the commitment Mezzanine Loans period (a ticking fee). The lines are then repaid A mezzanine loan is a subordinated instru- over a specified period (the term-out period). ment that carries second-ranking security or Repaid amounts may not be reborrowed. third-ranking security if the capital structure also includes second lien. Historically, mezza- nine has been a financing option of choice for Second-Lien Loans small transactions, while the high-yield bond Second-lien loans are another classic example market provided subordinated financing for of a U.S. import to the Europe leveraged large deals. However, mezzanine has extended loan market. This asset class came to Europe its reach to include large deals, becoming a in 2004, but its U.S. history goes back to the staple of LBO financings ranging in size from mid-1990s. These facilities fell out of favor E10 million to E1 billion. after the Russian debt crisis caused investors Mezzanine is popular with private equity to adopt a more cautious tone. But after groups because unlike public high-yield default rates fell precipitously in 2003, bonds, it is a private instrument, syndicated arrangers rolled out second-lien facilities to to a group of lenders ranging from traditional help finance issuers struggling with liquidity shops that specialize in mezzanine to new problems. By 2005, the market had accepted investors, such as hedge funds. In addition to second-lien loans to finance a wide array being subordinated debt, mezzanine includes of transactions, including acquisitions a number of unique features. The interest and recapitalizations. consists of a cash and PIK margin above a However, second lien never served as res- base rate. Due to its secondary or tertiary cue financing in Europe. By the time it position in the priority line, the total margin reached this side of the Atlantic, it joined the is considerably higher than on senior bank

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loans, ranging anywhere from Euribor + 700 on a pro forma basis, it was still within this to Euribor + 1,100 depending on the constraint. If, not then it would have tranche’s size and credit quality, and on the breeched the covenant and be in technical level of appetite for mezzanine. default on the loan. If, on the other hand, an In addition to spread, mezzanine has tra- issuer found itself above this 5x threshold ditionally included warrants to provide lend- simply because its earnings had deteriorated, ers an unlimited upside potential should the it would not violate the covenant. issuer perform well. Deals with warrants Maintenance covenants are far more carry lower spreads than those without restrictive. This is because they require an them. Mezzanine often has a non-call provi- issuer to meet certain financial tests every sion, for one to three years, plus prepayment quarter whether or not it takes an action. penalties at 102 bps and 101 bps in the sub- So, in the case above, had the 5x leverage sequent years. This also appeals to private maximum been a maintenance rather than equity groups because when they decide to incurrence test, the issuer would need to exit the company it will be cheaper to repay pass it each quarter and would be in viola- mezzanine than high-yield bonds, which tion if either its earnings eroded or its debt have longer non-call periods. level increased. For lenders, clearly, mainte- This instrument carries the same financial nance tests are preferable because it allows covenants as senior bank loans. Some facilities them to take action earlier if an issuer expe- have identical covenant levels as the first riences financial distress. What’s more, the ranking debt while others include a “haircut.” lenders may be able to wrest some conces- Haircut refers to how much looser the mezza- sions from an issuer that is in violation nine covenants are compared with senior of covenants (a fee, incremental spread, debt. Usually this number is around 10%. or additional collateral) in exchange for The standard mezzanine standstill periods a waiver. are either 60/90/120 days or 90/120/150 Conversely, issuers prefer incurrence cove- days for mezzanine payment defaults/finan- nants precisely because they are less strin- cial covenant defaults/other mezzanine gent. Covenant-lite loans, therefore, thrive defaults, respectively. only in the hottest markets when the supply/ During the 2008/2009 credit crunch, mez- demand equation is tilted persuasively in zanine tranches were less common in LBO favor of issuers. structures as mezzanine funds sought much Covenant-lite loans made only a brief higher spreads—in the mid- to high teens— appearance in the European market, and on these tranches to compensate for losses disappeared with the credit crunch. on restructured deals. Private equity subse- quently switched to all-senior structures where possible. Toggle Facilities Toggle facilities are primarily a by-product of hyper-liquid markets. They provide issu- Covenant-Lite Loans ers with a “pay if you want” feature that Like second-lien loans, covenant-lite loans are allows them to switch off any cash-pay ele- really just another type of syndicated loan ment and convert all spread to PIK without facility. But they also are sufficiently different consulting the lending group. The toggle fea- to warrant their own section in this primer. ture has appeared on second-lien as well as At the most basic level, covenant-lite loans mezzanine facilities. are loans that have bond-like financial incur- rence covenants rather than traditional main- tenance covenants that are normally part and Cross-Border Loans parcel of a loan agreement. Cross-border loans are transactions that Incurrence covenants generally require that are syndicated simultaneously into multiple if an issuer takes an action (paying a divi- markets. The most common cross-border dend, making an acquisition, issuing more transaction is one that is sold to both U.S. debt), it would need to still be in compliance. and European investors. However, cross-bor- So, for instance, an issuer that has an incur- ders can also be transactions sold in Asia and rence test that limits its debt to 5x cash flow the U.S., Asia and Europe, or even Asia, the would only be able to take on more debt if, U.S., and Europe.

16 www.standardandpoors.com The tranches that make up a cross-border and guarantees. This role occurs primarily loan are denominated in currencies to match only in the case of complex security packages. the markets that they are being sold to. Thus, the U.S. portion of a cross-border will be denominated in U.S. dollars and the European Secondary Sales portion will be denominated in euros. Secondary sales occur after the loan is closed For a cross-border transaction to be viable, and allocated, when investors are free to the issuer must have operations in all of the trade the paper. Loan sales are structured as markets that it is selling debt to. For exam- either assignments or participations, with ple, a traditionally U.S. issuer, such as HCA, investors usually trading through dealer desks must also have assets and/or business in at the large underwriting banks. Europe to support a euro tranche sold to The secondary market in Europe is rela- European investors. tively nascent, especially when compared with that in the U.S. Bank lenders typically do not trade in secondary, but the influx of Lender Titles institutional investors in 2005-2007 drove Lender titles in Europe reflect either the rapid growth in secondary activity, amid banks’ position in the arrangement and hyper liquid conditions. In mid-2007, that underwriting of the transaction or their secondary liquidity contracted once again, administrative role. The MLA designation and the market re–mained highly illiquid remains the most significant lender title for throughout 2008 and 2009. the bank (or banks) providing the primary arrangement and initial underwriting, and Assignments receiving the majority of fees. As the loan In an assignment, the assignee becomes a market has grown and matured, however, direct signatory to the loan and receives inter- the array of other lender, or “co-agent,” est and principal payments directly from the titles has proliferated. administrative agent. The co-agents are designated during the Assignments typically require the consent sub-underwriting phase. The primary co- of the borrower and agent. In the U.S., con- agent title is joint lead arranger (JLA). The sent may be withheld only if a reasonable JLAs make the largest underwriting commit- objection is made and the borrower fre- ments and, in turn, receive the largest fees. quently loses its right to consent in the event Co-agent titles assigned during general syndi- of default. In Europe, the issuer consent, or cation include arranger, co-arranger, and lead more realistically sponsor consent, is not sub- manager. These co-agent titles have become ject to a reasonable standard and remains in largely ceremonial, routinely awarded for place regardless of default status. what amounts to no more than large retail The loan document usually sets a mini- commitments in exchange for upfront fees. mum assignment amount, usually E2.5 The primary administrative title is that of million to E5.0 million for pro rata commit- bookrunner (or joint bookrunner when there ments. As the institutional market grew, is more than one bank involved). The book- administrative agents started to break out runner role is almost always assigned to the specific assignment minimums for institu- MLA(s) and it takes on the administrative tional tranches. Where there are separate tasks generally associated with the adminis- institutional assignment minimums, they trative agent and syndication in the U.S. range from E1.0 million to E2.5 million. The other administrative titles seen regu- larly in the European market are the facility Participations agent and security agent. A participation is an agreement between The facility agent administers the syndi- an existing lender and a participant. As cate, keeping track of syndicate members’ the name implies, it means the buyer is commitments, repayments, secondary trades, taking a participating interest in the existing and also handling alterations to documenta- lender’s commitment. tion via waivers. The lender remains the official holder of The security agent oversees the manage- the loan, with the participant owning the ment of the underlying security, particularly rights to the amount purchased. Consents, with regards to the intercreditor agreement

Standard & Poor’s ● A Guide To The European Loan Market January 2010 17 A Primer For The European Syndicated Loan Market

fees, or minimums are almost never required. which it bought the LCDS contract. For The participant has the right to vote only on instance, say an account buys five-year protec- material changes in the loan document (rate, tion for a given loan, for which it pays 250 term, and collateral). Nonmaterial changes bps per year. Then in year two the loan goes do not require approval of participants. A into default and the market price falls to 80% participation can be a riskier way of purchas- of par. The buyer of the protection can then ing a loan, because, if a lender becomes insol- buy the loan at 80 and deliver to the counter- vent or defaults, the participant does not part at 100, a 20-point pickup. Or instead of have a direct claim on the loan. In this case, physical delivery, some buyers of protection the participant then becomes a creditor of the may prefer a cash settlement in which the dif- lender and often must wait for claims to be ference between the current market price and sorted out to collect on its participation. the delivery price is determined by polling Sub-participations are also a mechanism dealers or using a third-party pricing service. for transferring paper in Europe. In the case Cash settlement could also be used if there’s of a sub-participation, the participant has no not enough paper to physically settle all right to vote as its position in the lending LCDS contracts on a particular loan. group is only based on its agreement with LCDS auctions generally take place after the lender of record. the declaration of a credit event. To kick off the auction process, the LevX index (see next section) market makers must provide two Loan Derivatives pieces of public information to notify admin- Loan credit default swaps istrators of a credit event, which includes fail- Traditionally, accounts bought and sold ure to pay, bankruptcy, or a restructuring. loans in the cash market through assign- The next step is to poll LevX market makers ments and participations. Aside from that, to decide whether to hold an auction process there was little synthetic activity outside to determine the settlement price for LCDS over-the-counter total rate of return swaps. contracts. The default form of settlement is By 2007, however, the market for syntheti- by the physical delivery of the reference obli- cally trading loans was budding. gation, but there is an option to cash-settle Loan credit default swaps (LCDS) are stan- instead, at a price determined by the auction. dard derivatives that have secured loans as reference instruments. In June 2006, LevX and LCDX The International Settlement and Dealers Introduced in 2006, the LevX is an index of Association issued a standard trade confirma- 75 senior or 45 subordinated (second- or tion for LCDS contracts. third-lien) LCDS obligations that participants Like all credit default swaps (CDS), an can trade. The index provides a straightfor- LCDS is basically an insurance contract. The ward way for participants to take long or seller is paid a spread in exchange for agree- short positions on a broad basket of loans, as ing to buy at par, or a prenegotiated price, a well as to hedge their exposure to the market. loan if that loan defaults. An LCDS enables The equivalent in the U.S. market is the participants to synthetically buy a loan by LCDX, which is an index of 100 LCDS obli- going short the CDS or to sell the loan by gations. The LCDX is administered by Markit going long the CDS. Theoretically, then, a Partners, and is an over-the-counter product. loanholder can hedge a position either directly These indices are designed to be reset every (by buying CDS protection on that specific six months, with participants able to trade name) or indirectly (by buying protection on a each vintage of the index that is still active. comparable name or basket of names). The index will be set at an initial spread Moreover, unlike the cash markets, which based on the reference instruments and trade are long-only markets for obvious reasons, the on a price basis. CDS market provides a way for investors to According to the primer posted by Markit short a loan. To do so, the investor would buy (http://www.markit.com/information/affilia- protection on a loan that it doesn’t hold. If tions/lcdx/alertParagraphs/01/document/ the loan subsequently defaults, the buyer of LCDX%20Primer.pdf), “the two events that protection should be able to purchase the loan would trigger a payout from the buyer (pro- in the secondary market at a discount and tection seller) of the index are bankruptcy or then deliver it at par to the counterparty from

18 www.standardandpoors.com failure to pay a scheduled payment on any Pricing Terms debt (after a grace period), for any of the Rates constituents of the index.” Bank loans usually offer borrowers different All documentation for the index is posted interest-rate options. Several of these options at: http://www.markit.com/information/affili- allow borrowers to lock in a given rate for ations/lcdx/alertParagraphs/01/document/ one month to one year. Pricing on many LCDX%20Primer.pdf. loans is tied to performance grids, which adjust pricing by one or more financial crite- Total rate of return swaps ria. Pricing is typically tied to ratings in This is the oldest way for participants to pur- investment-grade loans and to financial ratios chase loans synthetically. And, in reality, a in leveraged loans. Syndication pricing total rate of return swap (TRS) is little more options are either a broad Euribor rate or a than buying a loan on margin. In simple local currency base option: terms, under a TRS program a participant • The Euribor option is so called because, buys the income stream created by a loan from with this option, the interest on borrowings a counterparty, usually a dealer. The partici- is set at a spread over Euribor for a period pant puts down some percentage as collateral, of one month to one year. The correspond- say 10%, and borrows the rest from the ing Euribor rate is used to set pricing. Bor– dealer. Then the participant receives the spread rowings cannot be prepaid without penalty. of the loan less the financial cost plus base rate • Local currency options. Facilities can fund on its collateral account. If the reference loan in a number of currencies other than the defaults, the participant is obligated to buy it euro, particularly the U.S. dollar and the at par or cash settle the loss based on a mark- British pound. U.S. dollar- and sterling- to-market price or an auction price. denominated tranches will generally use Here is how the economics of a TRS work, their respective LIBORs as the base rate. in simple terms. A participant buys via TRS a Tranches denominated in other local cur- E10 million position in a loan paying Euribor rencies, such as the Swiss franc or the + 250. To affect the purchase, the participant Swedish krona, can float over a local puts E1 million in a collateral account and money market base rate, but usually also pays Euribor + 50 on the balance (meaning provide a further option to fund in a more leverage of 9 to 1). Thus, the participant common currency such as the euro or the would receive: U.S. dollar and will thus use the relevant • Euribor + 250 on the amount in the collat- base rate. eral account of E1 million, plus • 200 bps (Euribor + 250 less the borrowing Fees cost of Euribor + 50) on the remaining There are various fees associated with loans E amount of 9 million. and the multiple phases of syndication. The resulting income is LIBOR + 250 times An arranger fee is the fee paid by the issuer E E1 million plus 200 bps times 9 million. to the arranger for the service it provides in Based on the participants’ collateral amount— underwriting and arranging the debt. This E or equity contribution—of 1 million, the will be a one-time, upfront payment. return is LIBOR + 2020. If Euribor is 5%, the An upfront fee or retail fee is a fee paid by return is 25.5%. Of course, this is not a risk- the arranger/s to a lender. These fees will free proposition. If the issuer defaults and the typically be tiered according to the size of the value of the loan goes to 70 cents on the euro, commitment, with co-arrangers receiving a E the participant will lose 3 million. And, if the larger fee for providing senior support in loan does not default but is marked down for syndication, scaling down through to the whatever reason—market spreads widen, it is smallest tickets earning the smallest fee. downgraded, its financial condition deterio- These are one-time fees, usually paid on a rates—the participant stands to lose the differ- lender’s final allocation. ence between par and the current market In recent years, bank lenders have been price when the TRS expires. Or, in an extreme paid upfront fees, but funds have been asked case, the value declines below the value in the to commit without fees. To make a deal more collateral account and the participant is hit attractive to funds, arrangers can offer an with a margin call. original issue discount (OID), whereby the

Standard & Poor’s ● A Guide To The European Loan Market January 2010 19 A Primer For The European Syndicated Loan Market

fund is sold the paper at a discount to par. issuing (or fronting, or facing) fee for issuing The OID will vary according to demand for and administering the LOC. This fee is the deal. almost always 12.5 bps to 25 bps (0.125% to A commitment fee is a fee paid to lenders 0.25%) of the LOC commitment. on undrawn amounts, under a revolving An original issue discount (OID) is yet credit or a term loan before draw-down. On another term imported from the bond mar- term loans, this fee is sometimes referred to ket. The OID the discount from par at loan is as a “ticking” fee. offered in the new issue market as a spread A facility fee, which is paid on a facility’s enhancement. A loan may be issued at 99 to entire committed amount, regardless of usage. pay par. The OID in this case is said to be A usage fee is a fee paid when the utiliza- 100 bps, or 1 point. tion of a revolving credit falls below a certain OIDs and upfront fees have many similari- minimum. These fees are applied mainly to ties but are, in fact, structurally different. investment-grade loans and generally call for From the perspective of the lender, actually, fees based on the utilization under a revolv- there is no difference. But for the issuer ing credit. In some cases, the fees are for high and arrangers, the distinction is far more use and, in some cases, for low use. Often, than semantics. either the facility fee or the spread will be Upfront fees are generally paid from the adjusted higher or lower based on a preset arrangers underwriting fee as an incentive to usage level. bring lenders into the deal. An issuer may pay A prepayment fee is a feature generally the arranger 2% of the deal and the arranger, associated with institutional term loans. This to rally investors, may then pay a quarter of fee is seen mainly in weak markets as an this amount, or 0.50%, to lender group. inducement to institutional investors. Typical Upfront fees are more issuer friendly and, prepayment fees will be set on a sliding scale; thus, are staples of better market conditions. for instance, 2% in year one and 1% in year An OID, however, is generally borne by the two. The fee may be applied to all repay- issuer, above and beyond the arrangement ments under a loan or “soft” repayments, fee. So if there were a 1% OID, the arranger those made from a refinancing or at the dis- would receive its 2% fee but the issuer would cretion of the issuer (as opposed to hard only receive 99 cents for every dollar of loan repayments made from excess cash flow or sold. An OID is a better deal for the arranger asset sales). and, therefore, is generally seen in more chal- An administrative agent fee is the annual lenging markets. fee typically paid to administer the loan (including to distribute interest payments to the syndication group, to update lender lists, Voting Rights and to manage borrowings). For secured Amendments or changes to a loan agreement loans (particularly those backed by receiv- must be approved by a certain percentage of ables and inventory), the agent often collects lenders. Most loan agreements have three lev- a collateral monitoring fee, to ensure that the els of approval: required-lender level, full promised collateral is in place. vote, and supermajority: An LOC fee can be any one of several • The “required-lenders” level, usually just a types. The most common—a fee for standby simple majority, is used for approval of or financial LOCs—guarantees that lenders nonmaterial amendments and waivers or will support various corporate activities. changes affecting one facility within a deal. Because these LOCs are considered “bor- • A full vote of all lenders, including partici- rowed funds” under capital guidelines, the fee pants, is required to approve material is typically the same as the Euribor margin. changes such as RATS (rate, amortization, Fees for commercial LOCs (those supporting term, and security; or collateral) rights, inventory or trade) are usually lower, because but, as described below, there are occasions in these cases actual collateral is submitted). when changes in amortization and collat- The LOC is usually issued by a fronting bank eral may be approved by a lower percent- (usually the agent) and syndicated to the age of lenders (a supermajority). lender group on a pro rata basis. The group • A supermajority is typically 67% to 80% receives the LOC fee on their respective of lenders and is sometimes required for shares, while the fronting bank receives an certain material changes such as changes in

20 www.standardandpoors.com amortization (in-term repayments) and liabilities. The presence of these maintenance release of collateral. Used periodically in covenants--so called because the issuer must the U.S. in the mid-1990s, these provisions maintain quarterly compliance or suffer a fell out of favor by the late 1990s. In technical default on the loan agreement—is a Europe it is still commonly seen for mate- critical difference between loans and bonds. rial changes, simply known as “majority.” As a borrower’s risk increases, financial • The “Yank The Bank” clause provides for covenants in the loan agreement become the replacement of a minority nonconsent- more tightly wound and extensive. In general, ing lender where the majority of lenders there are five types of financial covenants— are in agreement. This is a uniquely coverage, leverage, current ratio, tangible net European term and is generally only seen worth, and maximum capital expenditures: in LBO transactions. • A coverage covenant requires the borrower • The “You Snooze, You Lose” clause to maintain a minimum level of cash flow excludes from the final calculation any or earnings, relative to specified expenses, lender who fails to reply in a timely fashion most often interest, debt service (interest to an amendment request. and repayments), fixed charges (debt ser- vice, capital expenditures, and/or rent). • A leverage covenant sets a maximum level Covenants of debt, relative to either equity or cash Loan agreements have a series of restrictions flow, with the debt-to-cash-flow level being that dictate, to varying degrees, how borrow- far more common. ers can operate and carry themselves finan- • A current-ratio covenant requires that the cially. For instance, one covenant may require borrower maintain a minimum ratio of the borrower to maintain its existing fiscal- current assets (cash, marketable securities, year end. Another may prohibit it from tak- accounts receivable, and inventories) to ing on new debt. Most agreements also have current liabilities (accounts payable, short- financial compliance covenants, for example, term debt of less than one year), but that a borrower must maintain a prescribed sometimes a “quick ratio,” in which level of equity, which, if not maintained, gives inventories are excluded from the numera- banks the right to terminate the agreement or tor, is substituted. push the borrower into default. The size of • A tangible-net-worth (TNW) covenant the covenant package increases in proportion requires that the borrower have a mini- to a borrower’s financial risk. Agreements to mum level of TNW (net worth less intangi- investment-grade companies are usually thin ble assets, such as goodwill, intellectual and simple. Agreements to leveraged borrow- assets, excess value paid for acquired com- ers are often much more onerous. panies), often with a build-up provision, The three primary types of loan covenants which increases the minimum by a percent- are affirmative, negative, and financial. age of net income or equity issuance. Affirmative covenants state what action the • A maximum-capital-expenditures covenant borrower must take to comply with the loan, requires that the borrower limit capital such as that it must maintain insurance. expenditures (purchases of property, plant, These covenants are usually boilerplate and and equipment) to a certain amount, which require a borrower to pay the bank interest may be increased by some percentage of and fees, maintain insurance, pay taxes, and cash flow or equity issuance, but often so forth. allowing the borrower to carry forward Negative covenants limit the borrower’s unused amounts from one year to the next. activities in some way, such as regarding new Some transactions include terms geared to investments. Negative covenants, which are diminish the impact of covenant testing: highly structured and customized to a bor- • A mulligan essentially allows the borrower rower’s specific condition, can limit the type a “do-over” on the covenant tests. If, for and amount of investments, new debt, liens, example, a company does not comply asset sales, acquisitions, and guarantees. with its covenants for one quarter but is Financial covenants enforce minimum back in line the following quarter, the financial performance measures against the previous quarter is disregarded as if it borrower, such as that he must maintain a never happened. higher level of current assets than of current

Standard & Poor’s ● A Guide To The European Loan Market January 2010 21 A Primer For The European Syndicated Loan Market

• An equity cure allows issuers to fix a cove- The one exception to a change in control nant violation—exceeding the maximum being a default trigger is in the case of a debt to EBITDA test for instance—by mak- transferable recapitalization. In this situa- ing an equity contribution. These provi- tion, the documentation regarding a buyout sions are generally found in private allows the sponsor to sell the target acquisi- equity-backed deals, giving the sponsor the tion to an accepted list of other sponsors right, but not the obligation, to inject without triggering a change of control. The equity and cure a violation without having outstanding debt is transferred to the new to request a waiver or amendment. Some sponsor without requiring repayment to the agreements do not limit the number of original lenders. equity cures, while others cap the number to, say, one per year or two over the life of the loan, with the exact details negotiated Security Collateral for each deal. Bull markets tend to bring more generous equity cures as part of In the leveraged market, collateral usually looser overall documentation, while in bear includes all the tangible and intangible assets markets documentation is tighter and of the borrower and, in some cases, specific equity cures are less easily available. assets that back a loan. Virtually all leveraged loans and some Mandatory prepayments weaker investment-grade credits are backed by pledges of collateral. In the asset-based Leveraged loans usually require a borrower market, for instance, that typically takes the to prepay with proceeds of excess cash flow, form of inventories and receivables, with the asset sales, debt issuance, or equity issuance. amount of the loan tied to a formula based Excess cash flow is typically defined as on the value of these assets. A common rule cash flow after all cash expenses, required is that an issuer can borrow against 50% of dividends, debt repayments, capital expendi- inventory and 80% of receivables. Naturally, tures, and changes in working capital. The there are loans backed by certain equipment, typical percentage required is 50% to 75%. real estate, and other property. Asset sales are defined as net proceeds of asset sales, normally excluding receivables or Inter-creditor agreements and cross-guarantees inventories. The typical percentage required is 100%. European borrowers tend to have more com- Debt issuance is defined as net proceeds plex corporate structures than U.S. firms due from debt issuance. The typical percentage to the multijurisdictional nature of the required is 100%. Eurozone, as well as the prevalence of private Equity issuance is defined as the net pro- equity management. As a result, intercreditor ceeds of equity issuance. The typical percent- agreements and cross-guarantees are signifi- age required is 50% to 100%. cant parts of ensuring lender rights regarding Often, repayments from excess cash flow a loan transaction particularly with regards and equity issuance are waived or relaxed if to underperformance or default. the issuer meets a preset financial hurdle, The intercreditor agreement is an agree- most often structured as a debt/EBITDA test. ment to subordination and stipulates the pri- ority of repayment to all lenders, senior and Change of control subordinated, in the case of default. It applies to lenders across borders and codifies their Invariably, one of the events of default in a positions in the absence of intervention from credit agreement is a change of issuer control. individual bankruptcy courts. For both investment-grade and leveraged Similarly, cross-guarantees ensure that the issuers, an event of default in a credit agree- varied operating units associated with a bor- ment will be triggered by a merger, an acqui- rower guarantee its assets as collateral. sition of the issuer, some substantial purchase Thus, should one part trigger a default, all of the issuer’s equity by a third party, or a the associated companies will be equally change in the majority of the board of direc- responsible and their assets will be available tors. For sponsor-backed leveraged issuers, for repayment. the sponsor’s lowering its stake below a pre- The fixed and floating liens are another set amount can also trip this clause. type of guarantee from operating units of

22 www.standardandpoors.com the borrower. This type of guarantee bal- instance, 50% of work-in-process inventory ances the need of the borrower to have the and 65% of finished goods inventory. ability to actively manage its business with In many receivables-based facilities, issuers regards to acquiring and disposing of assets are required to place receivables in a “lock with that of the lender to have claim to box.” That means that the bank lends against those assets in the case of underperformance the receivable, takes possession of it, and or default. The terms of this guarantee then collects it to pay down the loan. essentially allow the borrower to dispose of In addition, asset-based lending is often assets without consent (thus the floating done based on specific equipment, real aspect). However, the proceeds must go estate, car fleets, and an unlimited number through certain channels, including certain of other assets. designated accounts, so that the borrower has the right to freeze those assets (fixing them) under certain circumstances. Default And Restructuring There are two primary types of loan defaults: Springing liens/collateral release technical defaults and the much more serious payment defaults. Technical defaults occur Some loans have provisions that borrowers when the issuer violates a provision of the that sit on the cusp of investment-grade and loan agreement. For instance, if an issuer speculative- grade must either attach collat- does not meet a financial covenant test or eral or release it if the issuer’s rating changes. fails to provide lenders with financial infor- A ‘BBB’ or ‘BBB-’ issuer may be able to mation or some other violation that doesn’t convince lenders to provide unsecured financ- involve payments. ing, but lenders may demand springing liens When this occurs, the lenders can acceler- if the issuer’s credit quality deteriorates. ate the loan and force the issuer into bank- Often, an issuer’s rating being lowered to ruptcy. That is the most extreme measure ‘BB+’ or exceeding its predetermined leverage and rarely employed. In many cases, the level will trigger this provision. Likewise, issuer and lenders are able to agree on an lenders may demand collateral from a strong, amendment that waives the violation in speculative-grade issuer, but will offer to exchange for a fee, spread increase, and/ release under certain circumstances, such as if or tighter terms. the issuer gains an investment-grade rating. A payment default is a more serious matter. As the term implies, this type of default Asset-Based Lending occurs when a company misses either an Most of the information above refers to “cash interest or principal payment. There is often a flow” loans, loans that may be secured by col- pre-set period of time, say 30 days, during lateral, but are repaid by cash flow. Asset- which an issuer can cure a default (the “cure based lending is a distinct segment of the loan period”). After that, the lenders can choose market. These loans are secured by specific to either provide a forbearance agreement assets and usually governed by a borrowing that gives the issuer some breathing room or formula (or a “borrowing base”). The most take appropriate action, up to and including common type of asset-based loans are receiv- accelerating, or calling, the loan. ables and/or inventory lines. These are revolv- If the lenders accelerate, the company will ing credits that have a maximum borrowing generally declare bankruptcy. In this case, juris- limit, say E100 million, but also have a cap dictional issues abound in the European loan based on the value of an issuer’s pledged market as most borrowers have operations in a receivables and inventories. Usually, the multitude of countries. Additionally, each juris- receivables are pledged and the issuer may diction may treat lender seniority differently. borrow against 80%, give or take. Inventories are also often pledged to secure borrowings. Amend-To-Extend However, because they are obviously less liq- This technique allows an issuer to push out uid than receivables, lender advance rates are part of its loan maturities through an amend- less generous. Indeed, the borrowing base for ment, rather than a full refinancing. Amend- inventories is typically in the 50% to 65% to-extend transactions appeared in 2009 as range. In addition, the borrowing base may be borrowers struggled to push out maturities. further divided into subcategories—for

Standard & Poor’s ● A Guide To The European Loan Market January 2010 23 A Primer For The European Syndicated Loan Market

Amend-to-extend allows them to do this Loan Math—The Art without requiring a full refinancing. Of Spread Calculation First the borrower must obtain consent to Calculating loan yields or spreads is not roll existing loans into longer-dated paper. straightforward. Unlike most bonds, which The new debt is typically pari passu with the have long no-call periods and high-call premi- existing loan, but matures later and therefore ums, most loans can be prepaid at any time, carries a higher margin. The second phase is typically without prepayment fees. And, even the conversion, in which lenders can in cases where prepayment fees apply, they exchange existing loans for are rarely more than 2% in year one and 1% new loans. The issuer is left with two in year two. Therefore, affixing a spread-to- tranches: (1) the legacy paper at the initial maturity or a spread-to-worst on loans is lit- price and maturity and (2) the new facility at tle more than a theoretical calculation. a wider spread. This is because an issuer’s behavior is unpredictable. It may repay a loan early Sub-Par Loan Buybacks because a more compelling financial opportu- nity presents itself or because the issuer is This is another technique that grew out of the acquired or because it is making an acquisi- bear market that began in 2007. Performing tion and needs additional financing. Traders paper fell to levels not seen before in the loan and investors will often speak of loan market, with many trading south of 70. This spreads, therefore, as a spread to a theoretical created an opportunity for borrowers with call. For example, European leveraged loans, the financial wherewithal and the covenant on average, between 1997 and 2004 had a headroom to repurchase loans via a tender, or 15-month average life. Thus, if you buy a in the open market, at prices below par. In loan with a spread of 250 bps at a price of some instances, sponsors also bought back 101, you might assume your spread-to- debt, either quietly behind the scenes or via expected-life as the 250 bps less the amor- an auction, as an efficient way to put money tized 100 bps premium or Euribor + 170. to work to delever the business in question. Conversely if you bought the same loan at Typically, the debt would be retired, losing 99, the spread-to-expect life would be voting rights. Euribor + 330. l

24 www.standardandpoors.com Glossary BWIC. An acronym for “bids wanted in com- petition.” It’s really just a fancy way of Arranger fee. The fee paid by the issuer to describing a secondary auction of loans or the arranger for arranging and underwriting bonds. Typically an account will offer up a a loan. portfolio of facilities via a dealer. The dealer Asset sales prepayment. The prepayment will then put out a BWIC, asking potential required as a result of the net proceeds of buyers to submit for individual names or asset sales, normally excluding receivables or the entire portfolio. The dealer will then inventories. The typical percentage required collate the bids and award each facility to is 100%. the highest bidder.

Assignment minimum. The amount that the Circled. When a loan or bond is full subscribed lender can assign to a different lender. It at a given price it is said to be circled. After ranges from E1 million to E5 million. that, the loan or bond moves to allocation and funding. Axe sheets. These are sheets with lists of secondary bids and offers for loans that Commitment fee. A fee paid on unused portion dealers send to accounts. Axes are simply of the facility that ranges from 50 to 75 bps. price indications. For example, the company might have a E100 million revolving credit, but it only Bank book (information memo). This document, needs to draw E20 million; it must pay a fee prepared by the arranging bank, describes the on the remaining E80 million to compensate transaction’s terms. The bank book, or IM, the lenders for keeping this money available. typically will include an executive summary, investment considerations, a list of terms and Corporate LBO. A buyout of a company by a conditions, an industry overview, and a finan- private equity firm from a corporation. It’s cial model. Because loans are not securities, also called corporate divestiture. this will be a confidential offering made only Covenant-lite. Loans that have bond-like to qualified banks and accredited investors. financial incurrence covenants rather than Break price. Price on the facility at the traditional maintenance covenants that are moment it goes free to trade in the secondary normally part and parcel of a loan agreement. market once allocations are made or how Cover bid. The level that a dealer agrees to much investors are willing to pay for this deal essentially underwrite a BWIC or an auction. if they would like to hold it. When the market The dealer, to win the business, may give an is strong and the transaction is well received, account a cover bid, effectively putting a the break price generally will be above par. floor on the auction price. Buyback. In a buyback, a sponsor or com- Credit statistics. Financial ratios, such as pany will opportunistically buy back the leverage ratio, interest coverage ratio, etc. company’s debt out of the secondary market, typically taking advantage of depressed sec- Cross border. A transaction syndicated to both ondary prices. The issuer might use surplus U.S. and European investors. cash off its balance sheet or the sponsor Deal size. Total amount of bank debt raised might use its own equity to purchase the for the transaction. debt. LMA Loan Market Association guide- lines suggest the company should tender for Default rate. Calculated by either number of its debt via a transparent auction process, as loans or principal amount. The formula is well as suggesting measures to reduce the risk similar. For default rate by number of loans: of a conflict of interests resulting from the the number of loans that default over a given sponsor owning debt and equity. Although 12-month period divided by the number of buybacks reduce the company’s debt burden, loans outstanding at the beginning of that they are often contentious, especially if done period. For default rate by principal amount: using surplus cash rather than equity, and in the amount of loans that default over a some cases lenders refuse to sign waivers to 12-month period divided by the total amount give their permission. outstanding at the beginning of the period. Standard & Poor’s defines a default for the

Standard & Poor’s ● A Guide To The European Loan Market January 2010 25 A Primer For The European Syndicated Loan Market

purposes of calculating default rates as a vate equity-backed deals, giving the sponsor loan that is either: the right, but not the obligation, to inject • Rated ’D’ by Standard & Poor’s, equity and cure a violation without having • Made to an issuer that has filed to request a waiver or amendment. Some for bankruptcy, agreements do not limit the number of • In payment default on interest or equity cures, while others cap the number to, principal, or maybe one per year or two over the life of • Restructured in such a way as to create a the loan, with the exact details negotiated material loss to the lender. for each deal. Bull markets tend to bring more generous equity cures as part of looser Default. There are two primary types of loan overall documentation, while in bear mar- defaults, technical defaults and the much kets documentation is tighter and equity more serious payment defaults. Technical cures are less easily available. defaults occur when the issuer violates a pro- vision of the loan agreement. For instance, if Equity issuance prepayment. The prepayment an issuer doesn’t meet a financial covenant required as a result of the net proceeds of test or fails to provide lenders with financial equity issuance. The typical percentage information or some other violation that required is 50% to 100%. doesn’t involve payments. A payment Excess cash flow prepayment. The prepayment default, as the name implies, happens when required as a result of excess cash flow which a company misses either an interest or prin- is typically defined as cash flow after all cash cipal payment. There is often a preset period, expenses, required dividends, debt repay- say 30 days, during which an issuer can cure ments, capital expenditures and changes in a default (the “cure” or “grace” period). working capital. The typical percentage After that, the lenders can take appropriate required is 50% to 75%. action, up to and including accelerating, or calling, the loan. Financial covenant. Financial covenants enforce minimum financial performance Disintermediation. Disintermediation refers to measures against the borrower, for instance the process whereby banks are replaced (or to maintain a higher level of current assets disintermediated) by institutional investors. than current liabilities. As a borrower’s risk Distressed loans. In the loan market, loans increases, these covenants become more traded at less than 80 cents on the dollar restrictive and extensive. were traditionally considered distressed, First-lien debt. Senior debt that holds the first although in 2007-2008 some performing priority on security. loans traded in the 80s and below due to technical rather than fundamental weakness. Flex. Margin flex language allows the In the bond market, the common definition arranger to change spreads during syndication is a spread of 1,000 bps or more. In the loan to adjust pricing to current liquidity levels. market, however, calculating spreads is an To entice more investors into buying the elusive art (see above) and therefore a more credit, spreads will be raised, or “flexed up.” pedestrian price measure is used. When liquidity is high and demand outstrips supply, the spread will be decreased, or EBITDA. Earnings before interest, taxes, “reverse flexed.” A structural flex occurs depreciation, and amortization. This is often when the arranger adjusts the size of tranches used as a proxy for cash flow. during syndication to reflect current liquidity Equity contribution. How much money the levels. As a result, during highly liquid times, sponsor put in to finance the transaction. an arranger may move debt from the more Calculated as the sponsor’s equity amount expensive tranches, such as mezzanine, to divided by total transaction amount. cheaper tranches, such as second lien or first lien. Equity cure. These provisions allow issuers to fix a covenant violation—exceeding the Forward calendar. A list of loans or bonds maximum debt to EBITDA test for that have been announced but not yet instance—by making an equity contribution. launched via a general syndication bank These provisions are generally found in pri- meeting. In the U.S., this is a list of loans or

26 www.standardandpoors.com bonds that have been announced but not yet market. Some participants use a spread cut- closed, including both instruments that are off: i.e., any loan with a spread of Euribor + yet to come to market as well as those that 125 or Euribor + 150 or higher qualifies. are actively being sold but have yet to be cir- Others use rating criteria: i.e., any loan rated cled. ‘BB+’ or lower qualifies. But what of loans that are not rated? At Standard & Poor’s Haircut. In relationship to financial covenants, Leveraged Commentary & Data, we have this refers to the looser maintenance cove- developed a more complex definition. We nants set for mezzanine tranches compared include a loan in the leveraged universe if it with senior credit. is rated ‘BB+’ or lower or it is not rated or Implied ratings (credit estimates or shadow rated ‘BBB-‘ or higher but has (1) a spread of rating). Credit opinions that are not available Euribor + 125 or higher and (2) is secured by publicly on Standard & Poor’s RatingsDirect a first or second lien. Under this definition, a and other public sources. Implied ratings are loan rated ‘BB+’ that has a spread of Euribor not backed by the borrowers. CLO arrangers + 75 would qualify, but a nonrated loan with request the ratings agencies to issue an the same spread would not. It is hardly a implied rating to ensure that the portfolio perfect definition, but one that Standard & maintains certain agreed standards. For Poor’s thinks best captures the spirit of loan example, a CLO should not have more than market participants when they talk about 5% of rated debt in the ‘CCC’ category. leveraged loans.

Institutional facilities. These tranches are sold Loan credit default swaps (LCDS). Standard primarily to institutional investors. They tra- derivatives that have secured loans as ditionally have had a bullet repayment with reference instruments. no amortization, a maturity of eight to nine Loss given default. A measure of how much years, and a spread of Euribor + 250 to 325. creditors lose when an issuer defaults. The The TLb can have a pricing grid with fewer loss will vary depending on creditor class and step downs than pro rata. The TLc usually the enterprise value of the business when it does not have a pricing grid. defaults. Naturally, all things being equal, Interest coverage. EBITDA to interest. secured creditors will lose less than unsecured creditors. Likewise, senior creditors will loss LBO (European version). Any transaction in less than subordinated creditors. Calculating which the issuer is owned by a private equity loss given default is tricky business. Some firm (sponsor). It includes a buyout of a com- practitioners express loss as a nominal per- pany by a sponsor, a follow-on acquisition, a centage of principal or a percentage of princi- dividend to the sponsor, refinancing, etc. pal plus accrued interest. Others use a present LBO (U.S. version). A subset of the above, but value calculation using an estimated discount includes only buyouts of a company by a rate, typically 15% to 25%, demanded by sponsor. Excludes recaps, refinancings, and distressed investors. This can also be follow-on acquisitions. expressed as (1-Recovery Rate).

LevX/LCDX. LevX Senior is an index of 75 Maintenance capex. The minimum amount senior LCDS obligations, and LevX Sub an the company has to spend to keep its assets index of 45 subordinated (second- or third- in shape. If the company cannot maintain its lien) LCDS obligations, that participants can assets, those assets will not continue generat- trade. The U.S. equivalent is LCDX. The ing the same level of revenues. indices provide a straightforward way for Mandatory prepayment. Leveraged loans usu- participants to take long or short positions ally require a borrower to prepay the loans on a broad basket of loans as well as to with proceeds of excess cash flow, asset sales, hedge their exposure to the market. debt issuance, or equity issuance. Leverage ratio or debt/EBITDA. Many bank Mezzanine. A subordinated instrument that books use net debt to EBITDA, which is carries second-ranking security or, if the (debt minus cash) to EBITDA. capital structure also includes second lien, Leveraged loans. Defining a leveraged loan is third-ranking security. a discussion of long standing in the loan

Standard & Poor’s ● A Guide To The European Loan Market January 2010 27 A Primer For The European Syndicated Loan Market

Mulligan. A clause that essentially allows the EBITDA could include cost savings generated borrower a “do-over” on the covenant tests. by headcount reductions. Often pro forma If, for example, a sponsor does not comply financials covers the last 12 months. We also with its covenants for one quarter but is back track “estimated” (full fiscal current year) in line the following quarter, the previous and “projected year one” (first full year after quarter is disregarded as if it never happened. the current year).

Original issue discount (OID). A way of remu- Pro rata. Facilities sold to banks (revolving nerating primary lenders, usually institutional credit, TLa, acquisition facility, capex facil- investors, by offering them a discount to par. ity). These tranches generally have a gradual Varies according to demand for the deal. amortization until maturity (except for the revolver) and a maturity of six to seven years. Non-call. During the non-call period, borrow- They will usually carry a spread of Euribor + ers are obligated to pay a fee to lenders if 200 and greater and might have two to four they repay the debt during the stated non-call step-downs based on a pricing grid. period. Generally, the fee is 2% in the first year and 1% in subsequent years. Pro rata spread. Average spread of revolving credit and TLa tranches (which are usually OWIC. This stands for “offers wanted in com- the same). petition” and is effectively a BWIC in reverse. Instead of seeking bids, a dealer is asked to Public ratings. Ratings that are available buy a portfolio of paper and solicits potential publicly on RatingsDirect and other sellers for the best offer. public sources.

P2P (public to private). A buyout of a publicly Purchase price multiple. Purchase price paid to listed company by a private equity firm result- acquire the company divided by its EBITDA. ing in its delisting from the stock exchange. Recap/dividend. Capital structure shift in Paramount outstanding. This is the amount of which additional debt is raised to finance a institutional bank loans issued previously and cash payment to the owners (sponsor, in case still outstanding at the particular point in of a private company and general public, in time and is tracked by the U.S. and European case of a listed company). Some part of leveraged loan indexes. the new debt may also be used to refinance existing debt. Prepayment fee. Fees paid by the issuer if the debt is repaid before maturity. Recap/equity infusion. Capital structure shift in which the sponsor injects new equity Pricing grid (aka margin ratchet). A set of into the company, usually to refinance financial measures that allows the issuer to existing debt. pay lower interest on the facilities. For exam- ple, if the issuer’s debt to EBITDA is less than Recap/stock repurchase. Capital structure shift 3x, pricing is Euribor + 275; if such ratio in which additional debt is raised to repur- decreases to 2.5x, pricing is Eurobor + 250. chase shares from the owners (sponsor, in case of a private company and general public, Primary price (institutional). Reflects how much in case of a listed company). Stock repur- investors pay for a facility if they buy it in the chase can be in the form of shareholder loan primary syndication. Primary price is par repayment. Some part of the new debt may unless accompanied by an upfront fee. When also be used to refinance existing debt. For the market is strong, institutional paper is research purposes, dividend and stock repur- issued without upfront fees. chase are considered the same thing because Printing a deal. Refers to the price or spread both reflect a payment to the sponsor. at which the deal syndicates. Recapitalization. A shift in the issuer’s capi- tal structure between debt and equity. Types Pro forma financials. Financials that include of recap include: dividend, stock repurchase, the “side effects” of the current transaction. equity infusion. For example, in case of an acquisition, pro forma EBITDA will reflect the combined Recovery. Recovery is the opposite of loss EBITDA of the two companies plus synergies given default—it is the amount a creditor from their merger. For an LBO, pro forma recovers, rather than loses, in a given default.

28 www.standardandpoors.com Refinancing. A transaction in which new debt penalties in the first two years. Their matu- replaces existing debt of the company and rity is usually one-half to one year longer only the debt portion of the capital structure than the TLc. is affected. Secondary LBO. A buy-out of a company by Relative value. This can refer to the relative one private equity firm from another private return or spread between (1) various instru- equity firm. ments of the same issuer, comparing for Senior leverage ratio (senior debt to EBITDA). instance the loan spread with that of a bond; Many bank books use net senior debt to (2) loans or bonds of issuers that are similarly EBITDA, which is (senior debt minus cash) rated and/or in the same sector, comparing to EBITDA. for instance the loan spread of one ‘BB’ rated healthcare company with that of another; and Senior loans. These loans have the highest (3) spreads between markets, comparing for seniority in the issuer’s capital structure, i.e., instance the spread on offer in the loan mar- obligations are contractually paid before sub- ket with that of high-yield or corporate ordinated securities. They have a stated matu- bonds. Relative value is a way of uncovering rity of six to nine years, but are fully undervalued, or overvalued, assets. prepayable at any time and prepayment pen- alties are rare. They are floating rate and Reverse-flex. Spread decrease during syndica- priced based on a spread over Euribor or tion when facilities are oversubscribed to the LIBOR. They have maintenance-based finan- point where a spread reduction will not dam- cial covenants, usually calculated quarterly, age the arranger’s ability to syndicate the facil- and there is no equity kicker to debtholders. ities. A sign of demand outstripping supply. Shareholder loan. Sponsors’ frequently con- Revolving credit. A facility that allows bor- tribute equity in the form of a deeply dis- rowers to draw down, repay, and reborrow counted bond that pays paid-in-kind interest. as often as necessary. The facility acts much An equity-like instrument that is subordi- like a corporate credit card, except that bor- nated to senior and subordinated debt. rowers are charged an annual commitment fee on unused amounts, which drives up the Sources of proceeds. Sources used to finance overall cost of borrowing (the facility fee). the transaction (i.e., bank debt, mezzanine, high yield, and equity). Rich/cheap. A loan that is “rich” is trading at a spread that is low compared with other Split rating. When a loan is rated differently similarly rated loans in the same sector. by Moody’s and Standard & Poor’s such that Conversely, something that is “cheap” means the rating comes out as a “three B” or a “five it is trading at a spread that is high compared B”. “Three B” means ‘B’ (‘B-‘, ‘B’, or ‘B+’) by with its peer group. That is, you can buy it one agency and ‘BB’ (‘BB-‘, ‘BB’, or ‘BB+’) by relatively cheaply. another (if you count all the B’s you’ll get three). “Five B” means ‘BB’ by one agency Rollover equity. Reinvesting funds contributed and ‘BBB’ by another. to the company under previous ownership into a “new” company under new ownership. Sponsored (volume, issuance, etc.). Any type of transaction whereby a private equity group Running the books (or bookrunner). Generally owns the issuer. Same thing as the European the loan arranger is said to be “running the definition of LBO. books,” i.e., preparing documentation and syndicating and administering the loan. Spread. Interest paid on top of a “risk-free” rate, i.e. Euribor (for Euro deals) or LIBOR Second lien. Loan that has second-priority (for U.S. dollar- or sterling-denominated interest on security. Subordinated to senior deals). loans (TLa, TLb, TLc, etc.), but senior to mezzanine, high-yield, PIK notes, and equity. Spread to maturity/spread to call. The spread to They are floating-rate-instrument-like senior maturity adjusts the value of the spread over loans, priced at roughly 200 to 300 bps base rate for any nonpar price, over the life higher than senior loans. Second liens are of the loan. The spread to call calculates the more expensive to prepay than senior debt same, except that the time horizon is a more since many second liens have prepayment realistic estimation of the actual life of these

Standard & Poor’s ● A Guide To The European Loan Market January 2010 29 A Primer For The European Syndicated Loan Market

instruments, which are usually fully prepay- Transferable recapitalization. Buy-out in able without penalty at any time. which the sponsor has the right to sell the targeted acquisition to another sponsor with- Staple financing. Staple financing—or staple- out triggering a change of control. on financing—is a financing agreement “stapled on” to an acquisition, typically by Upfront fee. Fee paid by the arranger to lend- the M&A advisor. So, if a private equity ers joining the syndicate, tiered so that larger firm is working with an investment bank to commitments earn larger fees. acquire an asset, that bank, or a group of Vendor note (aka seller note). A type of financ- banks, may provide a staple financing to ing provided by the seller of the company. ensure that the firm has the wherewithal to An equity-like instrument that is subordinate complete the deal. Because the staple financ- to senior and subordinated debt. ing provides guidelines on both structure and leverage, it typically forms the basis for the Volume. Sum of all leveraged loans raised eventual financing that is negotiated by the (first and second lien) within the given auction winner, and the staple provider will period; new debt raised only. Therefore, if a usually serve as one of the arrangers of the deal is an amendment to the previous credit financing, along with the lenders that were and no new debt is raised, this will be backing the buyer. excluded. All amounts are converted to Euros using the exchange rate either (1) pro- Subordinated debt. Debt that has subordi- vided in the bank book, or (2) spot rate on nated claim on security and payments behind the date of the deal’s bank meeting (our senior debt or has no security at all. Types of proxy for a launch date). subordinated debt are mezzanine, public high yield, and PIK notes (which have certain Warrants (on mezzanine). Gives the mezza- quasi-equity characteristics). nine lenders the right to purchase equity from the issuer at a specific price. Warrants Term loan. This facility is simply an install- potentially provide unlimited upside to ment loan, such as a loan one would use to lenders if the company does really well. buy a car. The borrower may draw on the However, deals that carry warrants have loan during a short commitment period and lower pricing. repays it based on either a scheduled series of repayments or a one-time lump-sum pay- Weighted average institutional spread. ment at maturity (bullet payment). Average spread of TLb and TLc tranches weighted by the size of each tranche, i.e. Toggle facilities. This feature provides issuers [TLb spread times TLb size/(TLb plus with a “pay if you want” feature that allows TLc size)] + [TLc spread times TLc size/ them to switch off any cash-pay element and (TLb plus TLl size)]. convert all spread to PIK without consulting the lending group. Weighted average bid. A price at which an investor is willing to buy a loan, weighted by Total rate of return swaps (TRS). Under a TRS the par amount outstanding. By definition, program, a participant buys the income larger deals will have a stronger influence on stream created by a loan from a counter- the average. party on margin. Then the participant receives the spread of the loan less the finan- Yank The Bank. This clause provides for the cial cost plus base rate on its collateral replacement of a minority nonconsenting account. If the reference loan defaults, the lender where the majority of lenders are participant is obligated to buy it at par or in agreement. cash settle the loss based on a markto-market You Snooze, You Lose. This clause excludes price or an auction price. from the final calculation any lender who Transaction size. Total amount of all debt and fails to reply in a timely fashion to an all equity raised for the transaction. amendment request. l

30 www.standardandpoors.com Loans Limp Along, High-Yield Strides Out As Europe Moves Into Recovery Mode In 2009

Ruth McGavin ctivity in the European leveraged debt market in 2009 took London (44) 20-7176-3924 A the form of secondary trading, restructuring distressed cred- Marina Lukatsky New York its, and new high-yield issuance—in short, in all areas except pri- (1) 212-438-2709 mary issuance of leveraged loans. After the shocks of late 2008, when the Lehman crisis caused the entire financial system to shud- der, the loan market has a very long way to go to recovery, both in terms of its reputation as well as simply in terms of activity levels.

With many banks forced to slash their lever- appetite for risk broadened, outweighing sup- aged loan books and collateralized loan obli- ply, and the entire market traded up. gations hands tied, it is still not clear how that But for portfolio managers and investors of recovery is going to take place and what shape every variety, 2009 has been less about the the market will take in the coming years. rally or the high-yield resurgence, and more Through 2009, the flow of new leveraged about restructuring. They have been fighting loan business has been thin, restricted to small to keep borrowers on track amid the global clubs put together among relationship banks, recession. This has included urgent situations frequently drawn from existing syndicates. where a heavily-leveraged borrower’s Arrangers have been reluctant to underwrite, EBITDA has collapsed and insolvency looms, making it harder for private equity sponsors to covenant resets for less-stressed companies. to bid aggressively for desirable targets. But the high-yield market has enjoyed what players hope will prove to be a turn-around Thin On The Ground year. Low interest rates have fuelled demand Although the year has brought more stable for the fixed-income product, and this has conditions for the global financial markets allowed borrowers to use the high-yield mar- than 2008’s rocky ride, 2009 has offered ket to refinance existing debt. A mix of cross- slim pickings in terms of new leveraged over and true high-yield issuers have tapped loan financing. into investors’ keen demand, which has given Through to the end of October, Standard & rise to hopes that high-yield will use this Poor’s Leveraged Commentary & Data (LCD) opportunity to establish itself as a reliable tracked only 29 leveraged deals, raising €13.1 alternative to leveraged loans. billion. Of this, an €8.9 billion block came Two other key trends have shaped 2009. from a single deal—Heidelberg Cement’s On a cheerful note, there has been a huge restructuring. Even with this, 2009 has been rally in secondary-market prices. Earlier in the thinnest year for new issuance since 1998, the year, buyers scented opportunities to when LCD began tracking the market. make excellent returns on downtrodden, but Leveraged buy-outs (LBO), which have strong, credits. As the rally continued, the traditionally been the dominant forum for

Standard & Poor’s ● A Guide To The European Loan Market January 2010 31 Loans Limp Along, High-Yield Strides Out As Europe Moves Into Recovery Mode In 2009

new leveraged loans, have been scarce. senior, 6.1x total averages set in 2007 (see Depressed valuations meant few sellers, chart 1). In addition, sponsors have been while sponsors faced difficulties in securing required to put in much large amounts of loan financing. From the beginning of 2009 their own money. up through the end of October there were 16 Some have even opted for 100% equity LBOs that generated only €2.7 billion of acquisitions, in the hope of being able to refi- senior debt. In the first 10 months of 2008, nance out into the debt markets again at by comparison, €47.8 billion of paper hit the some point in the future. But for the rest, market from 100 transactions, while in 2007 sponsors cut an average cheque of 55.9% of volume was a massive €128.7 billion from the capital structure. 251 deals. Not only have 2009 deals been few in In tune with the conservative mood, spon- number and small in size, but they have also, sors have found there is much less leverage with barely an exception, been put together available this year. The average leverage mul- on a club basis between banks that either tiples for 2009 through October stood at have relationships with the company, or with 3.4x senior, 4.2x total, down from 4.1x the sponsor in the case of LBOs. In many senior, 5.2x total in 2008. This is also, of cases, banks that were existing lenders to the course, a huge contraction from the 5.3x company in question were asked to roll into

Chart 1 Annual Pro Forma Debt/EBITDA Ratios*

First lien/EBITDA Second lien/EBITDA Other debt/EBITDA

(x) 7 6 5 4 3 2 1 0 2001 2002 2003 2004 2005 2006 2007 2008 Jan.-Oct. 2009

Chart 2 Weighted Average Spreads

Pro rata Institutional (Spread over Eurobar) 500 450 400 350 300 250 200 150

1Q 2007

2Q 2007

3Q 2007

4Q 2007

3Q 2009

1Q 2009

2Q 2009

1Q 2008

2Q 2008

3Q 2008

4Q 2008

1Q 2006

2Q 2006

3Q 2006

4Q 2006

1Q 2005

2Q 2005

3Q 2005

4Q 2005

1Q 2004

2Q 2004

3Q 2004

4Q 2004

32 www.standardandpoors.com new facilities, typically gaining a margin Bring Back The Funds uplift in return for their continued support. One part of the primary market that was The first 10 months of the year set an aver- almost entirely absent during 2009 is the age spread of the Euro Interbank Offered institutional-investor base. Having reached a Rate (E) + 388 basis points on pro rata and E position of great power in the boom market, + 452 on institutional tranches of senior debt. making up 57% of primary syndication in This is comfortably above the E + 252 and E 2007, this year institutional investors were + 337 set, respectively, in 2008, and a world missing from primary syndication. away from the E + 208 and E + 265 average CLO managers were busy working through readings from 2007 (see chart 2). problem credits and were unable to raise new But even late in the year, it was hard to say vehicles, while non-CLOs focused their buy- what “on-market” pricing really was, since ing power—such as it was—on the secondary deals were priced individually according to market opportunities that were so rich, at size, sector, and the willingness of banks to least in the first half of the year. support the transaction. There was simply Without this investor base, new deals relied not enough dealflow, nor any real bench- on banks, who themselves were coping with mark primary loan issuance, to say where internal constraints on lending, political pres- margins had shaken out after 2008’s turmoil. sure to keep their noses clean, and coping On this individual basis, arrangers were with rigorous Basel II capital requirements in willing to co-ordinate bank-club syndicates. a declining credit environment. But they shied away from underwriting new But into the fourth quarter, institutional deals, due to the uncertain depth of market investors, including CLOs, had started to liquidity for new transactions. amass cash and began to look around for The club route is by far the safest and has ways to put it to work. This trend was stron- allowed deals to get done, but on the whole it ger in the U.S. market, where the institutional meant that activity was confined to small sit- investor base is deep and varied, but even in uations. It also changed the way sponsors Europe a trickle of scheduled and unsched- could compete during auctions. Rather than uled repayments (including some from bond searching around for the arranger that was issuance, mergers and acquisitions, and buy- willing to underwrite the most aggressive backs from performing and nonperforming debt package, sponsors had to learn to make credits) began to mount up. do with one staple financing that typically Over the course of the year repayments have used all the available liquidity and left no been very thin. From January through October room for discussion. 2009, a total of €3.1 billion was repaid out of Despite their limitations, bank clubs kept the S&P European Leveraged Loan Index the market alive—just barely—during the (ELLI), including only one full repayment. By year, but by the fourth quarter market play- comparison, a total of €5.4 billion was repaid ers were hoping that underwriting appetite during 2008 and €34.5 billion during 2007. would improve into 2010 and that deal sizes The gradual build-up of cash within the would start to increase. fund world gave some hope that in 2010 the

Chart 3 S&P European Leveraged Loan Index—Average Bid

110

100

90

80

70

60

50 1Q 2004 3Q 2004 1Q 2005 3Q 2005 1Q 2006 3Q 2006 1Q 2007 3Q 2007 1Q 2008 3Q 2008 1Q 2009 3Q 2009

Standard & Poor’s ● A Guide To The European Loan Market January 2010 33 Loans Limp Along, High-Yield Strides Out As Europe Moves Into Recovery Mode In 2009

European market would gradually recover money have been tremendous for trading some of its depth, allowing for slightly larger desks and mark-to-market buyers. CLOs also deals, underwritten rather than clubbed, and felt the benefit of the rally, as more assets sold to a mix of investors rather than to have been lifted back within buying range banks only. Indeed, by the fourth quarter, the above the 80-85% of par mark, and assets calls for new product to feed hungry funds rated ‘CCC’ assets also rallied, lessening the were getting louder. pain inflicted by overflowing ‘CCC’ buckets. Indeed, the ‘CCC’ assets within the ELLI rallied most aggressively during the summer, Trading Up, Up, Up relative to the ‘BB’ and ‘B’ rating categories, One of the key drivers of fund appetite—and indicating that buyers were jumping on the more importantly of the improvement in chance to extract excellent value from the overall market sentiment during 2009—was most risky assets. the secondary market’s extraordinary perfor- By the autumn, the rally had squeezed mance (see charts 3 and 4). much of the value out of the secondary mar- Extraordinary is certainly the right word. ket, and paper was scarce. The yield to The 2008 post-Lehman crash in loan prices maturity on the flow names had tightened to was a long way beyond the worst expectations E + 502 by the end of October, from E + of even the most fearful or fanciful market par- 1,536 at the beginning of January. This ticipant. The average bid of LCD’s European helped drive investors’ attention back Institutional Flow Names dropped to a hideous towards the primary market, in search of low 60.23% of par at year-end- 2008, while new investment opportunities. the average bid of the broad market composite did not bottom out until late March when it scraped down to 56.31% of par. High Hopes For High-Yield But 2009’s rally has also been well beyond One of the anxieties for leveraged companies the ordinary. The flow names gained more is the question of how to refinance outstand- than 30 points during the first 10 months of ing debt. On the assumption that neither the the year to end October at 92.91% of par, bank nor fund market will recover sufficient while the ELLI returned a record-busting appetite for leveraged debt to refinance all of 38.82% over the same period, based on the outstanding paper within the required huge market value gains. time frame, many borrowers will in due During the first quarter, only the strongest course face the problem of how to meet pay- names were rallying, but into the second ments on maturing debt. quarter a swathe of assets, including some This problem is not so acute in Europe as underperformers, gained ground as investors it is in the U.S., since so much of the out- hunted for yield. The opportunities to make standing European paper was put in place in

Chart 4 S&P European Leveraged Loan Index—Total Return

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3ME 10/30/2009

34 www.standardandpoors.com 2006 and 2007 with seven- to nine-year low interest rates drove investors toward the maturities. But for some borrowers, includ- fixed-income products. ing nonsponsor leveraged corporates, the On top of this, issuers themselves needed problem is more immediate, and lenders to the product. Although leveraged merger and certain credits were asked to roll into longer- acquisition activity was feeble during much of dated tranches with higher margins. the year, the need for refinancing meant there During the year, the high-yield bond mar- was a call for high-yield. ket emerged as an invaluable refinancing During the first 10 months of the year, route. This trend developed rapidly in the €14.3 billion in paper was raised in the high- U.S., and fed across into Europe. By the yield market from 33 deals (see chart 5). (All fourth quarter there were high hopes that but €189 million of this was fixed rate.) Out high-yield issuance was going to boom in of this, general refinancing accounted for 2010 not only for refinancings but also--in- 48%, and a further 14% specifically went for vestors hoped—for new business. for refinancing bank debt. Two powerful drivers opened the way for One popular play that developed during high-yield. First, the stalling of the leveraged the year was to replace senior secured loans loan engine has left companies to seriously with senior secured bonds that were longer- consider other financing options. Secondly, dated but pari passu in terms of security.

Chart 5 European Leveraged Finance New-Issue Volume

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Chart 6 Distressed Credits—Number Of Defaults Vs. Restructurings

Defaults Restructurings

(No.) 90 80 70 60 50 40 30 20 10 0 2004 2005 2006 2007 2008 Jan.-Oct. 2009

Standard & Poor’s ● A Guide To The European Loan Market January 2010 35 Loans Limp Along, High-Yield Strides Out As Europe Moves Into Recovery Mode In 2009

Lenders showed a willingness to consent to structure. On the other side, mark-to-market having bonds rank alongside them, because it funds and nonpar buyers including distressed brought them a repayment at par. funds argued in favour of reducing debt Into the fourth quarter, strong demand steeply but retaining a good margin, and from investors compressed spreads and making up for the pain of the debt write- made the market all the more attractive for down through the upside in equity. other potential issuers, including some new- This argument played out, in various comers. High-yield desks within banks were forms, across numerous situations. The in celebratory mood. power often lay in the hands of whichever But a question mark remained over the role parties could contribute additional cash to high-yield would play in new capital-raising solve a liquidity problem, but in other cases for acquisitions in the year ahead. Some were investors built up blocking stakes via second- confident that the bond market was set to ary trading. In a small number of instances, establish itself as a viable alternative source of courts decided the matter—but out-of-court funding, while others questioned how easy it settlements were popular, even if it took time would be for would-be borrowers to handle and trouble to reach an agreement. the reporting requirements in what has tradi- During the year, the volume and sudden- tionally been a much more private market ness of defaults and heavy restructurings environment than the U.S. started to slacken, and the number of lighter restructurings and covenant amendments began to pick up by comparison. A Distressed Year But these covenant amendments were also But away from the loan clubs, secondary rally, a battleground in some cases, as investors and high-yield resurgence, 2009 was in essence demanded better terms in exchange for their a year for dealing with distressed credits. leniency, and as syndicate members argued The global recession took a heavy toll on among themselves about whether to allow a over-leveraged companies, and investors felt reset or push for a full restructuring. the strain as the queue of businesses needing Various trends emerged through the year to restructure their balance sheets lengthened. in the distressed forum, including the use of Lenders had to get to grips with the implica- debt buybacks that saw the sponsor or com- tions of Europe’s varied legal systems, and pany buying debt up below par, either qui- hastily had to turn theoretical knowledge into etly behind the scenes or via an open practical negotiating skill to get the best auction process. Sponsors favored this as an result out of a nasty situation. efficient way to inject new money and bring In late 2008 and 2009’s first quarter, there about deleveraging. was a series of sudden collapses as compa- Including debt buybacks for performing nies destocked and borrowers rapidly companies, a total of €1.1 billion debt was crashed into covenants and failed to make tendered during the year in Europe. interest payments. These restructurings and resets dominated In the first half of the year, LCD tracked most of the year, and it was only in the 61 distressed issuers, including default or fourth quarter that market players really entering a restructuring process (see chart 6). began to think about moving forward again. This rate appeared to ease off in the second There appeared to be decent appetite for half, but, nevertheless LCD’s implied distress new paper, but little product with which to test rate stood at 8.1% at the end of October, up the depth of this demand, and there was also a from 6.3% at the end of June, and 2.2% at slowing in the bad-news flow that helped lift the start of 2009. sentiment. Added to this, the U.S. returned to During negotiations that were often highly- GDP growth, allowing investors to hope that charged and drawn-out, sharp differences European countries would follow suit. emerged as to what different investors These factors gave investors reason to regarded as a good result. believe that deal flow would improve in On one side, many banks and CLOs 2010, in turn giving them a better chance of argued in favour of light haircuts to the exist- freeing up capital and raising new funds to ing debt and instead preferred to cut margins restart a virtuous circle and get the market or accept payment-in-kind margins to pre- moving again. l serve as much debt as possible in the capital

36 www.standardandpoors.com Western European Leveraged Loan Defaults Should Have Peaked In Q3 2009, But Only Gradually Fall In 2010

Paul Watters he number of defaults in 2009 to the end of September was London (44) 20-7176-3542 Tthe highest on record, with 101 corporate defaults for specu- Alexandra Krief Paris lative-grade companies in Western Europe. This translates into (33) 1-4420-7308 a revised trailing 12-month default rate of 13.8%. That period reflects the full 12 months of fallout from the Lehman Brothers collapse in September 2008. Companies that had severe liquidity issues and few, if any, external funding options available almost immediately felt the recession’s impact.

Since the end of 2008 and the beginning of low recovery will limit top-line growth in 2009, the unprecedented fiscal and monetary most sectors, capacity utilization will take support that authorities provided has given key several years to recover to 2006-2007 levels support to the major industrialized economies and, therefore, internally generated cash in Europe and the U.S. and their systemically flow won’t be able to pay down enough important banks. This support has gradually debt to prevent a debt restructuring in the improved the funding options for (initially) next two or three years for many companies. more highly rated companies, but it has also In our view, this will ensure that the default engendered a more supportive stance from the rate, while declining, will likely remain lender community when faced with potential somewhat higher than the long-term average covenant issues for more highly levered credits. of 4.5% for longer than we might normally Specifically, lenders, for the near term at expect over the course of a more typical least, are placing the greatest emphasis on economic cycle. short-term cash generation and the ability Marking the default experience in the to service interest payments even where there European leveraged finance market during are clearly longer term refinancing issues that the first three quarters of 2009 were: they must still address. This has led to a • We revised the headline default rate (by slow-down in the rising default rate since the number) for the 12 months to Sept. 30, end of the first quarter. 2009 up to 13.8% from the preliminary In our view, improving visibility and con- 13.1% that we published on Nov. 4. fidence in the economic outlook, short-term • 101 European speculative-grade companies interest rates at historical lows, and a desire in our data sets defaulted over the past 12 on behalf of lenders to minimize debt write- months on E71.1 billion of outstanding downs, suggests that under our baseline sce- drawn debt, of which 23 companies nario the corporate speculative-grade default defaulted in the third quarter with out- rate would fall to 8.7% at the end of 2010. standing debt of E12.8 billion. This would be a material improvement over • The equivalent default rate by value at 2009. However, we anticipate that the shal- the end of the third quarter was 9.9%,

Standard & Poor’s ● A Guide To The European Loan Market January 2010 37 Western European Leveraged Loan Defaults Should Have Peaked In Q3 2009, But Only Gradually Fall In 2010

up from a revised 8.3% at the end of the fall further to 8.7%. This would corre- second quarter. spond to 55 companies defaulting. • We anticipate that the third quarter will When evaluating the defaults, we use most likely represent the peak in the trail- European corporate data that combines both ing 12-month speculative-grade corporate speculative-grade industrial credits publicly default rate, with the default rate by num- rated by Standard & Poor’s with companies ber slipping back below 12% at the end of that are leveraged loan issuers where Standard 2009. This would place the 2009 full-year & Poor’s provides privat credit estimates. outcome within the 11.7% (base case) and 14.7% (downside case) range that we pro- jected for the end of the year back in early Default Rate Increases April (see “Leveraged Buyouts Are Fuelling To A Revised 13.8% Surging Defaults in Western Europe,” pub- As of Sept. 30, 2009, Standard & Poor’s had lished April 8, 2009, on Ratings Direct). identified 101 defaults over the previous 12 • Under our base case scenario for year-end months, which is more than six times the 16 2010, we project that the default rate could defaults that we saw in the 12 months ended

Table 1 Western European Public And Private Speculative-Grade Default*

—Private credit estimates— —Public speculative-grade ratings— TTM default TTM default TTM default Number¶ Defaults rate (%) Number¶ Defaults rate (%) rate combined 2003 180 5 2.8 111 5 4.5 3.4 2004 263 4 1.5 126 2 1.6 1.5 2005 334 5 1.5 147 2 1.4 1.5 2006 461 8 1.7 152 4 2.6 2.0 2007 567 8 1.4 152 3 2.0 1.5 2008 609 35 5.7 146 5 3.4 5.3 Q408 609 23 5.7 146 4 3.4 5.3 Q109 604 25 9.8 146 5 6.9 9.2 Q209 598 20 12.4 146 1 7.6 11.4 Q309 589 18 14.6 144 5 10.4 13.8

*Europe = EU plus Iceland, Norway, and Switzerland. ¶Average number in database over period. TTM—Trailing 12 months. Source: Standard & Poor’s.

Table 2 Western European Publicly Rated Corporate Defaults Through Sept. 2009*

Company Country Industry Default date Akerys Holdings S.A. France Real estate February 10, 2009 Castle HoldCo 4 Cayman Islands Real estate February 17, 2009 Bite Finance International B.V. Lithuania Telecommunications March 19, 2009 Sensata Technologies B.V. Netherlands Aerospace/automotive/capital goods/metal March 31, 2009 NXP B.V. (A) Netherlands High technology/computers/office equipment April 2, 2009 Thomson S.A. France Consumer/service sector May 7, 2009 Safilo SpA Italy Consumer/service sector July 3, 2009 CEVA Group PLC Netherlands Transportation July 20, 2009 Treofan Holdings GmbH Germany Health care/chemicals July 29, 2009 ESCADA AG Germany Consumer/service sector August 14, 2009 Head N.V. Netherlands Leisure time/media August 14, 2009

*Western Europe = EU plus Iceland, Norway, and Switzerland. Source: Standard & Poor’s GFIR: “Global Bond Markets’ Weakest Links And Monthly Default Rates,” published Dec. 4, 2009.

38 www.standardandpoors.com Sept. 30, 2008. This breaks down into 86 E71.07 billion in the 12 months to Sept. 30, defaults (see table 1) in our private credit esti- 2009. This compares with only E5.66 bil- mate portfolio and 15 publicly rated indus- lion in the comparable prior year period trial sub-investment grade issuers, of which to Sept. 30, 2008. 11 occurred in 2009 (see table 2). The trailing 12-month default rate (by number) to the end of September 2009 was Default Rate By Value Was 9.9% 13.8%, higher than the 11.4% default rate At The End Of September 2009 at end Q2 2009 and more than double the The 12-month default rate by value, combin- 5.3% rate at the end of December 2008 (see ing both public ratings and private credit esti- chart 1). Of note, the default rate within mates, stood at 9.9% at the end of September our private credit estimate portfolio, at 2009 compared with 8.3% at the end of June 14.6% at the end of September 2009, 2009 and 4.5% at the end of December 2008 remains significantly higher than the equiva- (see table 3). lent 10.4% rate for those publicly rated For the first time during this cycle the companies that defaulted in the same default rate by value for those companies for period. Essentially, this reflects the higher which we provided private credit estimates is average level of credit risk for smaller, more almost as high as the equivalent default rate highly leveraged companies (mainly LBOs), for publicly rated companies. This reflects not where institutional investors have requested only the higher number of defaults in the pri- private credit estimates. vate credit estimate portfolio but also the The total outstanding debt held by these increasing number of large private companies defaulting companies before default was that have defaulted.

Chart 1 Western European Speculative-Grade Default Rate*

Combined Private credit estimates Public speculative-grade ratings

(%) 16 14 12 10 8 6 4 2 0 2003 2004 2005 2006 2007 2008 Q408¶ Q109¶ Q209¶ Q309¶

Table 3 Western European Public And Private Speculative-Grade Defaults (By Value)*

—Private credit estimates— —Public speculative-grade ratings— 12-month 12-month 12-month No. of Value default No. of Value default default rate defaults (bil. ) rate (%) defaults (bil. ) rate (%) % combined Fourth-quarter 2008 23 7.45 3.3 4 19.98 5.6 4.5 First-quarter 2009 25 8.73 5.0 5 3.35 6.5 5.8 Second-quarter 2009 20 10.50 7.8 1 8.23 8.8 8.3 Third-quarter 2009 18 7.96 9.8 5 4.86 10.0 9.9

*Europe = EU plus Iceland, Norway, and Switzerland. Source: Standard & Poor’s.

Standard & Poor’s ● A Guide To The European Loan Market January 2010 39 Western European Leveraged Loan Defaults Should Have Peaked In Q3 2009, But Only Gradually Fall In 2010

The average drawn debt outstanding for of private credit estimates and public ratings the private credit estimate companies in the (see table 4). third quarter was E442 million, up from The third quarter saw a sharp fall in the E349 million in the first quarter. Similarly, number of defaults in the automotive and the average outstanding debt amount for homebuilders/real estate sectors, mainly those publicly rated speculative-grade com- reflecting the severity of the early cycle panies that defaulted decreased to E971 mil- impact during late 2008 and early 2009. lion in the third quarter from E1.63 billion Even so, automotive contributed almost 10% in the first quarter. of all 2009 defaults and has the highest Eight private companies defaulted with default rate relative to their 5.4% sector more than E1 billion of outstanding debt in weight in our combined portfolio. the first nine months of 2009, of which four In 2009, the healthcare sector stands out occurred in the second quarter and three in for its defensive quality as reflected in only the third. two defaults through the end of September We derive outstanding debt at default 2009, although telecommunications (1.4%) from the latest financial data available and oil and gas also had relatively few before default. defaults relative to their sector weights.

Breakdown Of European Germany, Spain, And Italy Defaults By Sector Contributed Disproportionately Six sectors contributed just over 70% of the To Default Level defaults seen in 2009 and the level of defaults The six larger countries in Europe account has been worse (apart from retail/restaurants) for almost 82% of the companies by number than we would expect by the their 57% sec- in our combined speculative-grade dataset. tor weight in the overall combined portfolio Of those, Germany (17 2009 defaults), Spain

Table 4 Defaults Of Western European Speculative-Grade Companies By Sector*

First- Third- % 2009 Sector weight (Combined datasets) 2003 2004 2005 2006 2007 2008 half 2009 quarter 2009 defaults (% Sept. 2009) Media and entertainment 2 1 0 2 2 5 9 3 16.2 15.2 Chemicals, packaging, and environmental services 0 0 1 1 1 7 4 5 12.2 8.1 Business equipment and services 0 0 0 0 1 1 4 4 10.8 9.3 Homebuilders/real estate 0 0 0 0 0 7 7 1 10.8 8.0 Retail/restaurants 1 0 4 0 1 4 6 2 10.8 10.5 Automotive 0 1 0 5 2 4 7 0 9.5 5.4 Consumer products 1 1 0 2 2 5 3 2 6.8 8.5 Capital goods 0 1 0 0 1 1 2 2 5.4 6.7 High technology 1 0 0 1 0 1 2 1 4.1 2.6 Metals, mining, and steel 0 0 0 0 1 0 2 1 4.1 1.8 Transportation 1 0 1 0 0 2 2 1 4.1 5.3 Healthcare 0 1 1 1 0 2 1 1 2.7 8.6 Paper and forest products 0 0 0 0 0 0 1 0 1.4 0.9 Telecommunications 1 0 0 0 0 1 1 0 1.4 3.9 Aerospace and defense 0 0 0 0 0 0 0 0 0.0 1.1 Oil and gas, exploration and production 1 0 0 0 0 0 0 0 0.0 2.6 Utility 1 1 0 0 0 0 0 0 0.0 0.5 Total 9 6 7 12 11 40 51 23 100.0 100.0

*Europe = EU plus Iceland, Norway, and Switzerland. Source: Standard & Poor’s.

40 www.standardandpoors.com (eight), and Italy (six) have fared relatively The Netherlands and Spain each had three poorly in 2009, with more defaults than their defaults (8%), while Italy suffered only two. country weights would suggest (see table 5). Germany has suffered due to the importance of manufacturing and exports to its industrial Missing Payments Remains The base, with the automotive sector hit particu- Most Common Driver Of Default larly badly. The economic downturn in Spain By type of default, missing a payment (usu- and the lack of domestic funding avenues ally interest rather than principal) continues appear to have severely hurt leveraged cor- to be the commonest reason for default, porate companies across a range of sectors. causing 46% of defaults in 2009 so far There is little discernable pattern to the (see chart 2). defaults seen in Italy in terms of sector con- A variation on a missed payment is when a centration, company size, or timing of company enters into a standstill arrangement default, although it is clear that all but one with its lender group in response to say a defaulted due to missing a payment. breach or potential breach of covenants to Conversely, the number of defaulted credits allow enough time to commission a restruc- in France is notably low, continuing the pat- turing plan. When a lender defers or waives tern seen in 2008. This is due partly to the an interest or principal payment under such low concentration of LBOs in the industrial an arrangement, Standard & Poor’s criteria equipment, automotive, and building and defines that as a default. In Europe, we have development segments. In addition, French classified 24% of 2009 defaults in this way. consumers fared better than their more Notably, the frequency of standstill agree- indebted counterparts in countries like the ments subsequently leading to a default fell U.K., Spain, and Ireland, for instance. sharply in the third quarter to only 9% per- This compares with 2008, when France haps due to improving management confi- had only four (10%) of the 40 speculative- dence in business forecasts, as well as lenders grade corporate defaults in Western Europe, being more amenable to waiving or resetting compared with the U.K.’s 14 (35%; the covenants in response to moderate short-term most), followed by Germany with 6 (15%). underperformance issues.

Table 5 Defaults Of Western European Speculative-Grade Companies By Country*

Country weight (Combined data sets) Total % 2009 defaults (% Sept. 2009) Germany 17 23.0 16.7 U.K. 13 17.6 25.1 France 9 12.2 19.9 Netherlands 8 10.8 9.2 Spain 8 10.8 6.5 Italy 6 8.1 4.3 Sweden 3 4.1 3.2 Belgium 2 2.7 2.2 Switzerland 2 2.7 2.0 Greece 1 1.4 1.1 Hungary 1 1.4 0.8 Ireland 1 1.4 1.3 Lithuania 1 1.4 0.4 Luxembourg 1 1.4 1.1 Norway 1 1.4 1.1 Total 74 100.0

*Through Sept. 2009. Europe = EU plus Iceland, Norway, and Switzerland. Source: Standard & Poor’s.

Standard & Poor’s ● A Guide To The European Loan Market January 2010 41 Western European Leveraged Loan Defaults Should Have Peaked In Q3 2009, But Only Gradually Fall In 2010

Chart 2 Public And Private Defaults By CauseThroughThird-Quarter 2009

Restructuring (23%)

Standstill (24%)

Filing (7%)

Payment (46%)

Debt restructurings for distressed compa- credit estimates. Geographically, these spread nies where payments are deferred or maturi- across the 27 countries that make up the EU, ties extended, debt is exchanged for equity, or plus Iceland, Norway, and Switzerland. where distressed exchange offers or debt buy- backs occur at discounts to par caused almost a quarter of defaults seen year to date and a Standard & Poor’s higher 30% in the third quarter. Five of the Definition Of Default 17 restructurings that we categorized as Standard & Poor’s records a default when a defaults related to distressed exchange offers company fails to make a payment of princi- for publicly rated companies. pal or interest, files for bankruptcy, or experi- ences a restructuring that meets certain conditions including exchange offers that we The Scope Of Standard & Poor’s view as distressed. The first two categories European Leveraged Finance are usually fairly straightforward and include Market Database standstill agreements where lenders agree to To arrive at the conclusions in this report, we waive or defer interest or principal payments have regrouped our corporate ratings involv- without adequate compensation. In Europe, ing regular interaction with companies’ man- restructurings appear to be becoming a more agement teams into 17 standard industry frequent cause of default and we anticipate classifications. We have similarly regrouped that this will continue over the next couple of our private credit estimates, which are estab- years as and when lenders accede that a bal- lished on the basis of information provided by ance sheet restructuring is necessary. The cir- third parties. Credit estimates are, for the most cumstances where a distressed exchange offer part, used in assessing the asset pools of collat- translates into an event of default are clearly eralized loan obligations. On Sept. 30, 2009, articulated in an S&P General Criteria article Standard & Poor’s speculative-grade universe “Rating Implications Of Exchange Offers in Western Europe consisted of 145 public rat- And Similar Restructurings, Update,” pub- ings on discrete groups or companies and 578 lished May 12, 2009. l

42 www.standardandpoors.com LBO Performance In Europe Falls Behind Expectations As Recession Bites

Taron Wade he recession is proving particularly worrisome for leveraged London (44) 20-7176-3661 Tbuyout companies in Europe, in our opinion. We see that the Alexandra Krief Paris earnings growth that sponsors hoped to use to pay down debt is (33) 1-4420-7308 Paul Watters, CFA not materializing, and, in the current economic climate, investors London (44) 20-7176-3542 are forcing restructurings instead of covenant waivers or refinanc- David Gillmor London ings. This mismatch between the expectations of 2005-2007 and the (44) 20-7176-3673 realities of 2008-2009 is thrown into sharp relief by Standard & Poor’s Ratings Services’ latest survey of leveraged loan perfor- mance, which finds companies falling further behind their EBITDA projections as they wrestle with often unsustainable levels of debt.

Overall, the performance of European spec- (according to Standard & Poor’s LCD, only ulative-grade companies that have been 6.6% by transaction count and 10.8% by through a leveraged buy-out (LBO) has been volume were publicly rated in 2008). The significantly below their initial forecasts for results featured in this report are based on the year-end 2008. In our latest study of data collected from 90 companies across 13 LBO performance, 45% of companies were sectors on which we provide credit esti- more than 10% behind forecast on EBITDA mates. We have also used some data from at the end of 2008, compared with 31% our portfolio of publicly-rated speculative- at the end of 2007 (see article “Credit grade companies for comparative purposes. Conditions Deteriorate For Private Equity- When the results of our first study were Owned And Leveraged Companies In published in February 2008, year-end 2007 Europe,” published Dec. 10, 2008, figures showed that 56% of the sample was on RatingsDirect.) behind the companies’ original EBITDA Since early 2008, in an effort to shed forecasts (see article “European Private some light on prevailing trends in the Equity Deals Display Wide Disparity In European leveraged finance market, Performance; More Than Half Lag EBITDA Standard & Poor’s has been tracking the Forecasts”, published Feb. 12, 2008 on performance of a sample from its private RatingsDirect). That figure has now sharply credit estimate portfolio of European lever- increased to 69%. This will come as no sur- aged loans, composed primarily of specula- prise to the market, as default figures for tive-grade loans backing private-equity 2008 and 2009 have spiked to a recently buyouts. Information on the specific perfor- revised 11.0% trailing 12-month rate in mance of leveraged loans is difficult to Europe, based on Standard & Poor’s pub- obtain, as the majority are not publicly rated licly rated companies and those with credit

Standard & Poor’s ● A Guide To The European Loan Market January 2010 43 LBO Performance In Europe Falls Behind Expectations As Recession Bites

estimates outstanding (see article Performance Variance “Leveraged Loan Defaults Continue To Continues To Widen Climb In Western Europe As The Slowdown Companies were 6.9% behind their median Exposes Structural Weaknesses,” published EBITDA projections at the end of 2008. This Sept. 9, 2009 on RatingsDirect). We see data has a very wide variation, with a stan- that when debt for these transactions was dard deviation of 20.5% (see chart 1). The marketed to investors during the boom variation in performance has increased con- years of 2005-2007, transactions were siderably compared with year-end 2007. structured and sold on the basis of solid Then, companies were only 1.8% behind growth prospects, whether they were first- median EBITDA projections and the standard time LBOs, secondary or tertiary buyouts, deviation was 16.2%. There was also a wide or recapitalizations. We therefore believe variance across industry sectors at the end of that a shortfall in sales and EBITDA growth 2008. For the worst-performing sectors, such will have serious implications for covenant as health care, chemicals, and packaging, compliance and the ability to refinance an underperformance ranges from 15%-17% overleveraged balance sheet. behind forecasts.

Chart 1 Median Performance RelativeTo Initial Projections From Last Financing

2007 versus 2008 2007 2008 Standard deviation 2007 Standard deviation 2008

(%) 50

40

30

20

10

0

(10) Sales EBITDA Debt

© Standard & Poor’s 2009.

Chart 2 Median EBITDA Performance RelativeTo Projections*

2008 versus 2007

Year-end 2007 Year-end 2008

(%) 50 45 40 35 30 25 20 15 10 5 0 > 10% 5%-10% 0-5% 0-5% 5%-10% > 10% behind plan behind plan behind plan ahead of plan ahead of plan ahead of plan

*Does not include all data from defaulted companies due to lack of information for year-end. © Standard & Poor’s 2009.

44 www.standardandpoors.com

S134263C_02.cdr Many companies in our study were experi- Suppliers to major manufacturers, mean- encing severe underperformance by the end of while, are suffering from the effects of 2008, with 45% more than 10% behind fore- destocking as consumer demand falls. In the cast EBITDA (see charts 2 and 3). This trend fourth quarter of 2008 and the first quarter is reflected in the increase in defaults in 2008. of 2009, wholesalers and retailers avoided Of our sample, 11 companies, or 12.2%, have placing new stock orders as they tried to shift experienced a payment default, filed for insol- existing inventory. Auto suppliers, in particu- vency, or are undergoing a restructuring. The lar, suffered greatly as the automakers cut median EBITDA performance for these com- back their stock orders in line with the col- panies was 29% behind the original forecast lapse in auto sales. We understand that some at year-end 2008, while the median sales figure stock reordering is now occurring, but suppli- was down 18.6%. And 18 companies (20%), ers are still suffering the effects of previous including those that have defaulted, have quarters. By contrast, food retailers, along either breached covenants or asked lenders for with other retailers, are in a better position, a waiver or amendment to covenants. This as they have more flexibility to cut costs, in compares with the last update of our study in our view. They also have a shorter working December 2008, when 12.5% of companies in capital cycle. Although demand in general has the study had covenant-related problems. fallen—particularly for luxury goods and dis- cretionary items—we believe that most retail- ers can survive on smaller margins in the near Operating Performance In term. Chemicals companies, on the other Some Sectors Has Been hand, have been hit hard by falling demand Particularly Poor because their high fixed-cost bases cannot be The majority of companies in our study are adjusted quickly. This was exacerbated by ris- now experiencing a deterioration in operating ing raw material prices in 2008. performance and the predictability of future For example, BorsodChem, a chemical demand—particularly in sectors such as real company in Europe, is going through a estate and home building—remains low. restructuring with its lenders, according to Budgets prepared in 2008 now look optimis- reports from S&P LCD. It has been hit by tic, we believe, and have been reforecast to falling demand in the industries that use its levels lower than the actual figures recorded products, which include construction, auto- in 2008. What’s more, there is evidence that motive, and furniture companies. Borsod­ these 2009 budgets are still being revised Chem recently put in place new management downward as management teams grapple and has started to cut costs, LCD said, but with uncertain future demand. has been overtaken by the speed of the slow-

Chart 3 Distribution Of Companies MoreThan 10% Behind Median EBITDA Projections*

Year-end 2008 (%) 60

50

40

30

20

10

0 Greater than 50% 40%-50% 30%-40% 20%-30% 10%-20% behind plan (2) behind plan (4) behind plan (3) behind plan (9) behind plan (19)

*Does not include all data from defaulted companies due to some missing information for year-end 2008. © Standard & Poor’s 2009.

Standard & Poor’s ● A Guide To The European Loan Market January 2010 45

S134263C_03.cdr LBO Performance In Europe Falls Behind Expectations As Recession Bites

down. (We are citing BorsodChem as an As an example, another LBO in Europe, example known in the market, but Standard food-retail business Service Select Partners & Poor’s does not disclose any of the LBO (SSP), has now defaulted through a missed companies included in our study, or any interest payment, according to LCD. Lenders of the companies on which we maintain have been concerned about the company’s credit estimates). lack of EBITDA growth since March 2009. Sales at a number of companies appear According to LCD, lenders were worried to have grown rapidly from year-end about SSP’s drive to increase the number of 2007 to year-end 2008. However, closer outlets it operates, and the accompanying inspection reveals that this is mostly due high capex spend, since they did not see to acquisitions, which can also increase EBITDA growing in line with the expansion debt levels at the same time. Meanwhile, of the business. companies with high fixed-cost bases In an effort to deleverage their balance were not able to adjust quickly to a sharp sheets, some of the companies in our sample drop in demand. Others had high levels have received equity injections from their spon- of capital expenditure (capex) and were sors, since increases in profitability have not not able to increase EBITDA quickly been sufficient to decrease their ratio of debt enough to compensate for this. to EBITDA.

Chart 4 Best-Performing Sectors (Median EBITDAVersus Projection)

Year-end 2007 versus 2008 2007 2008

(%) 10

5

0

(5)

(10)

(15)

(20) Cable and telecoms Business equipment Industrials Food retail Retail

© Standard & Poor’s 2009.

Chart 5 Worst-Performing Sectors (Median EBITDAVersus Projection)

Year-end 2007 versus 2008 2007 2008

(%) 10

5

0

(5)

(10)

(15)

(20) Health care Chemicals Packaging Publishing Autos Building Food products

© Standard & Poor’s 2009.

46 www.standardandpoors.com

S134263C_04.cdr

S134263C_05.cdr Not all sectors posted a decline in their sustain high amounts of leverage. However, in EBITDA performance relative to that pro- the push to find suitable transactions, compa- jected at the end of 2008. Cable and telecom- nies that were cyclical or needed high levels of munications, business equipment, industrials, capex, for example, in our view took on food retail, and general retail generally per- unsustainable levels of debt. Headline figures formed according to plan. Two of these, busi- generally focus on the bigger transactions ness equipment and industrials, even with high absolute leverage, such as VNU improved their performance relative to that at World Directories, now called Truvo year-end 2007 (see chart 4). The worst per- Subsidiary Corp. (CCC+/Negative/—), or forming sectors were health care, chemicals, Alliance Boots (not rated). That said, there packaging, publishing, autos, building, and were many smaller transactions with lower food products (see chart 5). debt multiples that were to prove unsustain- able, and these also contribute to the high rate of defaults. Deleveraging Is Not Possible Without EBITDA Growth Leveraged buyouts are typically intended to Cash Flow Protection expand a company sufficiently to generate Measures Appear Weak enough cash to begin to repay debt, as well The weakness of the average cash flow pro- as reduce its leverage ratios. When sponsors tection measures—EBITDA to net interest, purchase these companies, they usually show funds from operations (FFO) to net debt, and potential investors detailed proposals for debt to EBITDA—of the companies in our how they plan to accomplish this, including study is a direct result of lower-than-expected specific projections for sales, EBITDA, and EBITDA growth. In most cases, where lever- absolute debt levels. This presupposes that age has shot up substantially, the cause was companies will be able to pay back debt an absolute decline in EBITDA as a result, we using earnings growth. However, as our data believe, of the weakening economic environ- show, in the majority of cases, the sponsors’ ment. Some companies were able to improve planned earnings growth did not materialize. their working capital or cut capex to improve This has resulted in absolute debt levels rela- their cash flow or leverage ratios. However, tive to forecast increasing in 2008 from we see that very few companies are delever- 2007. At the end of 2008, average debt levels aging through true growth in profitability were 11.4% higher than originally planned. and cash flow. A year earlier, the figure was 6.6%. The The average EBITDA-to-net-interest multi- averages are much higher than the median ple for the companies in our study is 2.2x, figures for this data as the standard devia- while FFO to net debt is 10%. These are tions increased dramatically to 41.9% from close to the average metrics for a company 20.1% (see chart 1). with a credit estimate of single-b in the sam- We have seen that the typical LBO strategy ple. Average leverage (net debt to EBITDA) of of cutting costs and increasing profitability 7.6x is slightly higher than the average level and cash flow to pay back debt can work well (6.5x) for a ‘b’ credit estimate in the sample for companies that are traditionally able to (see table 1).

Table 1 Average Credit Metrics Of Credit Estimates In Our LBO Performance Study (‘BB-’ To ‘B-’ Categories)

(Most recent credit estimate review)

No. of companies Credit estimate EBITDA/net interest (x) FFO/net debt (%) Debt to EBITDA (x) 4 BB- 3.7 19.3 3.7 12 B+ 3.1 16.3 4.1 34 B 2.2 8.9 6.5 22 B- 1.8 4.7 9.1

FFO—Funds from operations.

Standard & Poor’s ● A Guide To The European Loan Market January 2010 47 LBO Performance In Europe Falls Behind Expectations As Recession Bites

The credit metrics for the companies in our Covenant Breaches Can study are, on average, slightly worse than Quickly Lead To Defaults those for our publicly rated portfolio. But in In our opinion, the majority of reported cov- the speculative-grade category, companies enant breaches in 2008 were technical. What that pursue a public rating generally have a we see as very aggressive plans to deleverage higher rating than those without a public rat- through EBITDA growth meant that compa- ing. As an example, for the companies in our nies breached covenants even if their operat- study with credit estimates ranging from ‘bb-’ ing performance was healthy. Now, however, to ‘b-’, only 6% are at the ‘bb-’ level. The most breaches no longer fit in this category. equivalent figure in our publicly rated portfo- Rather, they are triggered by true operating lio is 28%. Similarly,­ of the companies in our difficulties. We see that in many cases this study within that range, only 17% have a results in liquidity problems for manage- credit estimate of ‘b+’. For our publicly rated ment, because companies are usually unable speculative-grade portfolio, that figure is to rely on undrawn revolving credit facilities 36%. (See tables 1 and 2.) when in breach. In general, in our opinion, the credit qual- Waivers and resets, which were relatively ity of companies in our sample has fallen easy and quick to agree on in early 2008, significantly since we first published the have become harder to obtain. As a conse- results of our study in early 2008. The num- quence, toward the end of 2008 and through- ber of credit estimates at ‘b-’ and ‘ccc+’-to- out 2009, covenant breaches have often led default both grew, while the number of more quickly to defaults. In the second half credit estimates at ‘bb’, ‘b+’, and ‘b’ declined of 2008, the average time from a financial (see chart 6). covenant breach to a payment default, dis-

Table 2 Average Credit Metrics Of Companies Publicly Rated By S&P (‘BB-’ To ‘B-’ Categories)

Fiscal year-end 2008

No. of companies Rating EBITDA/net interest (x) FFO/net debt (%) Debt to EBITDA (x) 27 BB- 5.7 32.1 4.3 35 B+ 3.7 15.8 4.7 20 B 2.0 11.1 5.6 14 B- 1.6 4.2 8.7

FFO—Funds from operations.

Chart 6 Distribution Of Credit Estimates Included In Our Study

February 2008 versus July 2009 Feb. 2008 July 2009

(%) 60

50

40

30

20

10

0 ‘BB’ (5, 4)* ‘B+’ (20, 12) ‘B’ (46, 34) ‘B-’ (17, 22) ‘CCC+’ to default (2, 12) *Number of credits in each category (2008, 2009). © Standard & Poor’s 2009.

48 www.standardandpoors.com tressed debt exchange, or restructuring con- the fundamental problems faced by compa- tracted to 2.0 months from 7.5 months in the nies that are in default. We believe that first half of the year. many companies, sponsors, and lenders are Of the transactions included in the study, simply buying time: By extending term loan 56% were syndicated in 2007, 36% in 2006, A maturities, converting cash interest pay- and 7% in 2005 or earlier. Transactions from ments to payments-in-kind (or taking advan- 2006 and 2007 are suffering from underper- tage of lower interest rates), and taking out formance due to aggressive growth projec- any balance-sheet solvency tests to avoid tions, in our view. Default rates have risen taking painful write-offs now, in the hope substantially in 2009 and we believe that the that the economic outlook, and therefore peak in Europe may occur later in 2009 as valuations, will eventually improve. the full 12 months of trading following the In our view, the leveraged finance market bankruptcy of Lehman Brothers translates in Europe is truly being tested in this current into a higher level of defaults. This will, in recession, mainly because it differs so funda- our view, cause more companies to breach mentally from the nascent market that existed covenants and force them into standstills and in 2003, before the influx of capital that restructuring negotiations with lenders. expanded the capacity for borrowers to raise record amounts of debt. To enable the market to recover and attract capital again, we Could More Conservative believe that new and restructured transac- Structures Bring Greater Stability? tions will need to revert to more conservative Looking forward, we aim to focus our atten- structures, with lower leverage, tighter docu- tion on whether such restructurings address mentation, and greater investor protection. l

Standard & Poor’s ● A Guide To The European Loan Market January 2010 49 Is History Repeating Itself In The European High-Yield Market?

Taron Wade We Believe That Investor Understanding Is Vital For Market Development London (44) (44) 20-7176-3661 re memories in the capital markets getting shorter? The David Gillmor London global markets have just experienced one of the worst (44) 20-7176-3673 A Paul Drake liquidity and credit dislocations since the Great Depression yet it London (44) 20-7176-7207 appears that in some cases investors are not exercising sufficient discipline in regard to speculative-grade debt transactions. If so, the market may be at risk of repeating past mistakes.

Standard & Poor’s Ratings Services believes ket because traditional sources of leveraged that there is no replacement for fundamental funding—bank loans and collateralized loan credit analysis and that investors are best obligation proceeds—have not been as readily served by understanding the nature and risks available as in the past (see “Refinancing of their investments, including their probabil- Needs Drive Leveraged Companies In Europe ity of default and the recovery potential for Toward The High-Yield Bond Market,” pub- speculative-grade debt in case the worst hap- lished July 29, 2009, on Ratings Direct). pens, in order to determine whether the pric- Although 74% of all issuance in the ing on offer is commensurate with the risk. European leveraged finance market in the We believe investor understanding is vital if third quarter of 2009 came from high-yield the European high-yield bond market is to bonds, according to Standard & Poor’s develop into a mature and liquid capital mar- Leveraged Commentary and Data (LCD), ket, with a stable infrastructure for pricing volumes still remain relatively low, compared and trading risk. with the period before the market dislocation. However, amid calls for market discipline, In 2006 there was just over E30 billion of not least from banking chiefs, the reality issuance, which fell to zero in 2008. For 2009 appears somewhat different. Standard & year-to-date, according to data from Standard Poor’s believes that the lack of returns in & Poor’s and Dealogic, high-yield borrowers money markets and investment-grade bonds have issued E17 billion in bonds, close to the may be prompting new investors to enter the E19 billion borrowed in 2007 before the mar- European high-yield market, compressing ket came to a halt in the middle of the year, spreads as volumes remain low. This market (see chart 1). data may suggest that investors may not fully There has been strong demand for these be factoring credit risk into their investment high-yield volumes, as shown by recent heav- decisions, given the tight pricing of new issu- ily oversubscribed transactions, such as ance and the reemergence of creditor- HeidelbergCement AG’s (B+/Positive/B) E2.5 unfriendly transaction terms. billion bond offering and Germany’s Evonik In July 2009, Standard & Poor’s predicted Industries’ (not rated) E750 million 7% notes. that refinancing needs would drive European Both bonds trade above par in the secondary companies toward the high-yield bond mar- market, like investment-grade bonds, accord-

50 www.standardandpoors.com ing to LCD. Of the 11 issues priced since July half-year offering for food and retail sector for which we have data, nine traded up in the holding company Rallye, which was priced at aftermarket and seven were trading above par a yield of 8.5%, referenced against recent as of October 20, 2009. This strong demand ‘BB’ rated transactions, according to is also evident in the tightening of the iTraxx International Financing Review magazine. crossover index (series 4), which was trading Given what we now know about what hap- at 279 basis points on Oct. 15, 2009. The pened in 2007-2008, we believe that investors last time the series was trading at this level might want to consider the benefits of main- was in June 2008, before the bankruptcy of taining discipline in structuring, pricing, and Lehman Brothers (see chart 2). distributing high-yield bond transactions. Some of the recent high-yield issuance is unrated (see table). Anecdotal evidence sug- gests that much of the demand for unrated Some Structures Give deals comes from private banks and other rel- More Protection Than Others atively new players to the credit market in We believe the quality of the security package Europe (many institutional investors are not is one of the most important considerations able to invest in unrated transactions). These when analyzing the downside risks pertaining investors, like many others in the market, to a potential future default. For example, in appear to be moving down the credit curve September 2009, Standard & Poor’s rated the in the search for yield. One recent unrated $210 million senior secured notes issued by transaction was a E500 million five-and-a The Netherlands-based logistics group CEVA

Chart 1 Total European HighYield Bond Issuance 1999–2009

( Bil.) 35 30 25 20 15 10 5 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 (to date)

Chart 2 The Markit iTraxx Crossover Index IsTightening

iTraxx five-year crossover index series 4 1,400

1,200 1,000 800

600 400 200 0 Oct. 2005 Oct. 2006 Oct. 2007 Oct. 2008 Oct. 2009

Standard & Poor’s ● A Guide To The European Loan Market January 2010 51 Is History Repeating Itself In The European High-Yield Market?

Group PLC (CCC+/Stable/—) two notches pany used the proceeds to repay a portion of below the existing debt due to a perceived its senior secured debt due 2014 and also weakness in the security package. Although repay its revolving credit facility due 2014. these notes have the same guarantee structure The new bond ranks pari passu with the and security as the company’s existing senior existing senior debt, with, in our view, imma- secured credit facilities, we assigned a recov- terial differences in the security package. ery rating of ‘5’ (indicating our expectation Additionally, we see some variation of 10%-30% recovery in the event of a between the covenant packages for investors default) to the new notes, compared with ‘2’ in senior secured bonds and those of the bank (70%-90% recovery) on the existing bank lenders at the same ranking. Although these facilities, reflecting our assessment of the new creditors may rank pari passu, if the senior notes only having a second-ranking claim on lenders have maintenance covenants while the a noncomprehensive security package. The high-yield bond investors have financial recovery ratings assume that the security incurrence covenants and there is a covenant available to the secured debtholders of the breach, the bond investors will sit beside the existing bank facilities is taken from the loan investors in a passive position, since they assets and share pledges of entities that gener- have no actual power to negotiate new terms. ate about 60% of CEVA’s EBITDA. Since Therefore, unlike bondholders, the bank these assets do not give full coverage to the investors would be in a position to negotiate senior first-lien lenders, the new secured lend- better terms for themselves to reflect the ers would need to share the limited residual increased risk. value (which comes from the unpledged Debt issued at the holding company level assets) on a pari passu basis with the existing is another related risk, due to structural sub- secured lenders, the second-lien lenders and ordination. Generally, investors are better the unsecured noteholders. protected if debt is issued at the operating This is in contrast with other senior company level rather than at the holding secured bonds that have been issued in recent company level. This is because such debt is months by speculative-grade companies. An closer to the physical assets of the company, example of this is Ardagh Glass Holdings usually giving the debtholders of the operat- Ltd. (B+/Stable/—), which in June 2009 ing company a stronger claim on those assets, issued E300 million of senior secured notes compared with creditors holding debt of the due 2016 to extend its maturities. The com- holding company. An example of a recent

Speculative-Grade European Corporates’ High-Yield Bond Issues July 1, 2009–Oct. 11, 2009

Term Corporate Issue Recovery Recovery Coupon Price Issuer Size Date (years) credit rating* rating* rating* prospects (%) (%)¶ (par value)¶ Wind Telecomunicazioni SpA €1.2 bil. July 1 8 BB-/Stable/— BB- 4 30–50 11.75 96.271 Wind Telecomunicazioni SpA $2 bil. July 1 8 BB-/Stable/— BB- 4 30–50 11.75 97.492 Virgin Media (add-on) $600 mil. July 16 7 B+/Stable/— B 5 10–30 9.50 98.662 ISS Global A/S§ €525 mil. July 16 5 BB-/Stable/— B 6 0–10 11.00 100.00 Fraport AG €800 mil. Sept. 1 10 N.A. N.A. N.A. N.A. 5.25 99.83 Fiat Finance & Trade Ltd. €1.2 bil. Sept. 8 5 BB+/Neg/B BB+ 3 50–70 7.63 99.498 Rallye SA €500 mil. Sept. 18 7 N.A. N.A. N.A. N.A. 7.63 99.605 Central European Media Enterprises Ltd. €240 mil. Sept. 23 7 B/Negative/— B N.A. N.A. 11.63 102.75 Lagardare €1.0 bil. Sept. 24 5 N.A. N.A. N.A. N.A. 4.88 99.74 Wendel €300 mil. Sept. 28 5 BB/Negative/B N.A. N.A. N.A. 4.88 85.04 Renault S.A. €750 mil. Sept. 29 5 BB/Stable/B BB 3 50–70 6.00 99.475 Evonik Industries AG €750 mil. Oct. 6 5 N.A. N.A. N.A. N.A. 7.00 99.489 Gruppo Campari €350 mil. Oct. 8 7 N.A. N.A. N.A. N.A. 5.38 99.43

*Standard & Poor’s Ratings Services’ ratings. ¶Bloomberg and Standard & Poor’s Leveraged Commentary & Data. §On July 16, 2009, we raised the issue ratings to ‘B’ from ‘B-’ and the recovery rating to 5 (10%-30% recovery). N.A.—Not applicable.

52 www.standardandpoors.com issue by a holding company is that by loan would be extended and could be senior unrated Evonik Industries. Its operating com- or secured at the point of default. In July pany is Evonik Degussa GmbH (BB/Stable/B), 2009, HeidelbergCement issued new E8.7 which holds the chemical operations of the billion syndicated bank facilities benefiting wider Evonik group. from extensive share pledges and guarantees, which we believed effectively subordinated the claims of existing bondholders. Bond Covenants Are Not Always Effective For High-Yield Debt We observe that bond covenants have not Should Investors Be Looking been particularly strong for unsecured high- At Rigorous Risk Assessment? yield debt. In fact, their generally weak In order to foster the development of a nature may often mean it is quite feasible for robust, sophisticated, and liquid capital mar- companies to raise additional debt with a ket for high-yield issuers in Europe follow- higher priority ranking. For example, many ing the recent credit dislocation, we believe investors in unsecured bonds will rely on neg- that certain minimum market standards ative pledge language. However, Standard & to support a disciplined approach to Poor’s recovery rating analysis factors in the risk assessment would benefit investors. potential for unsecured bank lenders to take However, because of an extremely competi- and perfect security, despite the existence of a tive market for new issues, we observe that negative pledge on the path to default. This financial intermediaries are incentivized to would put the unsecured high-yield bond accept only minimal disclosure standards on lenders, who originally ranked pari passu, in borrowers in the capital market—as long as a markedly inferior position, resulting in the those intermediaries are not putting their risk of very substantial dilution of recovery own capital at risk for the duration of the prospects in the event of a payment default. transaction. This means that, in the absence This is what happened in the case of of regulatory intervention, it is up to the HeidelbergCement AG. When we assigned a end-investors to exercise caution and recovery rating of ‘5’ to the senior unsecured demand protection. bonds in November 2008, we assumed that prior to default, based on stronger documen- tation for the acquisition loan, Related Research HeidelbergCement would be able to renego- “Criteria Guidelines For Recovery Ratings tiate its acquisition loan terms with lenders. On Global Industrials Issuers’ Speculative- Accordingly, we assumed that the acquisition Grade Debt,” Aug. 10, 2009. l

Standard & Poor’s ● A Guide To The European Loan Market January 2010 53 Charting The Evolution Of Post-Default Recovery Prospects At U.K.-Based Countrywide

Marc Lewis As Default Rates Rise, Recovery Ratings Face A Stiff Test London (44) 20-7176-7069 tandard & Poor’s Rating Services’ recovery ratings provide Taron Wade London our opinion on the estimated recovery potential for debt (44) 20-7176-3661 S Abigail Klimovich instruments. We use a fundamental, scenario-based analysis of London (44) 20-7176-3554 what we see as the factors most likely to precipitate a payment default, followed by our assessment of the value that would be available to repay creditors.

As default rates rise in Europe, our recovery estimated recovery expectations for the senior ratings will be tested. Investors will compare secured bonds of 30%-50%. This is signifi- our recovery expectations and the underlying cantly lower than the average recovery pros- default scenario analysis with actual recover- pects for senior secured debt in Europe. ies and events. In fact, defaults by specula- tive-grade companies are accelerating, with a rate of 10.2% in the 12 months to the end of Our Recovery Ratings On June 2009, up from 5.3% at the end of 2008. Countrywide Reflected Poor We expect that the number of defaults will Recovery Prospects For rise substantially in 2009. Our current esti- Some Lenders mate for defaults in our universe of specula- We initially assigned a recovery rating of ‘1’ tive-grade companies with corporate and to the group’s proposed senior secured £100 recovery ratings, as well as credit estimates million revolving credit facility (RCF), reflect- outstanding, is 11.7%-14.7%. ing our expectation of a very high (90%- One of the European companies that 100%) recovery of principal and pre-petition defaulted in 2009 was Castle HoldCo 4 interest in the event of a payment default. We (rated D/—/— on May 8, 2009), the holding assigned a recovery rating of ‘4’ to the pro- company for U.K.-based real-estate services posed £470 million senior secured floating- provider Countrywide PLC. The company’s rate notes due 2014, reflecting our revenues were hit by a downturn in the U.K. expectation of an average (30%-50%) recov- economy and the dislocation in the housing ery of principal and pre-petition interest in market. Although the company made efforts the event of a payment default. At the time to streamline costs, this provided little benefit the transaction was funded, we did not assign because of the severity in the drop in trading a recovery rating to the group’s £170 million and the company’s highly leveraged financial senior unsecured notes due 2015. However, profile. Standard & Poor’s first assigned a in March 2008, when we expanded our corporate credit rating and recovery ratings recovery ratings to all unsecured speculative- to Countrywide’s debt in April 2007, near the grade debt issuance, we assigned a recovery peak of the credit bubble. At that time, we rating of ‘6’ reflecting our expectation of neg-

54 www.standardandpoors.com ligible recovery of principal and pre-petition • Supportive insolvency regimes for secured interest in the event of a payment default. All creditors with the UK being the main coun- three of the recovery ratings remained the try of operation. same from first assignment to default. Unusual features in the Countrywide trans- Although the recovery rating on the RCF action included a payment-in-kind (PIK) ‘tog- was indicative of our expectation of a very gle’ option granted to lenders on a £100 high recovery, the recovery rating of ‘4’ on million tranche of the senior secured notes. the £470 million senior secured notes was This option allowed the issuer to pay interest well below our average recovery expectations in cash or PIK form at its discretion until of about 70% in Europe for other senior 2011. Thereafter this tranche was to revert to secured debt. cash interest only. The second unusual feature was the provision of a sizeable RCF relative to the working capital needs of the company. Our Methodology Identified Two We viewed these features, along with the Unusual And Negative Elements absence of financial maintenance covenants, In Countrywide’s Debt Structure as broadly supportive of credit quality by Standard & Poor’s methodology for recovery providing additional flexibility to the group. analysis falls into three broad steps: identify- However, from a recovery perspective, we ing the major business risks and simulating a viewed these features as negative: we believed path to default; valuing the enterprise at they could potentially adversely affect the default; and constructing the waterfall of pay- valuation of the business and the amount of ments according to the security structure, debt claims outstanding by the time of intercreditor arrangements, and insolvency default. We believed that the ability to pay regime to determine recovery to different interest in kind and the availability of the classes of debtholder. RCF created the potential for lower profit- In many cases, the security structure and ability at default. This is because Country– waterfall of payments remains relatively static wide’s financial performance would be able over time. In the case of Countrywide the to deteriorate more severely than might oth- main elements of the structure were as follows: erwise be the case if the company had a • Three classes of debt: superpriority RCF, higher interest burden or more constrained senior secured debt, and senior notes; liquidity. Indeed, our default scenario at • The comprehensive security package pro- inception, incorporating the risk of a severe vided to the senior secured debtholders, housing market downturn, highlighted that including share pledges, asset security, and the company was likely to achieve break-even intercompany guarantees. Very limited secu- EBITDA at best by the time of a default. rity was provided to the holders of senior Low profitability at default and our view of notes, although the senior notes benefitted poor medium-term growth prospects also from a comprehensive guarantee package. translated into a lower stressed valuation, • A clear waterfall, supported by an inter- reducing recovery prospects for lenders. This creditor agreement ensuring that recoveries was further compounded by the superpriority were distributed to the RCF ahead of the status of the RCF, which pushed secured secured notes, which in turn ranked ahead bondholders down the waterfall, making them of the senior notes. more vulnerable to losses, in our opinion.

Table 1 Castle HoldCo 4 (Countrywide) Actual Recoveries Versus Expected

Initial recovery rating Actual Amount Seniority (% recovery expectation) recovery Comments £100 mil. Revolving credit facility 1 (90%-100%) 100% Fully repaid. £470 mil. (split between Senior secured 4 (30%-50%) 37%* Lenders agreed to convert their debt into 35% of the cash and toggle tranches) floating-rate notes newly restructured company and new senior secured notes issued with a face value of £175 million. £170 mil. Senior notes 6 (0%-10%) 0% Holders will swap their debt for 5% in new equity.

*Nil value attributed to equity.

Standard & Poor’s ● A Guide To The European Loan Market January 2010 55 Charting The Evolution OfPost-Default Recovery ProspectsAt U.K.-Based Countrywide

Countrywide Underwent can get lower recoveries through this process A Scheme Of Arrangement than they would otherwise receive as only Restructuring 75% of creditors need to give approval, so those with smaller economic interests are at On Feb. 17, 2009, Standard & Poor’s Ratings risk of being squeezed out. Services lowered to ‘SD’ from ‘CCC’ its long- term corporate credit rating on Countrywide, following the group’s failure to honor its cou- We Revised Our Default Scenario pon payment due under its senior secured For Countrywide Several Times In notes and its proposed scheme of arrangement. Response To Market Conditions We lowered the corporate credit rating to ‘SD’ The variable elements of our recovery analy- and not ‘D’ because we understood, based on sis included our default scenario, which we information received, that the company had revised as market conditions changed not defaulted on other financial commitments. (although our recovery ratings remained the However, on May 8, 2009, we lowered the same). Our initial analysis highlighted that, rating to ‘D’ following court approval for the by the time of default, the company’s proposed scheme of arrangement. The scheme EBITDA might be negative. This was largely allowed the company to reduce its debt a result of the potential severe revenue decline through a lender write-down alongside an under our default scenario in the event of a injection of £112.5 million of fresh equity. The significant weakening in the housing market. company’s debt burden was reduced to £175.0 This created a challenge for valuing a busi- million, including the repayment in full of its ness where EBITDA multiples are typically RCF. We consider this to represent recovery of used as benchmarks for valuation. In order to 37% for the senior secured lenders (see table overcome this, we forecast profitability for- 1). As per our general criteria, we consider the ward past our hypothetical point of default completion of a distressed exchange offer–-in- to what we considered would be an ‘average’ cluding through a scheme of arrangement-–as level of profitability across the cycle. We used equivalent to a default (for more information, this level of EBITDA for the terminal valua- see article “General Criteria: Rating tion in our discounted cash flow model and Implications Of Exchange Offers And Similar as the benchmark for our market multiple Restructurings, Update,” published on May analysis. Table 2 shows how these variables 12, 2009, on RatingsDirect). evolved over time. These schemes are popular for both lenders Given our assessment of Countrywide’s and companies because they allow the various strong market position, well-respected parties with economic interest to achieve a brands, and established branch network compromise. The schemes can preserve value across the U.K., we believed the company because they are typically put in place before would be more likely to default due to high a company runs out of cash and a payment leverage than because of a fundamental busi- default occurs. Furthermore, they avoid a ness problem. Because of this we also lengthy bankruptcy process that can affect the believed that the company would be valued trading side of the business by undermining as a going concern following any default. creditor confidence. However, some lenders

Table 2 Castle HoldCo 4 (Countrywide) Progression Of Corporate Credit Rating From Assignment To Default

Corporate April 2007 Nov. 2007 Nov. 2008 Feb. 2009 credit rating to Nov. 2007 to Nov. 2008 to Feb. 2009 to May 2009 May 2009 Rationale for B/Stable/— B/Negative/— CCC/Negative/— SD D change View that the housing Countrywide’s worsening Countrywide failed to Countrywide received court market slowdown was liquidity position during honor its coupon payment approval for the noteholders’ becoming increasingly the first nine months of due under its senior proposed scheme of pronounced and the credit 2008, and our expectation secured notes and arrangement. environment during the that this position would noteholders proposed a summer of 2007 had progressively deteriorate scheme of arrangement. resulted in a reduced over the next 12 months pipeline of business as transaction volumes for Countrywide. remained at depressed levels.

56 www.standardandpoors.com Table 3 Castle HoldCo 4 (Countrywide) Progression Of Recovery Rating From Assignment To Default

April 2007 to May 2008 May 2008 to Aug. 2008 Aug. 2008 to May 2009 Hypothetical default scenario i) 30% decline in revenues over three Revised assumptions: 45% decline in Revised assumptions: >50% decline in years as a result of the housing market revenues by default in 2010 compared revenues by default in 2009 compared downturn; ii) Deteriorating gross with 2007. to 2007 margins as operating costs adjusted with a time-lag; iii) Interest rate increases on variable-rate debt; iv) PIK interest being paid on the £100 million toggle notes from 2008 until default. Default year forecast 2010 2010 2009 EBITDA at default Nil Nil Nil EBITDA for terminal valuation £62 million £53 mil. £55 mil. Stressed EV £370 mil. £320 mil. £275 mil. EV multiple of terminal valuation 6.0x 6.0x 5.0x RCF recovery rating 1 (90%-100%) 1 (90%-100%) 1 (90%-100%) Senior secured recovery rating 4 (30%-50%) 4 (30%-50%) 4 (30%-50%) Senior notes recovery rating N/A 6 (0%-10%) 6 (0%-10%)

EV—Enterprise value. RCF—Revolving credit facility. PIK—Payment-in-kind. N/A—Not applicable.

As table 2 highlights, the changes in our ered the valuation multiple to reflect the default scenario mirrored the more severe weaker long-term outlook. Thereafter, we weakening in the outlook for the housing maintained our recovery assumptions market as well as a worsening in throughout the subsequent corporate credit Countrywide’s liquidity position. In rating changes (see tables 2 and 3). l November 2007, we revised the outlook on the ‘B’ rating on Countrywide to negative from stable. This change resulted from our Related Research Castle HoldCo 4 (Countrywide) Long- view that the housing market slowdown was • Term Rating Lowered To ‘D’ On Court becoming increasingly pronounced and the Approval For Scheme Of Arrangement, credit environment during the summer of May 8, 2009. 2007 had resulted in a reduced pipeline of Castle HoldCo 4 (Countrywide) L-T business for Countrywide. • Rating Cut To ‘SD’ On Missed Coupon The negative outlook remained until Payment, Feb. 17, 2009. November 2008 and our initial recovery Castle HoldCo 4 (Countrywide) L-T Rating assumptions were unchanged through this • Cut To ‘CCC’ On Liquidity Concerns; first outlook transition. We first revised our Outlook Negative, Nov. 4, 2008. default scenario in May 2008, when we Castle Holdco 4 (Countrywide) Outlook increased our estimate of the severity of the • To Neg On Tougher Market Conditions; decline in the company’s revenues. We made ‘B’ CCR Affirmed, Nov. 15, 2007. further moderate revisions to our default-case assumptions in August 2008, but also low-

Standard & Poor’s ● A Guide To The European Loan Market January 2010 57 Key Contacts

London Kenneth Pfeil Director, Loan & Recovery Rating Analytics Marketing and Syndication Liaison 001-212-438-7889 Paul Drake [email protected] Managing Director, European Loan & Recovery Ratings Steve Wilkinson 44-207-176-3760 Director, Loan & Recovery Rating Analytics [email protected] 001-212-438-5093 Taron Wade [email protected] Senior Research Analyst, European Leveraged Finance and Recovery Group Standard & Poor’s Leveraged Data & 44-207-176-3661 Commentary [email protected] New York Loan and Recovery Rating Analytics Steven Miller David Gillmor Managing Director Senior Director, European Leveraged Finance and 001-212-438-2715 Recovery Group [email protected] 44-207-176-3673 Robert Polenberg [email protected] Vice President Paul Watters 001-212-438-2717 Head of European Corporate Research [email protected] 44-207-176-3542 Marina Lukatsky [email protected] Associate Marc Lewis 001-212-438-2709 Director, European Leveraged Finance and [email protected] Recovery Group London 44-207-176-7069 [email protected] Sucheet Gupte Associate Director 44-207-176-7235 New York [email protected] Reuven Shmulenson Loan & Recovery Rating Analytics Senior Analyst William Chew [email protected] Managing Director, Loan & Recovery Rating Analytics Anna Maria Cini 001-212-438-7981 Manager, Sales [email protected] 44-207-176-3997 Thomas Mowat [email protected] Director, Loan & Recovery Rating Analytics 001-212-438-1588 [email protected]

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January 2010

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