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Second-Lien Loans: Increased Use in LBO Financing

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Second-Lien Loans: Increased Use in LBO Financing DDJ CAPITAL MANAGEMENT, LLC SPECIALISTS IN HIGH YIELD AND LEVERAGED CREDIT INVESTMENTS NOVEMBER 2017 VOLUME 4 • ISSUE 4 Second-Lien Loans: Increased Use in LBO Financing > Favorable call profile typical of leveraged loans relative to bonds is driving this trend > Second-lien loan market is a small, niche segment with intricacies that differentiate it from the broader leveraged credit market Andrew Ross, CFA Director, Portfolio Specialist Mr. Ross joined DDJ in 2016 as a member of the Business Development and Client Service team. He works to communicate DDJ’s investment philosophy and strategies with clients, consultants, and prospects. Mr. Ross is a CFA charterholder. Stony Brook Office Park | 130 Turner Street | Building 3, Suite 600 | Waltham, MA 02453 Phone 781.283.8500 Web ddjcap.com SECOND-LIEN LOANS: INCREASED USE IN LBO FINANCING …leveraged Introduction Total institutional leveraged loan new issuance in the first nine months of 2017 has already buyouts (“LBOs”) surpassed the previous calendar year record set in 2013. However, with refinancing and repricing transactions accounting for over 70% of such volume, on a net basis, new issuance volume were the largest is less extreme. Examining second-lien loans specifically, issuance has increased significantly driver of this year, more than doubling calendar year 2016 total volume during the first three quarters. However, unlike total institutional leveraged loans (which comprise approximately 95% first-lien second-lien loan loans), leveraged buyouts1 (“LBOs”) were the largest driver of second-lien loan volume growth. We do not believe this is a one-off development, but rather the continuation of a trend that volume growth began a few years ago and more recently has picked up steam. More specifically, the trend we are referring to is a change in the funding structure that Private Equity (“PE”) firms are using to fund LBOs. Historically, it was common for such buyouts to be financed with a first-lien (senior secured) leveraged loan, an unsecured bond, and an equity contribution from the acquiring PE firm. More recently, however, many PE LBO sponsors are replacing the unsecured bond piece in the funding structure with a second-lien leveraged loan, resulting in all-loan debt financing. In this paper, we will discuss why we believe this development has occurred and whether it is likely to continue; compare and contrast the characteristics and new issuance process for bonds vs. second-lien loans; and summarize the pros and cons of each financing structure from an investor perspective. In addition, we will highlight certain key attributes that we believe are important to be successful investors in the second-lien loan market over the long term. What is driving this change? Exhibit 1 below compares second-lien loans to high yield bonds, highlighting the major differences between the two debt instruments. In addition, when referring to bonds, unless otherwise noted, we are referring to senior unsecured high yield bonds, which are commonly issued. Furthermore, it is important to emphasize that in many cases, because of the private nature of second-lien loans, investors typically gain greater access to information when compared to what is available in most high yield bond deals – a feature of second-lien loans we will reference throughout this paper. Exhibit 1: Typical Characteristics Second-lien leveraged loan High Yield Bond (Unsecured) Coupon Floating (based off 3-month LIBOR); generally higher Usually fixed; generally lower Secured Yes - second priority claim on issuer’s assets Not typically Private Yes Not typically Liquidity Less liquid More liquid Issue Size Typically smaller Typically larger Callable Issuer (borrower) friendly call profile Investor (lender) friendly call profile The move by many PE firms to utilize second-lien loans rather than unsecured bonds to finance LBOs has contributed to a meaningful increase in second-lien leveraged loan issuance thus far in 2017. While the increased second-lien loan issuance has caused many market participants to call attention to this change more recently, the trend has actually been underway for the last few years. As one can conclude from Exhibit 2 below, the percentage of total second-lien loan 1. A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company. DDJ | CAPITAL MANAGEMENT 2 SECOND-LIEN LOANS: INCREASED USE IN LBO FINANCING issuance used in LBO transactions is on pace to meaningfully exceed the longer-term average for a third consecutive year. Exhibit 2 also displays the actual dollar amount of LBO-related second-lien loan issuance by calendar year. We believe the reason for this change is the favorable call profile typical of leveraged loans relative to bonds, which provides issuers with significant flexibility to address their capital structure in the future. In general, leveraged loans can be called after a shorter time frame has passed post issuance, and the premium paid by the issuer to call the loan is significantly lower than that of a bond. We believe that PE firms are willing to pay a higher interest rate, and thereby increase their exposure to rising interest rates – which would increase the interest cost for the issuer – in exchange for the ability to refinance the loan sooner and less expensively than a bond. The PE sponsor views this flexibility very favorably as it could reduce the issuer’s borrowing costs considerably in the event that the issuer can refinance the loan at a lower rate should either the overall market and/or the issuer’s fundamental profile improve prior to maturity. We expect the use of second-lien loans rather than unsecured bonds to finance LBO transactions to continue and possibly to increase unless demand for second-lien loans declines significantly and/or the call protection of bonds declines and begins to resemble that of leveraged loans (an outcome that we believe to be unlikely). Exhibit 2: Historical LBO Driven Second-Lien Issuance (Annual Calendar Year Volume 2003 - YTD 2017*) LBO % of Second-lien Second-lien loan annual total new issue volume issuance $BN (LBOs) 70% $14 60% $12 50% $10 40% $8 30% $6 20% $4 10% $2 0% $0 7 7 2011 2011 2012 2012 2015 2015 2013 2013 2016 2016 2017* 2014 2014 2010 2010 200 200 2003 2003 2005 2005 2008 2008 2009 2006 2006 2009 2017* 2004 2004 LBO 16-yr Avg Source: S&P Leveraged Commentary and Data;* 2017 YTD through 9/30/17 Bonds vs. second-lien loans – the new issue process The second-lien loan market is a small, niche segment within the overall leveraged credit market that has some characteristics that differentiate it from the broader high yield bond market. These differences are especially evident in the new issue market. Below we provide a high level overview of the new issue process for high yield bonds and second-lien loans, highlighting some of the attractive features of second-lien loans, in particular, a longer period of time to research and better access to information regarding the issuer prior to making any commitment to invest. DDJ | CAPITAL MANAGEMENT 3 SECOND-LIEN LOANS: INCREASED USE IN LBO FINANCING The syndication In a typical LBO driven transaction process, both high yield bonds and second-lien loans usually go through a syndication process. The process for most high yield bond new issues typically process for follows a somewhat standard template: potential investors receive an offering memorandum for the bond deal – usually via email – with only a few days’ time to decide whether to participate second-lien loans, or not. The financial information accessible to potential bond investors is generally limited, and contains only pro forma financial data with no forecasts or detailed historical financial information. on the other The syndication process for second-lien loans, on the other hand, is more involved and can take weeks to complete. The process usually begins with a pre-marketing phase, in which potential hand, is more investors sign a confidentiality agreement, generally resulting in such investors being restricted from trading any securities of the issuer. Upon execution of the confidentiality agreement, involved and potential lenders are given access to significantly more information relative to bond offerings, especially historical company financial information as well as management projections for future can take weeks financial performance. Furthermore, likely as a result of the second-lien loan new issuance process (i.e., longer time from start to finish and fewer number of investors involved), DDJ’s to complete experience is that its research analysts typically obtain greater access to company management when analyzing a second-lien loan issuance relative to a bond issuance. DDJ believes that the additional financial information on the issuer (both historical and forecasted) and greater access to management provided in the second-lien loan process is especially beneficial to firms that perform extensive bottom-up fundamental analysis and due diligence with respect to each individual investment opportunity. Distinguishing factors of the second-lien loan market Given the relatively small size of the overall second-lien loan market and the intricacies of such market, DDJ believes that certain less tangible factors, such as relationships, reputation, infrastructure, and legal expertise, play an outsized importance in this market. For example, both cultivating relationships and establishing a well-regarded reputation typically take time and are correlated with a firm’s level of experience investing in the second-lien loan segment of the market. The universe of second-lien loan investors and market participants is relatively limited. Relationships oftentimes drive knowing whom to call when you are looking to trade, whether you receive a call from a broker when another firm is looking to sell, or whether you are informed of an upcoming second-lien loan new issue before the launch of the syndication process.
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