A Guide to the Loan Market

September 2011 I don’t like surprises—especially in my leveraged loan portfolio.

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All loans are not created equal. And distinguishing the well secured from those that aren’t is easier with a Standard & Poor’s Bank Loan & Recovery Rating. Objective, widely recognized benchmarks developed by dedicated loan and recovery analysts, Standard & Poor’s Bank Loan & Recovery Ratings are determined through fundamental, deal-specific analysis. The kind of analysis you want behind you when you’re trying to gauge your chances of capital recovery. Get the information you need. Insist on Standard & Poor’s Bank Loan & Recovery Ratings.

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September 2011 Copyright © 2011 by Standard & Poor’s Financial Services LLC (S&P) a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved. No content (including ratings, credit-related analyses and data, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of S&P. The Content shall not be used for any unlawful or unauthorized purposes. S&P, its affiliates, and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions, regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES 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, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties 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 Content even if advised of the possibility of such damages. Credit-related analyses, including ratings, and statements in the Content 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 to make any investment decisions. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. 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 their respective 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 may receive compensation for its ratings and certain 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), and www.ratingsdirect.com and www.globalcreditportal.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. To Our Clients

tandard & Poor's Ratings Services is pleased to bring you the 2011-2012 edition of our Guide To The Loan Market, which provides a detailed primer on the syndicated loan Smarket along with articles that describe the bank loan and recovery rating process as well as our analytical approach to evaluating loss and recovery in the event of default. Standard & Poor’s Ratings is the leading provider of credit and recovery ratings for leveraged loans. Indeed, we assign recovery ratings to all speculative-grade loans and bonds that we rate in nearly 30 countries, along with our traditional corporate credit ratings. As of press time, Standard & Poor's has recovery ratings on the debt of more than 1,200 companies. We also produce detailed recovery rating reports on most of them, which are available to syndicators and investors. (To request a copy of a report on a specific loan and recovery rating, please refer to the contact information below.) In addition to rating loans, Standard & Poor’s Capital IQ unit offers a wide range of infor- mation, data and analytical services for loan market participants, including: ● Data and commentary: Standard & Poor's Leveraged Commentary & Data (LCD) unit is the leading provider of real-time news, statistical reports, market commentary, and data for leveraged loan and high-yield market participants. ● Loan price evaluations: Standard & Poor's Evaluation Service provides price evaluations for leveraged loan investors. ● Recovery statistics: Standard & Poor's LossStats(tm) database is the industry standard for recovery information for bank loans and other debt classes. ● Fundamental credit information: Standard & Poor’s Capital IQ is the premier provider of financial data for leveraged finance issuers. If you want to learn more about our loan market services, all the appropriate contact information is listed in the back of this publication. We welcome questions, suggestions, and feedback on our products and services, and on this Guide, which we update annually. We publish Leveraged Matters, a free weekly update on the leveraged finance market, which includes selected Standard & Poor's recovery reports and analyses and a comprehensive list of Standard & Poor's bank loan and recovery ratings. To be put on the subscription list, please e-mail your name and contact information to [email protected] or call (1) 212-438-7638. You can also access that report and many other articles, including this entire Guide To The Loan Market in electronic form, on our Standard & Poor's loan and recovery rating website: www.bankloanrating.standardandpoors.com. For information about loan-market news and data, please visit us online at www.lcdcomps.com or contact Marc Auerbach at [email protected] or (1) 212-438-2703. You can also follow us on Twitter, Facebook, or LinkedIn.

Steven Miller William Chew

Standard & Poor’s ● A Guide To The Loan Market September 2011 3

Contents

A Syndicated Loan Primer 7

Rating Leveraged Loans: An Overview 31

Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt 36

Key Contacts 53

Standard & Poor’s ● A Guide To The Loan Market September 2011 5

A Syndicated Loan Primer

Steven C. Miller syndicated loan is one that is provided by a group of lenders New York (1) 212-438-2715 and is structured, arranged, and administered by one or [email protected] A several commercial or investment banks known as arrangers. Starting with the large leveraged buyout (LBO) loans of the mid- 1980s, the syndicated loan market has become the dominant way for issuers to tap banks and other institutional capital providers for loans. The reason is simple: Syndicated loans are less expen- sive and more efficient to administer than traditional bilateral, or individual, credit lines.

At the most basic level, arrangers serve the these borrowers will effectively syndicate a time-honored investment-banking role of rais- loan themselves, using the arranger simply to ing investor dollars for an issuer in need of craft documents and administer the process. capital. The issuer pays the arranger a fee for For leveraged issuers, the story is a very dif- this service, and, naturally, this fee increases ferent one for the arranger, and, by “different,” with the complexity and riskiness of the loan. we mean more lucrative. A new leveraged As a result, the most profitable loans are loan can carry an arranger fee of 1% to 5% those to leveraged borrowers—issuers whose of the total loan commitment, generally credit ratings are speculative grade and who speaking, depending on (1) the complexity of are paying spreads (premiums above LIBOR the transaction, (2) how strong market condi- or another base rate) sufficient to attract the tions are at the time, and (3) whether the interest of nonbank term loan investors, typi- loan is underwritten. Merger and acquisition cally LIBOR+200 or higher, though this (M&A) and recapitalization loans will likely threshold moves up and down depending on carry high fees, as will exit financings and market conditions. restructuring deals. Seasoned leveraged Indeed, large, high-quality companies pay issuers, by contrast, pay lower fees for little or no fee for a plain-vanilla loan, typi- refinancings and add-on transactions. cally an unsecured revolving credit instru- Because investment-grade loans are infre- ment that is used to provide support for quently used and, therefore, offer drastically short-term commercial paper borrowings or lower yields, the ancillary business is as for working capital. In many cases, moreover, important a factor as the credit product in

Standard & Poor’s ● A Guide To The Loan Market September 2011 7 A Syndicated Loan Primer

arranging such deals, especially because many arranger will total up the commitments and acquisition-related financings for investment- then make a call on where to price the paper. grade companies are large in relation to the Following the example above, if the paper is pool of potential investors, which would oversubscribed at LIBOR+250, the arranger consist solely of banks. may slice the spread further. Conversely, if it is The “retail” market for a syndicated loan undersubscribed even at LIBOR+275, then the consists of banks and, in the case of leveraged arranger will be forced to raise the spread to transactions, finance companies and institu- bring more money to the table. tional investors. Before formally launching a loan to these retail accounts, arrangers will Types Of Syndications often get a market read by informally polling select investors to gauge their appetite for the There are three types of syndications: an credit. Based on these discussions, the arranger underwritten deal, a “best-efforts” syndica- will launch the credit at a spread and fee it tion, and a “club deal.” believes will clear the market. Until 1998, this would have been it. Once the pricing was set, Underwritten deal it was set, except in the most extreme cases. If An underwritten deal is one for which the the loan were undersubscribed, the arrangers arrangers guarantee the entire commitment, could very well be left above their desired hold and then syndicate the loan. If the arrangers level. After the Russian debt crisis roiled the cannot fully subscribe the loan, they are market in 1998, however, arrangers have forced to absorb the difference, which they adopted market-flex language, which allows may later try to sell to investors. This is easy, them to change the pricing of the loan based of course, if market conditions, or the credit’s on investor demand—in some cases within a fundamentals, improve. If not, the arranger predetermined range—as well as shift amounts may be forced to sell at a discount and, between various tranches of a loan, as a stan- potentially, even take a loss on the paper. Or dard feature of loan commitment letters. the arranger may just be left above its desired Market-flex language, in a single stroke, hold level of the credit. So, why do arrangers pushed the loan market, at least the leveraged underwrite loans? First, offering an under- segment of it, across the Rubicon, to a full- written loan can be a competitive tool to win fledged capital market. mandates. Second, underwritten loans usually Initially, arrangers invoked flex language to require more lucrative fees because the agent make loans more attractive to investors by is on the hook if potential lenders balk. Of hiking the spread or lowering the price. This course, with flex-language now common, was logical after the volatility introduced by underwriting a deal does not carry the same the Russian debt debacle. Over time, how- risk it once did when the pricing was set in ever, market-flex became a tool either to stone prior to syndication. increase or decrease pricing of a loan, based on investor reaction. Best-efforts syndication Because of market flex, a loan syndication A “best-efforts” syndication is one for which today functions as a “book-building” exercise, the arranger group commits to underwrite less in bond-market parlance. A loan is originally than the entire amount of the loan, leaving the launched to market at a target spread or, as credit to the vicissitudes of the market. If the was increasingly common by the late 2000s, loan is undersubscribed, the credit may not with a range of spreads referred to as price talk close—or may need major surgery to clear the (i.e., a target spread of, say, LIBOR+250 to market. Traditionally, best-efforts syndications LIBOR+275). Investors then will make com- were used for risky borrowers or for complex mitments that in many cases are tiered by the transactions. Since the late 1990s, however, spread. For example, an account may put in the rapid acceptance of market-flex language for $25 million at LIBOR+275 or $15 million has made best-efforts loans the rule even for at LIBOR+250. At the end of the process, the investment-grade transactions.

8 www.standardandpoors.com Club deal post-closing—to investors through digital A “club deal” is a smaller loan (usually $25 platforms. Leading vendors in this space are million to $100 million, but as high as $150 Intralinks, Syntrak, and Debt Domain. million) that is premarketed to a group of The IM typically contain the following relationship lenders. The arranger is generally sections: a first among equals, and each lender gets a The executive summary will include a full cut, or nearly a full cut, of the fees. description of the issuer, an overview of the transaction and rationale, sources and uses, and key statistics on the financials. The Syndication Process Investment considerations will be, basically, The information memo, or “bank book” management’s sales “pitch” for the deal. Before awarding a mandate, an issuer might The list of terms and conditions will be a solicit bids from arrangers. The banks will preliminary term sheet describing the pricing, outline their syndication strategy and qualifi- structure, collateral, covenants, and other cations, as well as their view on the way the terms of the credit (covenants are usually loan will price in market. Once the mandate negotiated in detail after the arranger receives is awarded, the syndication process starts. investor feedback). The arranger will prepare an information The industry overview will be a description memo (IM) describing the terms of the trans- of the company’s industry and competitive actions. The IM typically will include an position relative to its industry peers. executive summary, investment considera- The financial model will be a detailed tions, a list of terms and conditions, an indus- model of the issuer’s historical, pro forma, try overview, and a financial model. Because and projected financials including manage- loans are not securities, this will be a confi- ment’s high, low, and base case for the issuer. dential offering made only to qualified banks Most new acquisition-related loans kick off and accredited investors. at a bank meeting at which potential lenders If the issuer is speculative grade and seek- hear management and the sponsor group (if ing capital from nonbank investors, the there is one) describe what the terms of the arranger will often prepare a “public” ver- loan are and what transaction it backs. sion of the IM. This version will be stripped Understandably, bank meetings are more of all confidential material such as manage- often than not conducted via a Webex or ment financial projections so that it can be conference call, although some issuers still viewed by accounts that operate on the pub- prefer old-fashioned, in-person gatherings. lic side of the wall or that want to preserve At the meeting, call or Webex, manage- their ability to buy bonds or stock or other ment will provide its vision for the transac- public securities of the particular issuer (see tion and, most important, tell why and how the Public Versus Private section below). the lenders will be repaid on or ahead of Naturally, investors that view materially non- schedule. In addition, investors will be public information of a company are disqual- briefed regarding the multiple exit strate- ified from buying the company’s public gies, including second ways out via asset securities for some period of time. sales. (If it is a small deal or a refinancing As the IM (or “bank book,” in traditional instead of a formal meeting, there may be a market lingo) is being prepared, the syndi- series of calls or one-on-one meetings with cate desk will solicit informal feedback from potential investors.) potential investors on what their appetite for Once the loan is closed, the final terms are the deal will be and at what price they are then documented in detailed credit and secu- willing to invest. Once this intelligence has rity agreements. Subsequently, liens are per- been gathered, the agent will formally mar- fected and collateral is attached. ket the deal to potential investors. Arrangers Loans, by their nature, are flexible docu- will distribute most IM’s—along with other ments that can be revised and amended information related to the loan, pre- and from time to time. These amendments require

Standard & Poor’s ● A Guide To The Loan Market September 2011 9 A Syndicated Loan Primer

different levels of approval (see Voting rated. CLOs are created as arbitrage vehicles Rights section below). Amendments can that generate equity returns through leverage, range from something as simple as a by issuing debt 10 to 11 times their equity covenant waiver to something as complex as contribution. There are also market-value a change in the collateral package or allow- CLOs that are less leveraged—typically 3 to 5 ing the issuer to stretch out its payments or times—and allow managers more flexibility make an acquisition. than more tightly structured arbitrage deals. CLOs are usually rated by two of the three The loan investor market major ratings agencies and impose a series of There are three primary-investor consisten- covenant tests on collateral managers, includ- cies: banks, finance companies, and institu- ing minimum rating, industry diversification, tional investors. and maximum default basket. By 2007, CLOs Banks, in this case, can be either a com- had become the dominant form of institutional mercial bank, a savings and loan institution, investment in the leveraged loan market, tak- or a securities firm that usually provides ing a commanding 60% of primary activity by investment-grade loans. These are typically institutional investors. But when the structured large revolving credits that back commercial finance market cratered in late 2007, CLO paper or are used for general corporate pur- issuance tumbled and by mid-2010, CLO’s poses or, in some cases, acquisitions. For share had fallen to roughly 30%. leveraged loans, banks typically provide Loan mutual funds are how retail investors unfunded revolving credits, LOCs, and— can access the loan market. They are mutual although they are becoming increasingly less funds that invest in leveraged loans. These common—amortizing term loans, under a funds—originally known as prime funds syndicated loan agreement. because they offered investors the chance to Finance companies have consistently repre- earn the prime interest rate that banks charge sented less than 10% of the leveraged loan on commercial loans—were first introduced market, and tend to play in smaller deals— in the late 1980s. Today there are three main $25 million to $200 million. These investors categories of funds: often seek asset-based loans that carry wide ● Daily-access funds: These are traditional spreads and that often feature time-intensive open-end mutual fund products into which collateral monitoring. investors can buy or redeem shares each Institutional investors in the loan market day at the fund’s net asset value. are principally structured vehicles known as ● Continuously offered, closed-end funds: collateralized loan obligations (CLO) and These were the first loan mutual fund loan participation mutual funds (known as products. Investors can buy into these “prime funds” because they were originally funds each day at the fund’s net asset pitched to investors as a money-market-like valueNAV. Redemptions, however, are fund that would approximate the prime rate). made via monthly or quarterly tenders In addition, hedge funds, high-yield bond rather than each day like the open-end funds, pension funds, insurance companies, funds described above. To make sure they and other proprietary investors do participate can meet redemptions, many of these opportunistically in loans. funds, as well as daily access funds, set up CLOs are special-purpose vehicles set up to lines of credit to cover withdrawals above hold and manage pools of leveraged loans. and beyond cash reserves. The special-purpose vehicle is financed with ● Exchange-traded, closed-end funds: These several tranches of debt (typically a ‘AAA’ are funds that trade on a stock exchange. rated tranche, a ‘AA’ tranche, a ‘BBB’ tranche, Typically, the funds are capitalized by an and a mezzanine tranche) that have rights to initial public offering. Thereafter, investors the collateral and payment stream in descend- can buy and sell shares, but may not ing order. In addition, there is an equity redeem them. The manager can also expand tranche, but the equity tranche is usually not the fund via rights offerings. Usually, they

10 www.standardandpoors.com are only able to do so when the fund is not (or not yet) a party to the loan. The sec- trading at a premium to NAV, however—a ond innovation that weakened the public-pri- provision that is typical of closed-end funds vate divide was trade journalism that focuses regardless of the asset class. on the loan market. In March 2011, Invesco introduced the Despite these two factors, the public versus first index-based exchange traded fund, private line was well understood and rarely PowerShares Senior Loan Portfolio controversial for at least a decade. This (BKLN), which is based on the S&P/LSTA changed in the early 2000s as a result of: Loan 100 Index. ● The proliferation of loan ratings, which, by The table below lists the 20 largest loan their nature, provide public exposure for mutual fund managers by AUM as loan deals; of July 31, 2011. ● The explosive growth of nonbank investors groups, which included a growing number of institutions that operated on the public Public Versus Private side of the wall, including a growing num- In the old days, the line between public and ber of mutual funds, hedge funds, and even private information in the loan market was a CLO boutiques; simple one. Loans were strictly on the private ● The growth of the credit default swaps side of the wall and any information trans- market, in which insiders like banks often mitted between the issuer and the lender sold or bought protection from institu- group remained confidential. tions that were not privy to inside In the late 1980s, that line began to blur as information; and a result of two market innovations. The first ● A more aggressive effort by the press to was more active secondary trading that report on the loan market. sprung up to support (1) the entry of non- Some background is in order. The vast bank investors in the market, such as insur- majority of loans are unambiguously private ance companies and loan mutual funds and financing arrangements between issuers and (2) to help banks sell rapidly expanding port- their lenders. Even for issuers with public folios of distressed and highly leveraged loans equity or debt that file with the SEC, the that they no longer wanted to hold. This credit agreement only becomes public when it meant that parties that were insiders on loans is filed, often months after closing, as an might now exchange confidential information exhibit to an annual report (10-K), a quar- with traders and potential investors who were terly report (10-Q), a current report (8-K), or

Largest Loan Mutual Fund Managers

Assets under management (bil. $) DWS Investments 2.61 Eaton Vance Management 13.39 T. Rowe Price 2.00 Fidelity Investments 12.12 BlackRock Advisors LLC 1.84 Hartford Mutual Funds 7.25 ING Pilgrim Funds 1.84 Oppenheimer Funds 6.39 RS Investments 1.51 Invesco Advisers 4.44 Nuveen Investments 1.37 PIMCO Funds 4.16 MainStay Investments 1.34 Lord Abbett 4.16 Pioneer Investments 0.88 RidgeWorth Funds 4.13 Highland Funds 0.74 Franklin Templeton Investment Funds 2.71 Goldman Sachs 0.64 John Hancock Funds 2.61

Source: Lipper FMI.

Standard & Poor’s ● A Guide To The Loan Market September 2011 11 A Syndicated Loan Primer

some other document (proxy statement, secu- the public side of the wall. As well, under- rities registration, etc.). writers will ask public accounts to attend a Beyond the credit agreement, there is a raft public version of the bank meeting and dis- of ongoing correspondence between issuers tribute to these accounts only scrubbed and lenders that is made under confidentiality financial information. agreements, including quarterly or monthly ● Buy-side accounts. On the buy-side there financial disclosures, covenant compliance are firms that operate on either side of information, amendment and waiver requests, the public-private divide. Accounts that and financial projections, as well as plans for operate on the private side receive all acquisitions or dispositions. Much of this confidential materials and agree to not information may be material to the financial trade in public securities of the issuers in health of the issuer and may be out of the question. These groups are often part of public domain until the issuer formally puts wider investment complexes that do have out a press release or files an 8-K or some public funds and portfolios but, via other document with the SEC. Chinese walls, are sealed from these parts In recent years, this information has leaked of the firms. There are also accounts that into the public domain either via off-line con- are public. These firms take only public versations or the press. It has also come to IMs and public materials and, therefore, light through mark-to-market pricing serv- retain the option to trade in the public ices, which from time to time report signifi- securities markets even when an issuer for cant movement in a loan price without any which they own a loan is involved. This corresponding news. This is usually an indi- can be tricky to pull off in practice cation that the banks have received negative because in the case of an amendment the or positive information that is not yet public. lender could be called on to approve or In recent years, there was growing concern decline in the absence of any real infor- among issuers, lenders, and regulators that mation. To contend with this issue, the this migration of once-private information account could either designate one person into public hands might breach confidential- who is on the private side of the wall to ity agreements between lenders and issuers sign off on amendments or empower its and, more importantly, could lead to illegal trustee or the loan arranger to do so. But trading. How has the market contended with it’s a complex proposition. these issues? ● Vendors. Vendors of loan data, news, and ● Traders. To insulate themselves from vio- prices also face many challenges in man- lating regulations, some dealers and buy- aging the flow of public and private infor- side firms have set up their trading desks mation. In generally, the vendors operate on the public side of the wall. under the freedom of the press provision Consequently, traders, salespeople, and of the U.S. Constitution’s First analysts do not receive private informa- Amendment and report on information in tion even if somewhere else in the institu- a way that anyone can simultaneously tion the private data are available. This is receive it—for a price of course. the same technique that investment banks Therefore, the information is essentially have used from time immemorial to sepa- made public in a way that doesn’t deliber- rate their private investment banking ately disadvantage any party, whether it’s activities from their public trading and a news story discussing the progress of an sales activities. amendment or an acquisition, or it’s a ● Underwriters. As mentioned above, in most price change reported by a mark-to-mar- primary syndications, arrangers will pre- ket service. This, of course, doesn’t deal pare a public version of information mem- with the underlying issue that someone oranda that is scrubbed of private who is a party to confidential information information like projections. These IMs is making it available via the press or will be distributed to accounts that are on prices to a broader audience.

12 www.standardandpoors.com Another way in which participants deal overall risk of their portfolios to their own with the public versus private issue is to ask investors. As of mid-2011, then, roughly counterparties to sign “big-boy” letters. 80% of leveraged-loan volume carried a loan These letters typically ask public-side institu- rating, up from 45% in 1998 and virtually tions to acknowledge that there may be none before 1995. information they are not privy to and they are agreeing to make the trade in any case. Loss-given-default risk They are, effectively, big boys and will accept Loss-given-default risk measures how severe a the risks. loss the lender is likely to incur in the event of default. Investors assess this risk based on Credit Risk: An Overview the collateral (if any) backing the loan and the amount of other debt and equity subordi- Pricing a loan requires arrangers to evaluate nated to the loan. Lenders will also look to the risk inherent in a loan and to gauge covenants to provide a way of coming back investor appetite for that risk. The principal to the table early—that is, before other credi- credit risk factors that banks and institutional tors—and renegotiating the terms of a loan if investors contend with in buying loans are the issuer fails to meet financial targets. default risk and loss-given-default risk. Investment-grade loans are, in most cases, Among the primary ways that accounts judge senior unsecured instruments with loosely these risks are ratings, credit statistics, indus- drawn covenants that apply only at incur- try sector trends, management strength, and rence, that is, only if an issuer makes an sponsor. All of these, together, tell a story acquisition or issues debt. As a result, loss about the deal. given default may be no different from risk Brief descriptions of the major risk incurred by other senior unsecured creditors. factors follow. Leveraged loans, by contrast, are usually sen- ior secured instruments that, except for Default risk covenant-lite loans (see below), have mainte- Default risk is simply the likelihood of a bor- nance covenants that are measured at the end rower’s being unable to pay interest or princi- of each quarter whether or not the issuer is in pal on time. It is based on the issuer’s compliance with pre-set financial tests. Loan financial condition, industry segment, and holders, therefore, almost always are first in conditions in that industry and economic line among pre-petition creditors and, in variables and intangibles, such as company many cases, are able to renegotiate with the management. Default risk will, in most cases, issuer before the loan becomes severely be most visibly expressed by a public rating impaired. It is no surprise, then, that loan from Standard & Poor’s Ratings Services or investors historically fare much better than another ratings agency. These ratings range other creditors on a loss-given-default basis. from ‘AAA’ for the most creditworthy loans to ‘CCC’ for the least. The market is divided, Credit statistics roughly, into two segments: investment grade Credit statistics are used by investors to help (loans to issuers rated ‘BBB-’ or higher) and calibrate both default and loss-given-default leveraged (borrowers rated ‘BB+’ or lower). risk. These statistics include a broad array of Default risk, of course, varies widely within financial data, including credit ratios measur- each of these broad segments. Since the mid- ing leverage (debt to capitalization and debt 1990s, public loan ratings have become a de to EBITDA) and coverage (EBITDA to inter- facto requirement for issuers that wish to do est, EBITDA to debt service, operating cash business with a wide group of institutional flow to fixed charges). Of course, the ratios investors. Unlike banks, which typically have investors use to judge credit risk vary by large credit departments and adhere to inter- industry. In addition to looking at trailing nal rating scales, fund managers rely on and pro forma ratios, investors look at man- agency ratings to bracket risk and explain the

Standard & Poor’s ● A Guide To The Loan Market September 2011 13 A Syndicated Loan Primer

agement’s projections and the assumptions tional investors, weight is given to an individ- behind these projections to see if the issuer’s ual deal sponsor’s track record in fixing its game plan will allow it to service its debt. own impaired deals by stepping up with addi- There are ratios that are most geared to tional equity or replacing a management team assessing default risk. These include leverage that is failing. and coverage. Then there are ratios that are suited for evaluating loss-given-default risk. Syndicating A Loan By Facility These include collateral coverage, or the value of the collateral underlying the loan rel- Most loans are structured and syndicated to ative to the size of the loan. They also include accommodate the two primary syndicated the ratio of senior secured loan to junior debt lender constituencies: banks (domestic and in the capital structure. Logically, the likely foreign) and institutional investors (primarily severity of loss-given-default for a loan structured finance vehicles, mutual funds, and increases with the size of the loan as a per- insurance companies). As such, leveraged centage of the overall debt structure so does. loans consist of: After all, if an issuer defaults on $100 million ● Pro rata debt consists of the revolving of debt, of which $10 million is in the form credit and amortizing term loan (TLa), of senior secured loans, the loans are more which are packaged together and, usually, likely to be fully covered in bankruptcy than syndicated to banks. In some loans, how- if the loan totals $90 million. ever, institutional investors take pieces of the TLa and, less often, the revolving Industry sector credit, as a way to secure a larger institu- tional term loan allocation. Why are these Industry is a factor, because sectors, natu- tranches called “pro rata?” Because rally, go in and out of favor. For that reason, arrangers historically syndicated revolving having a loan in a desirable sector, like tele- credit and TLas on a pro rata basis to com in the late 1990s or healthcare in the banks and finance companies. early 2000s, can really help a syndication ● Institutional debt consists of term loans along. Also, loans to issuers in defensive sec- structured specifically for institutional tors (like consumer products) can be more investors, although there are also some appealing in a time of economic uncertainty, banks that buy institutional term loans. whereas cyclical borrowers (like chemicals These tranches include first- and second- or autos) can be more appealing during an lien loans, as well as prefunded letters of economic upswing. credit. Traditionally, institutional tranches were referred to as TLbs because they were Sponsorship bullet payments and lined up behind TLas. Sponsorship is a factor too. Needless to say, Finance companies also play in the lever- many leveraged companies are owned by one aged loan market, and buy both pro rata or more private equity firms. These entities, and institutional tranches. With institutional such as Kohlberg Kravis & Roberts or investors playing an ever-larger role, how- Carlyle Group, invest in companies that have ever, by the late 2000s, many executions leveraged capital structures. To the extent were structured as simply revolving that the sponsor group has a strong following credit/institutional term loans, with the among loan investors, a loan will be easier to TLa falling by the wayside. syndicate and, therefore, can be priced lower. In contrast, if the sponsor group does not have a loyal set of relationship lenders, the Pricing A Loan In deal may need to be priced higher to clear the The Primary Market market. Among banks, investment factors Pricing loans for the institutional market is a may include whether or not the bank is party straightforward exercise based on simple to the sponsor’s equity fund. Among institu- risk/return consideration and market techni-

14 www.standardandpoors.com cals. Pricing a loan for the bank market, other fee-generating business to banks that however, is more complex. Indeed, banks are part of its loan syndicate. often invest in loans for more than just spread income. Rather, banks are driven by Pricing loans for institutional players the overall profitability of the issuer relation- For institutional investors, the investment ship, including noncredit revenue sources. decision process is far more straightforward, because, as mentioned above, they are Pricing loans for bank investors focused not on a basket of returns, but only Since the early 1990s, almost all large com- on loan-specific revenue. mercial banks have adopted portfolio-man- In pricing loans to institutional investors, agement techniques that measure the returns it’s a matter of the spread of the loan rela- of loans and other credit products relative tive to credit quality and market-based fac- to risk. By doing so, banks have learned tors. This second category can be divided that loans are rarely compelling investments into liquidity and market technicals (i.e., on a stand-alone basis. Therefore, banks are supply/demand). reluctant to allocate capital to issuers unless Liquidity is the tricky part, but, as in all the total relationship generates attractive markets, all else being equal, more liquid returns—whether those returns are meas- instruments command thinner spreads than ured by risk-adjusted return on capital, by less liquid ones. In the old days—before return on economic capital, or by some institutional investors were the dominant other metric. investors and banks were less focused on If a bank is going to put a loan on its bal- portfolio management—the size of a loan ance sheet, then it takes a hard look not didn’t much matter. Loans sat on the books only at the loan’s yield, but also at other of banks and stayed there. But now that sources of revenue from the relationship, institutional investors and banks put a pre- including noncredit businesses—like cash- mium on the ability to package loans and sell management services and pension-fund man- them, liquidity has become important. As a agement—and economics from other capital result, smaller executions—generally those of markets activities, like bonds, equities, or $200 million or less—tend to be priced at a M&A advisory work. premium to the larger loans. Of course, once This process has had a breathtaking result a loan gets large enough to demand on the leveraged loan market—to the point extremely broad distribution, the issuer usu- that it is an anachronism to continue to call it ally must pay a size premium. The thresholds a “bank” loan market. Of course, there are range widely. During the go-go mid-2000s, it certain issuers that can generate a bit more was upwards of $10 billion. During more bank appetite; as of mid-2011, these include parsimonious late-2000s $1 billion was con- issuers with a European or even a sidered a stretch. Midwestern U.S. angle. Naturally, issuers Market technicals, or supply relative to with European operations are able to better demand, is a matter of simple economics. If tap banks in their home markets (banks still there are a lot of dollars chasing little prod- provide the lion’s share of loans in Europe), uct, then, naturally, issuers will be able to and, for Midwestern issuers, the heartland command lower spreads. If, however, the remains one of the few U.S. regions with a opposite is true, then spreads will need to deep bench of local banks. increase for loans to clear the market. What this means is that the spread offered to pro rata investors is important, but so, Mark-To-Market’s Effect too, in most cases, is the amount of other, fee-driven business a bank can capture by Beginning in 2000, the SEC directed bank taking a piece of a loan. For this reason, loan mutual fund managers to use available issuers are careful to award pieces of bond- mark-to-market data (bid/ask levels and equity-underwriting engagements and reported by secondary traders and compiled

Standard & Poor’s ● A Guide To The Loan Market September 2011 15 A Syndicated Loan Primer

by mark-to-market services like Markit banks can offer issuers 364-day facilities at Loans) rather than fair value (estimated a lower unused fee than a multiyear revolv- prices), to determine the value of broadly ing credit. There are a number of options syndicated loans for portfolio-valuation that can be offered within a revolving purposes. In broad terms, this policy has credit line: made the market more transparent, 1. A swingline is a small, overnight borrow- improved price discovery and, in doing so, ing line, typically provided by the agent. made the market far more efficient and 2. A multicurrency line may allow the bor- dynamic than it was in the past. In the pri- rower to borrow in several currencies. mary market, for instance, leveraged loan 3.A competitive-bid option (CBO) allows spreads are now determined not only by rat- borrowers to solicit the best bids from its ing and leverage profile, but also by trading syndicate group. The agent will conduct levels of an issuer’s previous loans and, what amounts to an auction to raise often, bonds. Issuers and investors can also funds for the borrower, and the best look at the trading levels of comparable bids are accepted. CBOs typically loans for market-clearing levels. are available only to large, investment- grade borrowers. 4. A term-out will allow the borrower to con- Types Of Syndicated vert borrowings into a term loan at a given Loan Facilities conversion date. This, again, is usually a There are four main types of syndicated feature of investment-grade loans. Under loan facilities: the option, borrowers may take what is ● A revolving credit (within which are outstanding under the facility and pay it options for swingline loans, multicurrency- off according to a predetermined repay- borrowing, competitive-bid options, term- ment schedule. Often the spreads ratchet out, and evergreen extensions); up if the term-out option is exercised. ● A term loan; 5. An evergreen is an option for the bor- ● An LOC; and rower—with consent of the syndicate ● An acquisition or equipment line (a group—to extend the facility each year for delayed-draw term loan). an additional year. A revolving credit line allows borrowers A term loan is simply an installment loan, to draw down, repay, and reborrow. The such as a loan one would use to buy a car. facility acts much like a corporate credit The borrower may draw on the loan during a card, except that borrowers are charged an short commitment period and repays it based annual commitment fee on unused on either a scheduled series of repayments or amounts, which drives up the overall cost a one-time lump-sum payment at maturity of borrowing (the facility fee). Revolvers to (bullet payment). There are two principal speculative-grade issuers are often tied to types of term loans: borrowing-base lending formulas. This lim- ● An amortizing term loan (A-term loans, or its borrowings to a certain percentage of TLa) is a term loan with a progressive collateral, most often receivables and inven- repayment schedule that typically runs six tory. Revolving credits often run for 364 years or less. These loans are normally syn- days. These revolving credits—called, not dicated to banks along with revolving cred- surprisingly, 364-day facilities—are gener- its as part of a larger syndication. ally limited to the investment-grade market. ● An institutional term loan (B-term, C-term, The reason for what seems like an odd term or D-term loans) is a term loan facility is that regulatory capital guidelines man- carved out for nonbank, institutional date that, after one year of extending credit investors. These loans came into broad under a revolving facility, banks must then usage during the mid-1990s as the institu- increase their capital reserves to take into tional loan investor base grew. This institu- account the unused amounts. Therefore, tional category also includes second-lien

16 www.standardandpoors.com loans and covenant-lite loans, which are struggling with liquidity problems. By 2007, described below. the market had accepted second-lien loans to LOCs differ, but, simply put, they are guar- finance a wide array of transactions, including antees provided by the bank group to pay off acquisitions and recapitalizations. Arrangers debt or obligations if the borrower cannot. tap nontraditional accounts—hedge funds, Acquisition/equipment lines (delayed-draw distress investors, and high-yield accounts—as term loans) are credits that may be drawn well as traditional CLO and prime fund down for a given period to purchase speci- accounts to finance second-lien loans. fied assets or equipment or to make acquisi- As their name implies, the claims on col- tions. The issuer pays a fee during the lateral of second-lien loans are junior to commitment period (a ticking fee). The lines those of first-lien loans. Second-lien loans are then repaid over a specified period (the also typically have less restrictive covenant term-out period). Repaid amounts may not packages, in which maintenance covenant be reborrowed. levels are set wide of the first-lien loans. Bridge loans are loans that are intended to As a result, second-lien loans are priced at provide short-term financing to provide a a premium to first-lien loans. This pre- “bridge” to an asset sale, bond offering, mium typically starts at 200 bps when the stock offering, divestiture, etc. Generally, collateral coverage goes far beyond the bridge loans are provided by arrangers as claims of both the first- and second-lien part of an overall financing package. loans to more than 1,000 bps for less Typically, the issuer will agree to increasing generous collateral. interest rates if the loan is not repaid as There are, lawyers explain, two main expected. For example, a loan could start at a ways in which the collateral of second-lien spread of L+250 and ratchet up 50 basis loans can be documented. Either the sec- points (bp) every six months the loan remains ond-lien loan can be part of a single secu- outstanding past one year. rity agreement with first-lien loans, or they Equity bridge loan is a bridge loan pro- can be part of an altogether separate agree- vided by arrangers that is expected to be ment. In the case of a single agreement, the repaid by secondary equity commitment to a agreement would apportion the collateral, leveraged buyout. This product is used when with value going first, obviously, to the a private equity firm wants to close on a deal first-lien claims and next to the second-lien that requires, say, $1 billion of equity of claims. Alternatively, there can be two which it ultimately wants to hold half. The entirely separate agreements. Here’s a arrangers bridge the additional $500 million, brief summary: which would be then repaid when other ● In a single security agreement, the second- sponsors come into the deal to take the $500 lien lenders are in the same creditor class as million of additional equity. Needless to say, the first-lien lenders from the standpoint of this is a hot-market product. a bankruptcy, according to lawyers who specialize in these loans. As a result, for adequate protection to be paid the collat- Second-Lien Loans eral must cover both the claims of the first- Although they are really just another type of and second-lien lenders. If it does not, the syndicated loan facility, second-lien loans are judge may choose to not pay adequate pro- sufficiently complex to warrant a separate sec- tection or to divide it pro rata among the tion in this primer. After a brief flirtation with first- and second-lien creditors. In addition, second-lien loans in the mid-1990s, these the second-lien lenders may have a vote as facilities fell out of favor after the 1998 secured lenders equal to those of the first- Russian debt crisis caused investors to adopt a lien lenders. One downside for second-lien more cautious tone. But after default rates fell lenders is that these facilities are often precipitously in 2003, arrangers rolled out smaller than the first-lien loans and, there- second-lien facilities to help finance issuers fore, when a vote comes up, first-lien

Standard & Poor’s ● A Guide To The Loan Market September 2011 17 A Syndicated Loan Primer

lenders can outvote second-lien lenders to mum been a maintenance rather than incur- promote their own interests. rence test, the issuer would need to pass it ● In the case of two separate security each quarter and would be in violation if agreements, divided by a standstill agree- either its earnings eroded or its debt level ment, the first- and second-lien lenders increased. For lenders, clearly, maintenance are likely to be divided into two separate tests are preferable because it allows them to creditor classes. As a result, second-lien take action earlier if an issuer experiences lenders do not have a voice in the first- financial distress. What’s more, the lenders lien creditor committees. As well, first- may be able to wrest some concessions from lien lenders can receive adequate an issuer that is in violation of covenants (a protection payments even if collateral fee, incremental spread, or additional collat- covers their claims, but does not cover eral) in exchange for a waiver. the claims of the second-lien lenders. Conversely, issuers prefer incurrence This may not be the case if the loans are covenants precisely because they are less documented together and the first- and stringent. Covenant-lite loans, therefore, second-lien lenders are deemed a unified thrive when the supply/demand equation is class by the bankruptcy court. tilted persuasively in favor of issuers. For more information, we suggest Latham & Watkins’ terrific overview and Lender Titles analysis of second-lien loans, which was published on April 15, 2004 in the firm’s In the formative days of the syndicated loan CreditAlert publication. market (the late 1980s), there was usually one agent that syndicated each loan. “Lead manager” and “manager” titles were doled Covenant-Lite Loans out in exchange for large commitments. As Like second-lien loans, covenant-lite loans are league tables gained influence as a marketing a particular kind of syndicated loan facility. tool, “co-agent” titles were often used in At the most basic level, covenant-lite loans are attracting large commitments or in cases loans that have bond-like financial incurrence where these institutions truly had a role in covenants rather than traditional maintenance underwriting and syndicating the loan. covenants that are normally part and parcel During the 1990s, the use of league tables of a loan agreement. What’s the difference? and, consequently, title inflation exploded. Incurrence covenants generally require that Indeed, the co-agent title has become largely if an issuer takes an action (paying a divi- ceremonial today, routinely awarded for what dend, making an acquisition, issuing more amounts to no more than large retail commit- debt), it would need to still be in compliance. ments. In most syndications, there is one lead So, for instance, an issuer that has an incur- arranger. This institution is considered to be rence test that limits its debt to 5x cash flow on the “left” (a reference to its position in an would only be able to take on more debt if, old-time tombstone ad). There are also likely on a pro forma basis, it was still within this to be other banks in the arranger group, constraint. If not, then it would have which may also have a hand in underwriting breeched the covenant and be in technical and syndicating a credit. These institutions default on the loan. If, on the other hand, an are said to be on the “right.” issuer found itself above this 5x threshold The different titles used by significant par- simply because its earnings had deteriorated, ticipants in the syndications process are it would not violate the covenant. administrative agent, syndication agent, docu- Maintenance covenants are far more mentation agent, agent, co-agent or managing restrictive. This is because they require an agent, and lead arranger or book runner: issuer to meet certain financial tests every ● The administrative agent is the bank that quarter whether or not it takes an action. So, handles all interest and principal payments in the case above, had the 5x leverage maxi- and monitors the loan.

18 www.standardandpoors.com ● The syndication agent is the bank that han- these lower assignment fees remained rare dles, in purest form, the syndication of the into 2011, and the vast majority was set at loan. Often, however, the syndication agent the traditional $3,500. has a less specific role. One market convention that became firmly ● The documentation agent is the bank that established in the late 1990s was assignment- handles the documents and chooses the fee waivers by arrangers for trades crossed law firm. through its secondary trading desk. This was ● The agent title is used to indicate the lead a way to encourage investors to trade with bank when there is no other conclusive the arranger rather than with another dealer. title available, as is often the case for This is a significant incentive to trade with smaller loans. arranger—or a deterrent to not trade away, ● The co-agent or managing agent is largely depending on your perspective—because a a meaningless title used mostly as an award $3,500 fee amounts to between 7 bps to 35 for large commitments. bps of a $1 million to $5 million trade. ● The lead arranger or book runner title is a league table designation used to indicate Primary assignments the “top dog” in a syndication. This term is something of an oxymoron. It applies to primary commitments made by Secondary Sales offshore accounts (principally CLOs and hedge funds). These vehicles, for a variety of Secondary sales occur after the loan is closed tax reasons, suffer tax consequence from and allocated, when investors are free to buying loans in the primary. The agent will trade the paper. Loan sales are structured as therefore hold the loan on its books for some either assignments or participations, with short period after the loan closes and then investors usually trading through dealer desks sell it to these investors via an assignment. at the large underwriting banks. Dealer-to- These are called primary assignments and are dealer trading is almost always conducted effectively primary purchases. through a “street” broker. Participations Assignments A participation is an agreement between an In an assignment, the assignee becomes a existing lender and a participant. As the direct signatory to the loan and receives inter- name implies, it means the buyer is taking est and principal payments directly from the a participating interest in the existing administrative agent. lender’s commitment. Assignments typically require the consent The lender remains the official holder of of the borrower and agent, although consent the loan, with the participant owning the may be withheld only if a reasonable objec- rights to the amount purchased. Consents, tion is made. In many loan agreements, the fees, or minimums are almost never required. issuer loses its right to consent in the event The participant has the right to vote only on of default. material changes in the loan document (rate, The loan document usually sets a mini- term, and collateral). Nonmaterial changes mum assignment amount, usually $5 mil- do not require approval of participants. A lion, for pro rata commitments. In the late participation can be a riskier way of pur- 1990s, however, administrative agents chasing a loan, because, in the event of a started to break out specific assignment min- lender becoming insolvent or defaulting, the imums for institutional tranches. In most participant does not have a direct claim on cases, institutional assignment minimums the loan. In this case, the participant then were reduced to $1 million in an effort to becomes a creditor of the lender and often boost liquidity. There were also some cases must wait for claims to be sorted out to col- where assignment fees were reduced or even lect on its participation. eliminated for institutional assignments, but

Standard & Poor’s ● A Guide To The Loan Market September 2011 19 A Syndicated Loan Primer

Loan Derivatives settlement could also be employed if there’s Loan credit default swaps not enough paper to physically settle all Traditionally, accounts bought and sold LCDS contracts on a particular loan. loans in the cash market through assign- ments and participations. Aside from that, LCDX there was little synthetic activity outside Introduced in 2007, the LCDX is an index of over-the-counter total rate of return swaps. 100 LCDS obligations that participants can By 2008, however, the market for syntheti- trade. The index provides a straightforward cally trading loans was budding. way for participants to take long or short Loan credit default swaps (LCDS) are stan- positions on a broad basket of loans, as well dard derivatives that have secured loans as as hedge their exposure to the market. reference instruments. In June 2006, the Markit Group administers the LCDX, a International Settlement and Dealers product of CDS Index Co., a firm set up by a Association issued a standard trade confirma- group of dealers. Like LCDS, the LCDX tion for LCDS contracts. Index is an over-the-counter product. Like all credit default swaps (CDS), an The LCDX is reset every six months with LCDS is basically an insurance contract. The participants able to trade each vintage of the seller is paid a spread in exchange for agree- index that is still active. The index will be set ing to buy at par, or a pre-negotiated price, a at an initial spread based on the reference loan if that loan defaults. LCDS enables par- instruments and trade on a price basis. ticipants to synthetically buy a loan by going According to the primer posted by Markit short the LCDS or sell the loan by going long (http://www.markit.com/information/affilia- the LCDS. Theoretically, then, a loanholder tions/lcdx/alertParagraphs/01/document/LCD can hedge a position either directly (by buy- X%20Primer.pdf), “the two events that ing LCDS protection on that specific name) would trigger a payout from the buyer (pro- or indirectly (by buying protection on a com- tection seller) of the index are bankruptcy or parable name or basket of names). failure to pay a scheduled payment on any Moreover, unlike the cash markets, which debt (after a grace period), for any of the are long-only markets for obvious reasons, constituents of the index.” the LCDS market provides a way for All documentation for the index is posted investors to short a loan. To do so, the at: http://www.markit.com/information/affili- investor would buy protection on a loan that ations/lcdx/alertParagraphs/01/document/LC it doesn’t hold. If the loan subsequently DX%20Primer.pdf. defaults, the buyer of protection should be able to purchase the loan in the secondary Total rate of return swaps (TRS) market at a discount and then and deliver it This is the oldest way for participants to pur- at par to the counterparty from which it chase loans synthetically. And, in reality, a bought the LCDS contract. For instance, say TRS is little more than buying a loan on mar- an account buys five-year protection for a gin. In simple terms, under a TRS program a given loan, for which it pays 250 bps a year. participant buys the income stream created Then in year 2 the loan goes into default and by a loan from a counterparty, usually a the market price falls to 80% of par. The dealer. The participant puts down some per- buyer of the protection can then buy the loan centage as collateral, say 10%, and borrows at 80 and deliver to the counterpart at 100, a the rest from the dealer. Then the participant 20-point pickup. Or instead of physical deliv- receives the spread of the loan less the finan- ery, some buyers of protection may prefer cial cost plus LIBOR on its collateral cash settlement in which the difference account. If the reference loan defaults, the between the current market price and the participant is obligated to buy it at par or delivery price is determined by polling dealers cash settle the loss based on a mark-to-mar- or using a third-party pricing service. Cash ket price or an auction price.

20 www.standardandpoors.com Here’s how the economics of a TRS work, because the prime option is more costly to in simple terms. A participant buys via TRS a the borrower than LIBOR or CDs. $10 million position in a loan paying L+250. ● The LIBOR (or Eurodollar) option is so To affect the purchase, the participant puts called because, with this option, the inter- $1 million in a collateral account and pays est on borrowings is set at a spread over L+50 on the balance (meaning leverage of LIBOR for a period of one month to one 9:1). Thus, the participant would receive: year. The corresponding LIBOR rate is L+250 on the amount in the collateral used to set pricing. Borrowings cannot be account of $1 million, plus prepaid without penalty. 200 bps (L+250 minus the borrowing cost of ● The CD option works precisely like the L+50) on the remaining amount of $9 million. LIBOR option, except that the base rate is The resulting income is L+250 * $1 million certificates of deposit, sold by a bank to plus 200 bps * $9 million. Based on the par- institutional investors. ticipants’ collateral amount—or equity contri- ● Other fixed-rate options are less common bution—of $1 million, the return is L+2020. but work like the LIBOR and CD options. If LIBOR is 5%, the return is 25.5%. Of These include federal funds (the overnight course, this is not a risk-free proposition. If rate charged by the Federal Reserve to the issuer defaults and the value of the loan member banks) and cost of funds (the goes to 70 cents on the dollar, the participant bank’s own funding rate). will lose $3 million. And if the loan does not default but is marked down for whatever rea- LIBOR floors son—market spreads widen, it is down- As the name implies, LIBOR floors put a graded, its financial condition floor under the base rate for loans. If a loan deteriorates—the participant stands to lose has a 3% LIBOR floor and three-month the difference between par and the current LIBOR falls below this level, the base rate market price when the TRS expires. Or, in an for any resets default to 3%. For obvious extreme case, the value declines below the reasons, LIBOR floors are generally seen value in the collateral account and the partic- during periods when market conditions are ipant is hit with a margin call. difficult and rates are falling as an incentive for lenders. Pricing Terms Rates Fees Loans usually offer borrowers different inter- The fees associated with syndicated loans are est-rate options. Several of these options allow the upfront fee, the commitment fee, the borrowers to lock in a given rate for one facility fee, the administrative agent fee, the month to one year. Pricing on many loans is letter of credit (LOC) fee, and the cancella- tied to performance grids, which adjust pric- tion or prepayment fee. ing by one or more financial criteria. Pricing ● An upfront fee is a fee paid by the issuer at is typically tied to ratings in investment-grade close. It is often tiered, with the lead loans and to financial ratios in leveraged arranger receiving a larger amount in con- loans. Communications loans are invariably sideration for structuring and/or under- tied to the borrower’s debt-to-cash-flow ratio. writing the loan. Co-underwriters will Syndication pricing options include prime, receive a lower fee, and then the general LIBOR, CD, and other fixed-rate options: syndicate will likely have fees tied to their commitment. Most often, fees are paid on ● The prime is a floating-rate option. Borrowed funds are priced at a spread over a lender’s final allocation. For example, a the reference bank’s prime lending rate. loan has two fee tiers: 100 bps (or 1%) for The rate is reset daily, and borrowerings $25 million commitments and 50 bps for may be repaid at any time without penalty. $15 million commitments. A lender com- This is typically an overnight option, mitting to the $25 million tier will be paid on its final allocation rather than on initial

Standard & Poor’s ● A Guide To The Loan Market September 2011 21 A Syndicated Loan Primer

commitment, which means that, in this and 1% in year two. The fee may be example, the loan is oversubscribed and applied to all repayments under a loan or lenders committing $25 million would be “soft” repayments, those made from a refi- allocated $20 million and the lenders nancing or at the discretion of the issuer would receive a fee of $200,000 (or 1% of (as opposed to hard repayments made from $20 million). Sometimes upfront fees will excess cash flow or asset sales). be structured as a percentage of final allo- ● An administrative agent fee is the annual cation plus a flat fee. This happens most fee typically paid to administer the loan often for larger fee tiers, to encourage (including to distribute interest payments potential lenders to step up for larger com- to the syndication group, to update lender mitments. The flat fee is paid regardless of lists, and to manage borrowings). For the lender’s final allocation. Fees are usu- secured loans (particularly those backed ally paid to banks, mutual funds, and by receivables and inventory), the agent other non-offshore investors at close. often collects a collateral monitoring fee, CLOs and other offshore vehicles are typi- to ensure that the promised collateral is cally brought in after the loan closes as a in place. “primary” assignment, and they simply An LOC fee can be any one of several buy the loan at a discount equal to the types. The most common—a fee for standby fee offered in the primary assignment, for or financial LOCs—guarantees that lenders tax purposes. will support various corporate activities. ● A commitment fee is a fee paid to lenders Because these LOCs are considered “bor- on undrawn amounts under a revolving rowed funds” under capital guidelines, the fee credit or a term loan prior to draw-down. is typically the same as the LIBOR margin. On term loans, this fee is usually referred Fees for commercial LOCs (those supporting to as a “ticking” fee. inventory or trade) are usually lower, because ● A facility fee, which is paid on a facility’s in these cases actual collateral is submitted). entire committed amount, regardless of The LOC is usually issued by a fronting bank usage, is often charged instead of a com- (usually the agent) and syndicated to the mitment fee on revolving credits to invest- lender group on a pro rata basis. The group ment-grade borrowers, because these receives the LOC fee on their respective facilities typically have CBOs that allow a shares, while the fronting bank receives an borrower to solicit the best bid from its issuing (or fronting, or facing) fee for issuing syndicate group for a given borrowing. The and administering the LOC. This fee is lenders that do not lend under the CBO are almost always 12.5 bps to 25 bps (0.125% to still paid for their commitment. 0.25%) of the LOC commitment. ● A usage fee is a fee paid when the utiliza- tion of a revolving credit falls below a cer- Original issue discounts (OID) tain minimum. These fees are applied This is yet another term imported from the mainly to investment-grade loans and gen- bond market. The OID, the discount from erally call for fees based on the utilization par at loan, is offered in the new issue market under a revolving credit. In some cases, the as a spread enhancement. A loan may be fees are for high use and, in some cases, for issued at 99 bps to pay par. The OID in this low use. Often, either the facility fee or the case is said to be 100 bps, or 1 point. spread will be adjusted higher or lower based on a pre-set usage level. OID Versus Upfront Fees ● A prepayment fee is a feature generally At this point, the careful reader may be won- associated with institutional term loans. dering just what the difference is between an This fee is seen mainly in weak markets as OID and an upfront fee. After all, in both an inducement to institutional investors. cases the lender effectively pays less than par Typical prepayment fees will be set on a for a loan. sliding scale; for instance, 2% in year one

22 www.standardandpoors.com From the perspective of the lender, actually, changes such as RATS (rate, amortization, there isn’t much of a difference. But for the term, and security; or collateral) rights, issuer and arrangers, the distinction is far but, as described below, there are occasions more than semantics. Upfront fees are gener- when changes in amortization and collat- ally paid from the arrangers underwriting fee eral may be approved by a lower percent- as an incentive to bring lenders into the deal. age of lenders (a supermajority). An issuer may pay the arranger 2% of the ● A supermajority is typically 67% to 80% deal and the arranger, to rally investors, may of lenders and is sometimes required for then pay a quarter of this amount, or 0.50%, certain material changes such as changes in to lender group. amortization (in-term repayments) and An OID, however, is generally borne by the release of collateral. issuer, above and beyond the arrangement fee. So the arranger would receive its 2% fee Covenants and the issuer would only receive 99 cents for every dollar of loan sold. Loan agreements have a series of restrictions For instance, take a $100 million loan that dictate, to varying degrees, how borrow- offered at a 1% OID. The issuer would ers can operate and carry themselves finan- receive $99 million, of which it would pay the cially. For instance, one covenant may require arrangers 2%. The issuer then would be obli- the borrower to maintain its existing fiscal- gated to pay back the whole $100 million, year end. Another may prohibit it from tak- even though it received $97 million after fees. ing on new debt. Most agreements also have Now, take the same $100 million loan offered financial compliance covenants, for example, at par with an upfront fee of 1%. In this case, that a borrower must maintain a prescribed the issuer gets the full $100 million. In this level of equity, which, if not maintained, gives case, the lenders would buy the loan not at banks the right to terminate the agreement or par, but at 99 cents on the dollar. The issuer push the borrower into default. The size of would receive $100 million of which it would the covenant package increases in proportion pay 2% to the arranger, which would then to a borrower’s financial risk. Agreements to pay one-half of that amount to the lending investment-grade companies are usually thin group. The issuer gets, after fees, $98 million. and simple. Agreements to leveraged borrow- Clearly, OID is a better deal for the arranger ers are often much more onerous. and, therefore, is generally seen in more chal- The three primary types of loan covenants lenging markets. Upfront fees, conversely, are are affirmative, negative, and financial. more issuer friendly and therefore are staples Affirmative covenants state what action of better market conditions. Of course, during the borrower must take to be in compliance the most muscular bull markets, new-issue with the loan, such as that it must maintain paper is generally sold at par and therefore insurance. These covenants are usually boil- requires neither upfront fees nor OIDs. erplate and require a borrower to, for example, pay the bank interest and fees, Voting rights provide audited financial statements, pay taxes, and so forth. Amendments or changes to a loan agreement Negative covenants limit the borrower’s must be approved by a certain percentage of activities in some way, such as regarding new lenders. Most loan agreements have three lev- investments. Negative covenants, which are els of approval: required-lender level, full highly structured and customized to a bor- vote, and supermajority: rower’s specific condition, can limit the type ● The “required-lenders” level, usually just a and amount of acquisitions, new debt simple majority, is used for approval of issuance, liens, asset sales, and guarantees. nonmaterial amendments and waivers or Financial covenants enforce minimum finan- changes affecting one facility within a deal. cial performance measures against the bor- ● A full vote of all lenders, including partici- rower, such as that he must maintain a higher pants, is required to approve material

Standard & Poor’s ● A Guide To The Loan Market September 2011 23 A Syndicated Loan Primer

level of current assets than of current liabili- mum level of TNW (net worth less intangi- ties. The presence of these maintenance ble assets, such as goodwill, intellectual covenants—so called because the issuer must assets, excess value paid for acquired com- maintain quarterly compliance or suffer a panies), often with a build-up provision, technical default on the loan agreement—is a which increases the minimum by a percent- critical difference between loans and bonds. age of net income or equity issuance. Bonds and covenant-lite loans (see above), by ● A maximum-capital-expenditures covenant contrast, usually contain incurrence covenants requires that the borrower limit capital that restrict the borrower’s ability to issue new expenditures (purchases of property, plant, debt, make acquisitions, or take other action and equipment) to a certain amount, which that would breach the covenant. For instance, may be increased by some percentage of a bond indenture may require the issuer to not cash flow or equity issuance, but often incur any new debt if that new debt would allowing the borrower to carry forward push it over a specified ratio of debt to unused amounts from one year to the next. EBITDA. But, if the company’s cash flow dete- riorates to the point where its debt to EBITDA Mandatory Prepayments ratio exceeds the same limit, a covenant viola- tion would not be triggered. This is because Leveraged loans usually require a borrower the ratio would have climbed organically to prepay with proceeds of excess cash flow, rather than through some action by the issuer. asset sales, debt issuance, or equity issuance. As a borrower’s risk increases, financial ● Excess cash flow is typically defined as covenants in the loan agreement become cash flow after all cash expenses, required more tightly wound and extensive. In general, dividends, debt repayments, capital expen- there are five types of financial covenants— ditures, and changes in working capital. coverage, leverage, current ratio, tangible net The typical percentage required is 50% worth, and maximum capital expenditures: to 75%. ● A coverage covenant requires the borrower ● Asset sales are defined as net proceeds of to maintain a minimum level of cash flow asset sales, normally excluding receivables or earnings, relative to specified expenses, or inventories. The typical percentage most often interest, debt service (interest required is 100%. and repayments), fixed charges (debt serv- ● Debt issuance is defined as net proceeds ice, capital expenditures, and/or rent). from debt issuance. The typical percentage ● A leverage covenant sets a maximum level required is 100%. of debt, relative to either equity or cash ● Equity issuance is defined as the net pro- flow, with total-debt-to-EBITDA level ceeds of equity issuance. The typical per- being the most common. In some cases, centage required is 25% to 50%. though, operating cash flow is used as the Often, repayments from excess cash flow divisor. Moreover, some agreements test and equity issuance are waived if the issuer leverage on the basis of net debt (total less meets a preset financial hurdle, most often cash and equivalents) or senior debt. structured as a debt/EBITDA test. ● A current-ratio covenant requires that the borrower maintain a minimum ratio of Collateral and other protective loan provisions current assets (cash, marketable securities, In the leveraged market, collateral usually accounts receivable, and inventories) to includes all the tangible and intangible assets current liabilities (accounts payable, short- of the borrower and, in some cases, specific term debt of less than one year), but assets that back a loan. sometimes a “quick ratio,” in which Virtually all leveraged loans and some of inventories are excluded from the the more shaky investment-grade credits are numerate, is substituted. backed by pledges of collateral. In the asset- ● A tangible-net-worth (TNW) covenant based market, for instance, that typically requires that the borrower have a mini- takes the form of inventories and receivables,

24 www.standardandpoors.com with the amount of the loan tied to a formula change in the majority of the board of direc- based off of these assets. The common rule is tors. For sponsor-backed leveraged issuers, that an issuer can borrow against 50% of the sponsor’s lowering its stake below a pre- inventory and 80% of receivables. Naturally, set amount can also trip this clause. there are loans backed by certain equipment, real estate, and other property. Equity cures In the leveraged market, there are some These provision allow issuers to fix a loans that are backed by capital stock of oper- covenant violation—exceeding the maximum ating units. In this structure, the assets of the debt to EBITDA test for instance—by making issuer tend to be at the operating-company an equity contribution. These provisions are level and are unencumbered by liens, but the generally found in private equity backed holding company pledges the stock of the deals. The equity cure is a right, not an obli- operating companies to the lenders. This gation. Therefore, a private equity firm will effectively gives lenders control of these units want these provisions, which, if they think if the company defaults. The risk to lenders in it’s worth it, allows them to cure a violation this situation, simply put, is that a bankruptcy without going through an amendment court collapses the holding company with the process, through which lenders will often ask operating companies and effectively renders for wider spreads and/or fees in exchange for the stock worthless. In these cases, which hap- waiving the violation even with an infusion pened on a few occasions to lenders to retail of new equity. Some agreements don’t limit companies in the early 1990s, loan holders the number of equity cures while others cap become unsecured lenders of the company the number to, say, one a year or two over and are put back on the same level with other the life of the loan. It’s a negotiated point, senior unsecured creditors. however, so there is no rule of thumb. Bull markets tend to inspire more generous equity Springing liens/collateral release cures for obvious reasons, while in bear mar- Some loans have provisions that borrowers kets lenders are more parsimonious. that sit on the cusp of investment-grade and speculative-grade must either attach collateral Asset-based lending or release it if the issuer’s rating changes. Most of the information above refers to A ‘BBB’ or ‘BBB-’ issuer may be able to “cash flow” loans, loans that may be convince lenders to provide unsecured financ- secured by collateral, but are repaid by cash ing, but lenders may demand springing liens flow. Asset-based lending is a distinct seg- in the event the issuer’s credit quality deterio- ment of the loan market. These loans are rates. Often, an issuer’s rating being lowered secured by specific assets and usually gov- to ‘BB+’ or exceeding its predetermined lever- erned by a borrowing formula (or a “bor- age level will trigger this provision. Likewise, rowing base”). The most common type of lenders may demand collateral from a strong, asset-based loans are receivables and/or speculative-grade issuer, but will offer to inventory lines. These are revolving credits release under certain circumstances, such as if that have a maximum borrowing limit, say the issuer attains an investment-grade rating. $100 million, but also have a cap based on the value of an issuer’s pledged receivables Change of control and inventories. Usually, the receivables are Invariably, one of the events of default in a pledged and the issuer may borrow against credit agreement is a change of issuer control. 80%, give or take. Inventories are also often For both investment-grade and leveraged pledged to secure borrowings. However, issuers, an event of default in a credit agree- because they are obviously less liquid than ment will be triggered by a merger, an acqui- receivables, lenders are less generous in their sition of the issuer, some substantial purchase formula. Indeed, the borrowing base for of the issuer’s equity by a third party, or a inventories is typically in the 50% to 65%

Standard & Poor’s ● A Guide To The Loan Market September 2011 25 A Syndicated Loan Primer

range. In addition, the borrowing base may in year two. Therefore, affixing a spread-to- be further divided into subcategories—for maturity or a spread-to-worst on loans is lit- instance, 50% of work-in-process inventory tle more than a theoretical calculation. and 65% of finished goods inventory. This is because an issuer’s behavior is In many receivables-based facilities, issuers unpredictable. It may repay a loan early are required to place receivables in a “lock because a more compelling financial opportu- box.” That means that the bank lends against nity presents itself or because the issuer is the receivable, takes possession of it, and acquired or because it is making an acquisi- then collects it to pay down the loan. tion and needs a new financing. Traders and In addition, asset-based lending is often investors will often speak of loan spreads, done based on specific equipment, real therefore, as a spread to a theoretical call. estate, car fleets, and an unlimited number Loans, on average, between 1997 and 2004 of other assets. had a 15-month average life. So, if you buy a loan with a spread of 250 bps at a price of Bifurcated collateral structures 101, you might assume your spread-to- Most often this refers to cases where the expected-life as the 250 bps less the amor- issuer divides collateral pledge between tized 100 bps premium or LIBOR+170. asset-based loans and funded term loans. Conversely, if you bought the same loan at The way this works, typically, is that asset- 99, the spread-to-expect life would be based loans are secured by current assets LIBOR+330. like accounts receivables and inventories, while term loans are secured by fixed assets Default And Restructuring like property, plant, and equipment. Current There are two primary types of loan assets are considered to be a superior form defaults: technical defaults and the much of collateral because they are more easily more serious payment defaults. Technical converted to cash. defaults occur when the issuer violates a provision of the loan agreement. For Subsidiary guarantees instance, if an issuer doesn’t meet a financial Those not collateral in the strict sense of the covenant test or fails to provide lenders with word, most leveraged loans are backed by financial information or some other viola- the guarantees of subsidiaries so that if an tion that doesn’t involve payments. issuer goes into bankruptcy all of its units When this occurs, the lenders can acceler- are on the hook to repay the loan. This ate the loan and force the issuer into bank- is often the case, too, for unsecured invest- ruptcy. That’s the most extreme measure. In ment-grade loans. most cases, the issuer and lenders can agree on an amendment that waives the violation in Negative pledge exchange for a fee, spread increase, and/or This is also not a literal form of collateral, tighter terms. but most issuers agree not to pledge any A payment default is a more serious mat- assets to new lenders to ensure that the inter- ter. As the name implies, this type of est of the loanholders are protected. default occurs when a company misses either an interest or principal payment. Loan math—the art of spread calculation There is often a pre-set period of time, say Calculating loan yields or spreads is not 30 days, during which an issuer can cure a straightforward. Unlike most bonds, which default (the “cure period”). After that, the have long no-call periods and high-call premi- lenders can choose to either provide a for- ums, most loans are prepayable at any time bearance agreement that gives the issuer typically without prepayment fees. And, even some breathing room or take appropriate in cases where prepayment fees apply, they action, up to and including accelerating, or are rarely more than 2% in year one and 1% calling, the loan.

26 www.standardandpoors.com If the lenders accelerate, the company will DIP Loans generally declare bankruptcy and restructure Debtor-in-possession (DIP) loans are made to their debt through Chapter 11. If the com- bankrupt entities. These loans constitute super- pany is not worth saving, however, because priority claims in the bankruptcy distribution its primary business has cratered, then the scheme, and thus sit ahead of all prepretition issuer and lenders may agree to a Chapter 7 claims. Many DIPs are further secured by prim- liquidation, in which the assets of the busi- ing liens on the debtor’s collateral (see below). ness are sold and the proceeds dispensed to Traditionally, prepetition lenders provided the creditors. DIP loans as a way to keep a company viable during the bankruptcy process. In the early Amend-To-Extend 1990s, a broad market for third-party DIP loans emerged. These non-prepetition lenders This technique allows an issuer to push out were attracted to the market by the relatively part of its loan maturities through an amend- safety of most DIPs based on their super-prior- ment, rather than a full-out refinancing. ity status, and relatively wide margins. This was Amend-to-extend transactions came into the case again the early 2000s default cycle. widespread use in 2009 as borrowers strug- In the late 2000s default cycle, however, gled to push out maturities in the face of dif- the landscape shifted because of more dire ficult lending conditions that made economic conditions. As a result, liquidity refinancing prohibitively expensive. was in far shorter supply, constraining Amend-to-extend transactions have two availability of traditional third-party DIPs. phases, as the name implies. The first is an Likewise, with the severe economic condi- amendment in which at least 50.1% of the tions eating away at debtors’ collateral, not bank group approves the issuer’s ability to roll to mention reducing enterprise values, prep- some or all existing loans into longer-dated etition lenders were more wary of relying paper. Typically, the amendment sets a range solely on the super-priority status of DIPs, for the amount that can be tendered via the and were more likely to ask for priming new facility, as well as the spread at which the liens to secure facilities. longer-dated paper will pay interest. The refusal of prepetition lenders to con- The new debt is pari passu with the exist- sent to such priming, combined with the ing loan. But because it matures later and, expense and uncertainty involved in a prim- thus, is structurally subordinated, it carries a ing fight in bankruptcy court, has greatly higher rate, and, in some cases, more attrac- reduced third-party participation in the DIP tive terms. Because issuers with big debt market. With liquidity in short supply, new loads are expected to tackle debt maturities innovations in DIP lending cropped up aimed over time, amid varying market conditions, in at bringing nontraditional lenders into the some cases, accounts insist on most-favored- market. These include: nation protection. Under such protection, the ● Junior DIPs. These facilities are typically spread of the loan would increase if the issuer provided by bond holders or other unse- in question prints a loan at a wider margin. cured debtors as part of a loan-to-own The second phase is the conversion, in strategy. In these transactions, the which lenders can exchange existing loans for providers receive much or all of the post- new loans. In the end, the issuer is left with petition equity interest as an incentive to two tranches: (1) the legacy paper at the ini- provide the DIP loans. tial price and maturity and (2) the new facil- ● Roll-up DIPs. In some bankruptcies— ity at a wider spread. The innovation here: LyondellBasell and Spectrum Brands are amend-to-extend allows an issuer to term-out two 2009 examples—DIP providers are loans without actually refinancing into a new given the opportunity to roll up prepeti- credit (which obviously would require mark- tion claims into junior DIPs, that rank ing the entire loan to market, entailing higher ahead of other prepetition secured spreads, a new OID, and stricter covenants). lenders. This sweetener was particularly

Standard & Poor’s ● A Guide To The Loan Market September 2011 27 A Syndicated Loan Primer

compelling for lenders that had bought Bits And Pieces prepetition paper at distressed prices and What follows are definitions to some com- were able to realize a gain by rolling it mon market jargon not found elsewhere in into the junior DIPs. this primer, but used constantly as short-hand in the loan market: Exit Loans ● Staple financing. Staple financing is a financing agreement “stapled on” to an These are loans that finance an issuer’s emer- acquisition, typically by the M&A advisor. gence from bankruptcy. Typically, the loans So, if a private equity firm is working with are prenegotiated and are part of the com- an investment bank to acquire a property, pany’s reorganization plan. that bank, or a group of banks, may pro- vide a staple financing to ensure that the Sub-Par Loan Buybacks firm has the wherewithal to complete the This is another technique that grew out of the deal. Because the staple financing provides bear market that began in 2007. Performing guidelines on both structure and leverage, paper fell to price not seen before in the loan it typically forms the basis for the eventual market—with many trading south of 70. This financing that is negotiated by the auction created an opportunity for issuers with the winner, and the staple provider will usually financial wherewithal and the covenant room serve as one of the arrangers of the financ- to repurchase loans via a tender, or in the ing, along with the lenders that were back- open market, at prices below par. ing the buyer. Sub-par buybacks have deep roots in the ● Break prices. Simply, the price at which bond market. Loans didn’t suffer the price loans or bonds are initially traded into the declines before 2007 to make such tenders secondary market after they close and allo- attractive, however. In fact, most loan docu- cate. It is called the break price because ments do not provide for a buyback. Instead, that is where the facility breaks into the issuers typically need obtain lender approval secondary market. via a 50.1% amendment. ● Market-clearing level. As this phrase implies, the price or spread at which a Distressed exchanges deal clears the primary market. (Seems to be an allusion to a high-jumper clearing This is a negotiated tender in which classh- a hurdle.) olders will swap their existing paper for a ● Running the books. Generally the loan new series of bond that typically have a lower arranger is said to be “running the books,” principal amount and, often, a lower yield. In i.e., preparing documentation and syndicat- exchange the bondholders might receive ing and administering the loan. stepped-up treatment, going from subordi- ● Disintermediation. Disintermediation refers nated to senior, say, or from unsecured to the process where banks are replaced (or to second-lien. disintermediated) by institutional investors. Standard & Poor’s consider these programs This is the process that the loan market has a default and, in fact, the holders are agreeing been undergoing for the past 20 years. to take a principal haircut in order to allow Another example is the mortgage market the company to remain solvent and improve where the primary capital providers have their ultimate recovery prospects. evolved from banks and savings and loans This technique is used frequently in the bond to conduits structured by Fannie Mae, market but rarely for first-lien loans. One good Freddie Mac, and the other mortgage secu- example was from Harrah’s Entertainment. In ritization shops. Of course, the list of disin- 2009, the gaming company issued $3.6 billion termediated markets is long and growing. of new 10% second-priority senior secured In addition to leveraged loans and mort- notes due 2018 for about $5.4 billion of bonds due between 2010 and 2018.

28 www.standardandpoors.com gages, this list also includes auto loans and bond market, the common definition is a credit card receivables. spread of 1,000 bps or more. For loans, ● Loss given default. This is simply a meas- however, calculating spreads is an elusive ure of how much creditors lose when an art (see above) and therefore a more pedes- issuer defaults. The loss will vary trian price measure is used. depending on creditor class and the ● Default rate. Calculated by either number enterprise value of the business when it of loans or principal amount. The formula defaults. Naturally, all things being is similar. For default rate by number of equal, secured creditors will lose less loans: the number of loans that default than unsecured creditors. Likewise, sen- over a given 12-month period divided by ior creditors will lose less than subordi- the number of loans outstanding at the nated creditors. Calculating loss given beginning of that period. For default rate default is tricky business. Some practi- by principal amount: the amount of loans tioners express loss as a nominal percent- that default over a 12-month period age of principal or a percentage of divided by the total amount outstanding at principal plus accrued interest. Others the beginning of the period. Standard & use a present value calculation using an Poor’s defines a default for the purposes of estimated discount rate, typically 15% to calculating default rates as a loan that is 25%, demanded by distressed investors. either (1) rated ’D’ by Standard & Poor’s, ● Recovery. Recovery is the opposite of (2) to an issuer that has filed for bank- loss given default—it is the amount a ruptcy, or (3) in payment default on inter- creditor recovers, rather than loses, in est or principal. a given default. ● Leveraged loans. Just what is a leveraged ● Printing a deal. Refers to the price or loan is a discussion of long standing. Some spread at which the loan clears. participants use a spread cut-off: i.e., any ● Relative value. This can refer to the relative loan with a spread of LIBOR+125 or return or spread between (1) various LIBOR+150 or higher qualifies. Others use instruments of the same issuer, comparing rating criteria: i.e., any loan rated ‘BB+’ or for instance the loan spread with that of a lower qualifies. But what of loans that are bond; (2) loans or bonds of issuers that are not rated? At Standard & Poor’s LCD we similarly rated and/or in the same sector, have developed a more complex definition. comparing for instance the loan spread of We include a loan in the leveraged universe one ‘BB’ rated healthcare company with if it is rated ‘BB+’ or lower or it is not that of another; and (3) spreads between rated or rated ‘BBB-‘ or higher but has (1) markets, comparing for instance the spread a spread of LIBOR +125 or higher and (2) on offer in the loan market with that of is secured by a first or second lien. Under high-yield or corporate bonds. Relative this definition, a loan rated ‘BB+’ that has value is a way of uncovering undervalued, a spread of LIBOR+75 would qualify, but or overvalued, assets. a nonrated loan with the same spread ● Rich/cheap. This is terminology imported would not. It is hardly a perfect definition, from the bond market to the loan market. but one that Standard & Poor’s thinks best If you refer to a loan as rich, it means it is captures the spirit of loan market partici- trading at a spread that is low compared pants when they talk about leveraged with other similarly rated loans in the same loans. sector. Conversely, referring to something as ● Middle market. The loan market can be cheap means that it is trading at a spread roughly divided into two segments: large that is high compared with its peer group. corporate and middle market. There are as That is, you can buy it on the cheap. many was to define middle market as there ● Distressed loans. In the loan market, loans are bankers. But, in the leveraged loan mar- traded at less than 80 cents on the dollar ket, the standard has become an issuer with are usually considered distressed. In the no more than $50 million of EBITDA. Based

Standard & Poor’s ● A Guide To The Loan Market September 2011 29 A Syndicated Loan Primer

on this, Standard & Poor’s uses the $50 mil- ● OWIC. This stands for “offers wanted in lion threshold in its reports and statistics. competition” and is effectively a BWIC in ● Axe sheets. These are lists from dealers reverse. Instead of seeking bids, a dealer is with indicative secondary bids and offers asked to buy a portfolio of paper and solic- for loans. Axes are simply price indications. its potential sellers for the best offer. ● Circled. When a loan or bond is full sub- ● Cover bid. The level that a dealer agrees to scribed at a given price it is said to be cir- essentially underwrite a BWIC or an auc- cled. After that, the loan or bond moves to tion. The dealer, to win the business, may allocation and funding. give an account a cover bid, effectively put- ● Forward calendar. A list of loans or bond ting a floor on the auction price. that has been announced but not yet ● Loan-to-own. A strategy in which closed. These include both instruments lenders—typically hedge funds or distressed that are yet to come to market and those investors—provide financing to distressed that are actively being sold but have yet to companies. As part of the deal, lenders be circled. receive either a potential ownership stake if ● BWIC. An acronym for “bids wanted in the company defaults, or, in the case of a competition.” Really just a fancy way of bankrupt company, an explicit equity stake describing a secondary auction of loans or as part of the deal. bonds. Typically, an account will offer up a ● Most favored nation clauses. Some loans portfolio of facilities via a dealer. The will include a provision to protect lenders dealer will then put out a BWIC, asking if the issuer subsequently places a new loan potential buyers to submit for individual at a higher spread. Under these provision, names or the entire portfolio. The dealer the spread of the existing paper ratchets up will then collate the bids and award each to the new spread (though in some cases facility to the highest bidder. the increase is capped). ●

30 www.standardandpoors.com Rating Leveraged Loans: An Overview

Thomas L. Mowat espite recent favorable rating and default trends, Standard & New York (1) 212-438-1588 Poor’s Ratings Services believes credit quality among U.S. [email protected] D William H. Chew speculative-grade industrial issuers remains fragile. Since the fourth New York (1) 212-438-7981 quarter of 2009, we have raised more of our issuer credit ratings on [email protected] corporate industrial issuers than we’ve lowered. Default rates have also improved. According to Standard & Poor’s Global Fixed Income Research (GFIR), the current trailing 12-month default rate has dropped to 2.5%; this is well below the long-term average of 4.58% since 1982 and sharply below the peak rate of more than 11% in 2009. While these recent favorable trends reflect relative improve- ment in the credit quality of leveraged companies, we believe these companies remain exposed to several risks that could reverse the recent improvement in defaults.

These risks include a weak credit mix, with In December 2003, Standard & Poor’s about 47% of our ratings on U.S. corporate became the first rating agency to establish a industrials remaining concentrated in the ‘B’ separate, stand-alone rating scale to evaluate and ‘CCC’ rating categories, minimal revenue the potential recovery investors might expect growth, potential margin compression stem- in the event of a loan default. Before that, we ming from increased operating costs and the used our traditional rating scale, which return of refinancing risk in 2013–2016. focused almost exclusively on the likelihood of These risk factors, combined with the 2009 default (will the borrower pay on time?) rather spike in defaults, highlight the importance of than on what the ultimate repayment would fundamental credit analysis and recovery ana- be if the borrower failed to make timely pay- lytics. As default rates increase, recoveries ments. Since then, Standard & Poor’s has become the focus for many leveraged investors assigned recovery ratings to more than 3,000 because, with rising default rates, recoveries speculative-grade secured loans and bonds. play a greater role in overall credit losses. In March of 2008, Standard & Poor’s began

Standard & Poor’s ● A Guide To The Loan Market September 2011 31 Rating Leveraged Loans: An Overview

assigning recovery ratings to the unsecured unsecured in terms of the actual protection debt of speculative-grade issuers. afforded investors. A primary purpose of Standard & Poor’s recovery ratings is to help investors differenti- Why A Separate Recovery Scale? ate between loans that are fully secured, par- Investors in loans recognize that they are tially secured, and those that are “secured” in incurring both types of risks: the risk of name only. (See chart 1.) Second-lien loans default and the risk of loss in the event of are a specific example of secured loans default. In traditional bond markets, espe- whereby recovery prospects in a bankruptcy cially bonds issued by investment-grade com- could vary dramatically depending on the panies, the risk of default is relatively remote, overall makeup of the capital structure in and little attention is paid to covenants, col- question. These deals have attributes of both lateral, or other protective features that secured loans and subordinated debt, and would mitigate loss in the event of default. determining post-default recovery prospects Indeed, such protective features are rare in requires detailed analysis of the individual such markets. But in the leveraged loan mar- deal. Most second-lien loans that we rate ket, where the borrowers tend to be specula- have fallen into the lower recovery rating cat- tive grade (i.e., rated ‘BB+’ and below), the egories (categories 5 and 6; see table 1), but risk of default is significantly higher than it is occasionally a second lien has been so well for investment-grade borrowers. Therefore, protected that it has merited a higher rating. we have the necessity of collateral, covenants, Hence, once again, we have the need for and similar features of “secured” lending. recovery ratings to make that differentiation. But the challenge for investors is that not all loans labeled “secured” are equally secured, or even protected at all. In the past, Comparing Issuer And data has shown, for example, that the major- Recovery Ratings ity of all secured loans do, in fact, repay their Standard & Poor’s recovery rating methodol- lenders 100% of principal in the event of ogy builds upon its traditional corporate default, with another sizable percentage pro- credit issuer rating analysis. The traditional viding substantial, albeit less than full, recov- analysis focuses on attributes of the borrower eries. But a significant number do not do itself, which we tend to group under the nearly so well, and, indeed, might as well be heading of “business risk” factors (the bor-

Chart 1 To t al Distribution Of Current/Outstanding Speculative Grade Secured Issues With Recovery Ratings

As of Aug. 25, 2011

No. of ratings (left scale)* % of ratings (right scale)

1,000 35 900 30 800 700 25 600 20 500 400 15 300 10 200 5 100 0 0 1+ 1 2 3 4 5 6 (Recovery rating)

*Total number of ratings: 3,074. Average recovery rating: 2.44. Standard deviation:1.37. © Standard & Poor’s 2011.

32 www.standardandpoors.com rower’s industry, its business niche within financial profile to achieve the same overall that industry, and other largely qualitative rating level as a company in a more stable factors like the quality of its management, business. The companies that Standard & overall strategy, etc.) and “financial risk” fac- Poor’s rates ’BB’, for example, may present a tors (cash flow, capital structure, access to wide range of combinations of business and liquidity, as well as financial reporting and financial risk, but are all expected to have a accounting issues, etc.). The company’s abil- similar likelihood of defaulting on the timely ity to meet its financial obligations on time payment of their financial obligations. and, therefore, avoid default, is based on a Likewise with ’AA’ rated credits, ’B’ rated combination of all these qualities, and it is credits, etc. the analyst’s job to balance them appropri- Over the years, Standard & Poor’s has ately in coming up with an overall rating. tracked the actual default rates of companies (See chart 2.) that it has rated. Table 2 shows the cumula- In assigning its corporate credit ratings, tive default rates for the past 30 years by rat- Standard & Poor’s is actually grouping the ing category. As we might expect, the rate of rated companies into categories based on the default increases substantially moving across relative likelihood of their meeting their rating categories. For example, over five financial obligations on time (i.e., avoiding years, companies originally rated ’BB’ default.) The relative importance of the vari- default, as a group, almost four times the ous attributes may vary substantially from rate ’BBB’ rated companies do. ’B’ and one credit to another, even within the same ’CCC’ rated companies default at an even rating category. For example, a company accelerated pace. with a very high business risk (e.g., intense Saying that a given set of debt issuers in competition, minimal barriers to entry, con- the same rating category have similar charac- stant technology change, and risk of obsoles- teristics and are equally default-prone does cence) would generally require a stronger not tell an investor which of the companies in

Chart 2 Standard & Poor’s Criteria

Getting to the corporate credit rating (”CCR”)

Country Risk

Industry Characteristics Business Risk Company Position

Profitability / Peer Group Comparisons

Rating

● Accounting

● Governance, Risk Tolerance, Financial Policy Financial Risk ● Cash Flow Adequacy

● Capital Structure, Asset Protection

● Liquidity / Short-Term Factors

© Standard & Poor’s 2011.

Standard & Poor’s ● A Guide To The Loan Market September 2011 33 Rating Leveraged Loans: An Overview

that rating category will actually be the ones market is saying, in effect, that it can live to default. No amount of analysis can tell us with a default rate of that magnitude without that, since if we knew for certain that a given having to worry about protecting itself if a company that has the attributes of, for exam- default actually occurs. But for ’BB’ rated ple, a ’BB’, were actually going to default at credits, where the likelihood of default occur- some point, it would not, in fact, be rated ring is almost four times greater, the market ’BB’, but instead would be rated much lower. has drawn a line and decided that, for that As investors move down the rating scale, degree of default risk, it will generally insist they may not know exactly which deals will on collateral security. Lenders are, in effect, default, but they surely know that a larger willing to treat a ’BBB’ rated credit as though percentage of their deals will default; and it will not likely default. But the presumption they had better be prepared for it. In the syn- is reversed for ’BB’ (and below) credits, dicated loan market, the market practice has where the increased default risk is so severe evolved to the point that companies rated that the market insists on treating every ’BBB’ and which generally default at the rate credit as though it might well default. of about 2% over five years, are “allowed” Standard & Poor’s recovery ratings take a by the market to borrow unsecured. The similar approach by assigning recovery rat-

Table 1 Recovery Rating Scale And Issue Rating Criteria

For issuers with a speculative-grade corporate credit rating Recovery Issue rating notches relative Recovery rating* Recovery description expectations¶ to corporate credit rating 1+ Highest expectation, full recovery 100%§ +3 notches 1 Very high recovery 90%–100% +2 notches 2 Substantial recovery 70%–90% +1 notch 3 Meaningful recovery 50%–70% 0 notches 4 Average recovery 30%–50% 0 notches 5 Modest recovery 10%–30% -1 notch 6 Negligible recovery 0%–10% -2 notches

*As noted above, recovery ratings in certain countries are capped to adjust for reduced creditor recovery prospects in these jurisdictions. Furthermore, the recovery ratings on unsecured debt issued by corporate entities with corporate credit ratings of ‘BB-‘ or higher are generally capped at ‘3’ to account for the risk that their recovery prospects are at greater risk of being impaired by the issuance of additional priority or pari passu debt prior to default. ¶Recovery of principal plus accrued but unpaid interest at the time of default. §Very high confidence of full recovery resulting from significant overcollateralization or strong structural features.

Table 2 Global Corporate Average Cumulative Default Rates (1981–2010)

—Time horizon (years)— Rating 123451015 AAA 0.00 0.03 0.14 0.26 0.38 0.79 1.09 AA 0.02 0.07 0.15 0.26 0.37 0.82 1.15 A 0.08 0.19 0.33 0.50 0.68 1.84 2.77 BBB 0.25 0.70 1.19 1.80 2.43 5.22 7.71 BB 0.95 2.83 5.03 7.14 9.04 16.54 20.52 B 4.70 10.40 15.22 18.98 21.76 29.94 34.54 CCC/C 27.39 36.79 42.12 45.21 47.64 52.88 56.55

Source: Standard & Poor’s Global Fixed Income Research; Standard & Poor’s CreditPro.®

34 www.standardandpoors.com ings to speculative-grade issuers. While we 70% of all new leveraged loans. This is not do not assume that a given deal will default, surprising, considering that most investors in our analysts—the industry specialists who the U.S. leveraged loan market are nonbank cover companies on an ongoing basis, institutional investors, rather than commer- working along with the recovery specialist cial banks. These institutional investors: who is assigned to that industry team ● Are accustomed to having ratings on the specifically to do recovery analysis—deter- debt instruments they buy, and mine together the most likely default sce- ● Often have ratings on their own debt nario that is consistent with our assessment which, in turn, are dependent on of the company’s fundamental business and the ratings of the underlying loans financial risks. In other words, if this com- they purchase. pany were to default, what would be the In addition to the recovery rating itself, most likely scenario? They then project with its specific estimate of recovery in the what the company’s financial condition event of default, Standard & Poor’s analysts would be at the time of default and, equally provide a complete recovery report that important, at the conclusion of the workout explains in detail the analysis, the default sce- process. Then they evaluate what the com- nario, the other assumptions, and the reason- pany itself and/or the collateral (which may ing behind the recovery rating. This allows be the same, but not always) would be investors to look behind and, if they wish, worth and how that value would be distrib- even to “reverse engineer” our analysis, uted among the various creditors. (For a selecting what they agree or disagree with, detailed description of the analytical and altering our scenarios to reflect their own methodology used, see the accompanying view of the company, the industry, or the col- article in this book, ”Criteria Guidelines lateral valuation. For Recovery Ratings On Global Industrials For further information about Standard & Issuers’ Speculative-Grade Debt.”) Poor’s Recovery Ratings, or to receive the weekly S&P Loan & Recovery Rating Report by email, please contact Bill Chew Role Of Ratings In at 1-212-438-7981 or bill_chew@ The Loan Market standardandpoors.com, or visit our The U.S. leveraged loan market is a rated Bank Loan & Recovery Rating web site at: market, with Standard & Poor’s rating about www.bankloanrating.standardandpoors.com. ●

Standard & Poor’s ● A Guide To The Loan Market September 2011 35 Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

Steve Wilkinson tandard & Poor’s Ratings Services has been assigning recovery New York (1) 212-438-5093 ratings—debt instrument-specific estimates of post-default steve_wilkinson@ S standardandpoors.com recovery for creditors—since December 2003. At that time, we Anne-Charlotte Pedersen New York began issuing recovery ratings and analyses for all new secured (1) 212-438-6816 anne-charlotte_pedersen@ bank loans in the U.S. Since that time, we have steadily expanded standardandpoors.com William H. Chew our recovery ratings to cover secured debt issued in other countries Managing Director New York and, in March 2008, to unsecured and subordinated debt instruments. (1) 212-438-7981 [email protected] This article provides an overview of Standard & Poor’s general Anthony Flintoff Senior Director recovery analysis approach for global Industrials issuers, including Melbourne (61) 3-9631-2038 specific jurisdictional considerations for the U.S. market. This anthony_flintoff@ standardandpoors.com framework is the basis for our recovery methodology worldwide although, where appropriate, our analysis is tailored to consider jurisdiction-specific features that impact the insolvency process and creditor recovery prospects.

Recovery Ratings For bankruptcy proceeding or an informal out-of- Global Industrials— court restructuring. Lender recoveries could Definition And Context be in the form of cash, debt or equity securi- ties of a reorganized entity, or some combina- Recovery ratings assess a debt instrument’s tion thereof. We focus on nominal recovery ultimate prospects for recovery of estimated (versus discounted present value recovery) principal and pre-petition interest (i.e., inter- because we believe that discounted recovery est accrued but unpaid at the time of default) is better identified independently by market given a simulated payment default. Standard & participants that are best positioned to apply Poor’s recovery methodology focuses on esti- their own preferred discount rate to our nom- mating the percentage of recovery that debt inal recovery. However, in jurisdictions with investors would receive at the end of a formal creditor-unfriendly features, we will cap both

36 www.standardandpoors.com recovery ratings and issue ratings to account would be expected to impact lender recovery for incremental uncertainty. rates—provides valuable insight into creditor While informed by historical recovery data, recovery prospects. our recovery ratings incorporate fundamental In this light, our recovery ratings are deal-specific, scenario-driven, forward-looking intended to provide educated approximations analysis. They consider the impact of key of post-default recovery rates, rather than structural features, intercreditor dynamics, the exact forecasts. Our analysis also endeavors to nature of insolvency regimes, multijurisdic- comment on how the specific features of a tional issues, and potential changes in valua- company’s debt and organizational structure tion after a simulated default. Ongoing may affect lender recovery prospects. Of surveillance through periodic and event-spe- course, not all borrowers will default, but our cific reviews help ensure that our recovery rat- recovery ratings, when viewed together with a ings remain forward looking by monitoring company’s risk of default as estimated by developments in these issues and by evaluating Standard & Poor’s corporate credit rating, can the impact of changes to a borrower’s business help investors evaluate a debt instrument’s risks and debt and liability profile over time. risk/reward characteristics and estimate their We acknowledge that default modeling, expected return. Our approach is intended to valuation, and restructuring (whether as part be transparent (within the bounds of confiden- of a formal bankruptcy proceeding or other- tiality), so that market participants may draw wise) are inherently dynamic and complex value from our analysis itself rather than processes that do not lend themselves to pre- merely from the conclusion of the analysis. cise or certain predictions. These processes invariably involve unforeseen events and are Recovery Rating Scale subject to extensive negotiations that are influenced by the subjective judgments, nego- And Issue Rating Framework tiating positions, and agendas of the various The table summarizes our enhanced issue rat- stakeholders. Even so, we believe that our ing framework. The issue rating we apply to methodology of focusing on a company’s the loans and bonds of companies with spec- unique and fundamental credit risks— ulative-grade corporate credit ratings is based together with an informed analysis of how on the recovery rating outcome for the spe- the composition and structure of its debt, cific instrument being rated. Issues with a legal organization, and nondebt liabilities high recovery rating (‘1+’, ‘1’, or ‘2’) would

Recovery Rating Scale And Issue Rating Criteria

For issuers with a speculative-grade corporate credit rating Recovery Issue rating notches relative Recovery rating* Recovery description expectations¶ to corporate credit rating 1+ Highest expectation, full recovery 100%§ +3 notches 1 Very high recovery 90%–100% +2 notches 2 Substantial recovery 70%–90% +1 notch 3 Meaningful recovery 50%–70% 0 notches 4 Average recovery 30%–50% 0 notches 5 Modest recovery 10%–30% -1 notch 6 Negligible recovery 0%–10% -2 notches

*As noted above, recovery ratings in certain countries are capped to adjust for reduced creditor recovery prospects in these jurisdictions. Furthermore, the recovery ratings on unsecured debt issued by corporate entities with corporate credit ratings of ‘BB-‘ or higher are generally capped at ‘3’ to account for the risk that their recovery prospects are at greater risk of being impaired by the issuance of additional priority or pari passu debt prior to default. ¶Recovery of principal plus accrued interest at the time of default on a nominal basis. §Very high confidence of full recovery resulting from significant overcollateralization or strong structural features.

Standard & Poor’s ● A Guide To The Loan Market September 2011 37 Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

lead us to rate the loan or bond above the numerical analysis, we increase the trans- corporate credit rating, while a low recovery parency and consistency of our assessments rating (‘5’ or ‘6’) would lead us to rate the of the impact of countries’ insolvency rules— issue below the corporate credit rating. especially those that are less creditor friendly when assigning recovery and issue ratings. To review the details of our adjustments, Jurisdiction-Specific Adjustments the grouping of various countries into groups For Recovery And Issue Ratings with similar characteristics, and the extent of Standard & Poor’s due diligence for extend- our issue-notching caps for each group, see ing recovery ratings beyond the U.S. has “Jurisdiction-Specific Adjustments To entailed an assessment of how insolvency Recovery And Issue Ratings”. proceedings in practice in various countries affect post-default recovery prospects. This work has enabled us to consistently incorpo- General Recovery rate jurisdiction-specific adjustments when we Methodology And Approach assign recovery and issue ratings outside the For Global Industrials U.S. With the help of local insolvency practi- Recovery analytics for Industrials issuers has tioners, we have assessed each jurisdiction’s three basic components: (1) determining the creditor friendliness in theory as well as how most likely path to default for a company; (2) the law works in practice. For the latter, we valuing the company following default; and so far lack empirical data, as outside of the (3) distributing that value to claimants based U.S. very little reliable historical default and upon the relative priority of each claimant. recovery data is available to verify in practice Our analytical process breaks down these the predictability of insolvency proceedings components into the following steps: and actual recovery rates. We will refine and ● Establishing a simulated path to default; update our analysis and methodology over ● Forecasting the company’s profitability time as appropriate if more actual loss data and/or cash flow at default based on our and practical evidence becomes available. simulated default scenario; The four main factors that shape our analy- ● Determining an appropriate valuation for sis of the jurisdictions’ creditor friendliness are: the company following default; ● Security, ● Identifying and estimating debt and nondebt ● Creditor participation/influence, claims in our simulated default scenario; ● Distribution of value/certainty of ● Determining the distribution of value based priorities, and on relative priorities; ● Time to resolution. ● Assigning a recovery rating (or ratings), Based on the score reached on each of including a published “recovery report” that these factors, we have classified the reviewed summarizes our assumptions and conclusions. countries into three categories, according to their creditor-friendliness. This classification Establishing a simulated path to default has enabled us to make jurisdiction-specific This is a fundamental part of our recovery adjustments to our recovery analysis. Namely, analysis because we must first understand the relative to our standard assignment of recov- forces most likely to cause a default before ery and debt issue ratings, we cap both recov- we can estimate a reasonable valuation given ery ratings and the differential between the default. This step draws on the company and issuer credit and debt issue ratings in coun- sector knowledge of Standard & Poor’s tries if and to the extent we expect the recov- credit analysts to formulate and quantify the ery process and actual recovery rates to be factors most likely to cause a company to negatively affected by insolvency regimes that default given its unique business risks and favor debtors or other noncreditor con- the financial risk inherent in the capital stituencies. We believe that by transparently structure that we are evaluating in our overlaying analytical judgment on top of pure default and recovery analysis.

38 www.standardandpoors.com At the outset of this process, we decon- ● Required cash interest payments (including struct the borrower’s projections to under- assumed increases to LIBOR rates on float- stand management’s general business, ing-rate debt and to the margin charged on industry, and economic expectations. Once debt obligations that have maintenance we understand management’s view, we make financial covenants); and appropriate adjustments to key economic, ● Other cash payments the borrower is either industry, and firm specific factors to simulate contractually or practically obligated to the most likely path to a payment default. pay that are not already captured as an expense on the borrower’s income state- Forecasting profitability and/or ment. (Lease payments, for example, are cash flow at default accounted for within free cash flow and, The simulated default scenario is our assess- thus, are not considered a fixed charge.) ment of the borrower’s most likely path to a The insolvency proxy at the point of pro- payment default. The “insolvency proxy” is jected default may be greater than 1.0x in a the point along that path at which we expect few special circumstances: the borrower to default. In other words, the ● For “strategic” bankruptcy filings, when insolvency proxy is the point at which funds a borrower may attempt to take advan- available plus free cash flow is insufficient to tage of the insolvency process primarily pay fixed charges: to obtain relief from legal claims or onerous contracts; ● When a borrower may rationally be expected (Funds available + Free cash flow) / Fixed to retain a greater amount of cash (e.g., to charges <= 1.0 prepare for a complex, protracted restructur- ing; if it is in a very capital-intensive industry; The terms in this equation are defined as: or if it is in a jurisdiction that does not allow Funds available. The sum of balance sheet for super-priority standing for new credit in a cash and revolving credit facility availability (in post-petition financing); and excess of the minimal amount a company needs ● When a borrower’s financial covenants to operate its business at its seasonal peak). have deteriorated beyond the level at Free cash flow. EBITDA in the year of which even the most patient lender could default, less a minimal level of required tolerate further amendments or waivers. maintenance capital expenditures, less cash (Lenders with no financial maintenance taxes, plus or minus changes in working cap- covenants have effectively surrendered this ital. For default modeling and recovery esti- option and have reduced their ability to mates, our EBITDA and free cash flow influence company behavior.) estimates ignore noncash compensation Conversely, free cash flow may decline expenses and do not use Standard & Poor’s below the insolvency proxy when the bor- adjustments for operating leases. rower’s operating performance is expected to Fixed charges. The sum, in the year of continue to deteriorate due to cyclicality or default, of: business model contraction resulting from the ● Scheduled principal amortization (We gen- competitive and economic conditions assumed erally do not include “bullet” or “balloon- in the simulated default scenario. In any ing” maturities as fixed charges, as lenders event, our analysis will identify the level of typically would expect such amounts to be cash flow used as the basis for our valuation. refinanced and would presumably be reluc- tant to force a company into default that Determining valuation can otherwise comfortably service its fixed charges. Consequently, our default and To help us determine an appropriate valuation recovery modeling will typically assume for a company (given our simulated default that additional business and cash flow dete- scenario), we may consider a variety of valua- rioration is necessary to trigger a default.); tion methodologies, including market multi- ples, discounted cash flow (DCF) modeling,

Standard & Poor’s ● A Guide To The Loan Market September 2011 39 Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

and discrete asset analysis. The market multi- comparable firms because these are generally ples and DCF methods are used to determine more numerous. With transaction multiples, a company’s enterprise value as a going con- we try to use forward multiples (purchase cern. This is generally the most appropriate price divided by projected EBITDA) rather approach when our simulated default and than trailing multiples (purchase price divided recovery analysis indicates that the borrower’s by historical EBITDA). This is because we reorganization (or the outright sale of the believe that forward multiples, which are gen- ongoing business or certain segments) is the erally lower because they incorporate the ben- most likely outcome of an insolvency proceed- efit of perceived cash flow synergies used to ing. We use discrete asset valuation most often justify the purchase price, provide a more for industries in which this valuation appropriate reference point. In addition, approach is typically used, or when the simu- “trading” multiples for publicly traded firms lated default scenario indicates that the bor- can be useful because they allow us to track rower’s liquidation is the most likely outcome how multiples have changed over economic of insolvency. In addition, we may use a com- and business cycles. This is especially relevant bination of the discrete and enterprise valua- for cyclical industries and for sectors entering tion methods when we believe that a company a different stage of development or experienc- will reorganize, but that its debt and organi- ing changing competitive conditions. zational structure provides certain creditors A selection of multiples helps match our with priority claims against particular assets valuation with the conditions assumed in our or subsidiaries. For example, Standard & simulated default scenario. For example, a Poor’s will consider whether a company’s firm projected to default in a cyclical trough decision to securitize or not securitize material may warrant a higher multiple than one assets impacts the value available to distribute expected to default at a cyclical midpoint. to other creditors. Furthermore, two companies in the same Market multiples. The key to valuing a industry may merit meaningfully different firm using a market multiples approach is to multiples if their simulated default scenarios select appropriate comparable companies, or are very different. For example, if one is “comps.” The analysis should include several highly levered and at risk of default from rel- comps that are similar to the firm being val- atively normal competitive stresses while the ued with respect to business lines, geographic other is unlikely to default unless there is a markets, margins, revenue, capital require- large unexpected fundamental deterioration ments, and competitive position. Of course, in the cash flow potential of the business an ideal set of comps does not always exist, model (which could make historical sector so analytical judgment is often required to multiples irrelevant). adjust for differences in size, business pro- Our multiples analysis may also consider files, and other attributes. In addition, in the alternative industry specific multiples—such as context of a recovery analysis, our multiples subscribers, hospital beds, recurring revenue, must consider the competitive and economic etc.—where appropriate. Alternatively, such environments assumed in our simulated metrics may serve as a check on the soundness default scenario, which are often very differ- of a valuation that relied on an EBITDA mul- ent than present conditions. As a result, our tiple, DCF, or discrete asset approach. analysis strives to consider a selection of mul- Discounted cash flow (DCF). Standard & tiples and types of multiples. Poor’s DCF valuation analysis for recovery Ideally, we are interested in multiples for analytics generally uses a three-stage model. similar firms that have reorganized due to cir- The first stage is the simulated default sce- cumstances consistent with our simulated nario; the second stage is the period during default scenario. In practice, however, the insolvency; and the third stage represents the existence of such “emergence” multiple comps long-term operating performance of the reor- is rare. As a result, our analysis often turns to ganized firm. Our valuation is based on the “transaction” or “purchase” multiples for third stage, which typically values a company

40 www.standardandpoors.com using a perpetuity growth formula, which would allow the company to fully draw the contemplates a long-term steady-state growth facility in a simulated default scenario. For rate deemed appropriate for the borrower’s letters of credit, especially those issued under business. However, the third stage may also dedicated synthetic letter of credit tranches, include specific annual cash flow forecasts for we will assess whether these contingent obli- a period of time following reorganization gations are likely to be drawn following before assigning a terminal value through the default. Our estimate of debt outstanding at perpetuity growth formula. In any case, the default also includes an estimate of pre-peti- specifics underlying our cash flow forecast tion interest, which is calculated by adding six and valuation are outlined in Standard & months of interest (based on historical data Poor’s recovery reports. from Standard & Poor’s LossStats® database) Discrete asset valuation. We value the rele- to our estimated principal amount at default. vant assets by applying industry- and asset- The inclusion of pre-petition interest makes specific advance rates in conjunction with our recovery analysis more consistent with third-party appraisals (when we are provided regulatory credit risk capital requirements. with the appraisals). Our analysis focuses on the recovery prospects for the debt instruments in a com- Identifying and estimating the pany’s current or pro forma debt structure, value of debt and nondebt claims and generally does not make estimates for After valuing a company, we must then iden- other debt that may be issued prior to a tify and quantify the debt obligations and default. We feel that this approach is prudent other material liabilities that would be and more relevant to investors because the expected to have a claim against the company amount and composition of any additional following default. Potential claims fall into debt (secured, unsecured, and/or subordi- three broad categories: nated) may materially impact lender recovery ● Principal and accrued interest on all debt rates, and it is not possible to know these par- outstanding at the point of default, ticulars in advance. Further, incremental debt whether issued at the operating company, added to a company’s capital structure may subsidiary, or holding company level; materially affect its probability of default, ● Bankruptcy-related claims, such as debtor- which, in turn, could impact all aspects of our in-possession (DIP) financing and adminis- recovery analysis (i.e., the most likely path to trative expenses for professional fees and default, valuation given default, and loss given other bankruptcy costs; default). Consequently, changes to a com- ● Other nondebt claims such as taxes pany’s debt structure are treated as events that payable, certain securitization programs, require a reevaluation of our default and trade payables, deficiency claims on recovery analysis. This is a key aspect of our rejected leases, litigation liabilities, and ongoing surveillance of our default and recov- unfunded post-retirement obligations. ery ratings. We do, however, make some Our analysis of these claims and their exceptions to this approach. Such exceptions potential values strives to consider each bor- will be outlined in our recovery reports and rower’s particular facts and circumstances, as generally fall under two categories: well as the expected impact on the claims as ● Permitted, but uncommitted, incremental a result of our simulated default scenario. debt may be included as part of our default We estimate debt outstanding at the point and recovery analysis if this is consistent of default by reducing term loans by sched- with our expectations and our underlying uled amortization paid prior to our simulated corporate credit rating on a given issuer. default and by assuming that all committed ● Our default and recovery analysis may debt, such as revolving credit facilities and assume the repayment of near-term debt delayed draw term loans, is fully funded. For maturities if the company is expected to asset-based lending (ABL) facilities, we will retire these obligations and has the liquidity consider whether the borrowing base formula to do so. Similarly, principal prepayments—

Standard & Poor’s ● A Guide To The Loan Market September 2011 41 Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

whether voluntary or part of an excess collateral value is insufficient to fully cover a cash flow sweep provision—may be consid- secured claim, the uncovered amount or ered for certain credits when deemed “deficiency balance” will be pari passu with appropriate. Otherwise, we generally all other senior unsecured claims. assume that debt that matures prior to our ● Structural issues and contractual agree- simulated default date is rolled over on ments can also alter the priority of certain similar terms but at current market rates. claims relative to each other or to the value Our analytical treatment and estimates for attributable to specific assets or entities in bankruptcy-related and other nondebt claims an organization. in default is generally specific to the laws and As a result of these caveats, the recovery customs of the jurisdictions involved in our prospects for different debt instruments of the simulated default scenario. Please refer to same type (whether they be senior secured, sen- Appendix 1 for a review of our approach and ior unsecured, senior subordinated, etc.) might methodology for these claims in the U.S. be very different, depending on the structure of the transactions. While the debt type of an Determining distribution of value instrument may provide some indication as to The distribution follows a “waterfall” its relative seniority, it is the legal structure and approach that reflects the relative seniority of associated terms and conditions that are the the claimants and will be specific to the laws, ultimate arbiter of priority. Consequently, a customs, and insolvency regime practices for fundamental review of a company’s debt and the relevant jurisdictions for a company. For legal entity structure is required to properly example, the quantification and classification evaluate the relative priority of claimants. This of bankruptcy-related and nondebt claims for requires an understanding of the terms and insolvencies outside of the U.S. might be very conditions of the various debt instruments as different from the methodology for U.S. they pertain to borrower and guarantor rela- Industrials companies discussed in the tionships, collateral pledges and exclusions, Appendix. Furthermore, local laws and cus- facility amounts, covenants, and debt maturi- toms may warrant deviations from the water- ties. In addition, we must understand the fall distribution we follow in the U.S. Where breakout of the company’s cash flow and assets relevant, we will publish our guidelines and as it pertains to its legal organizational struc- rationale for these differences before rolling out ture and consider the effect of key jurisdic- our unsecured recovery ratings in these juris- tional and intercreditor issues. dictions. In the U.S., our general assumption of Key structural issues to explore include the relative priority of claimants is as follows: identifying: ● ● Super-priority claims, such as DIP financing, Higher priority liens on specific assets by ● Administrative expenses, forms of secured debt such as mortgages, ● Federal and state tax claims, industrial revenue bonds, and ABL facilities; ● ● Senior secured claims, Non-guarantor subsidiaries (domestic or ● Junior secured claims, foreign) that do not guarantee a com- ● Senior unsecured claims, pany’s primary debt obligations or provide ● Subordinated claims, asset pledges to support the company’s ● Preferred stock, secured debt; ● ● Common stock. Claims at non-guarantor subsidiaries that However, this priority of claims is subject will have a higher priority (i.e., a “struc- to two critical caveats: turally superior”) claim on the value ● The beneficial position of secured creditor related to such entities; claims, whether first-priority or otherwise, is ● Material exclusions to the collateral pledged valid only to the extent that the collateral to secured lenders, including the lack of supporting such claims is equal to, or greater asset pledges by foreign subsidiaries or the than, the amount of the claim (including absence of liens on significant domestic higher priority and pari passu claims). If the assets, including the stock of foreign or

42 www.standardandpoors.com domestic non-guarantor subsidiaries that remains after satisfying the structurally (whether due to concessions demanded by superior claims would be available to satisfy and granted to the borrower, poor transac- other creditors of the entities that own these tion structuring, regulatory restrictions, or subsidiaries. Well-structured debt will often limitations imposed by other debt inden- include covenants to restrict the amount of tures); and structurally superior debt that can be placed at ● Whether a company’s foreign subsidiaries such subsidiaries. Furthermore, well-structured are likely to file for bankruptcy in their secured debt will take a lien on the stock of local jurisdictions as part of the default and such subsidiaries to ensure a priority interest restructuring process. in the equity value available to support other The presence of obligations with higher-pri- creditors. In practice, the pledge of foreign ority liens on certain assets means that the subsidiary stock owned by U.S. entities is usu- enterprise value available to other creditors ally limited to 65% of voting stock for tax must be reduced to account for the distribution reasons. The residual value that is not cap- of value to satisfy these creditors first. In most tured by secured lenders through stock pledges instances, asset-specific secured debt claims would be expected to be available to all senior (such as those previously listed) are structured unsecured creditors on a pro rata basis. to ensure full collateral coverage even in a The exclusion of other material assets (other default scenario. As such, our analysis will typi- than whole subsidiaries or subsidiary stock) cally reduce the enterprise value by the amount from the collateral pledged to support secured of these claims to determine the remaining debt must also be incorporated into our analy- enterprise value available for other creditors. sis. The value of such assets is typically deter- That said, there may be exceptions that will be mined using a discrete asset valuation considered on a case-by-case basis if the approach, and our estimated value and related amounts are material. Well-structured secured assumptions will be disclosed in our recovery bank or bond debt that does not have a first report as appropriate. We expect the value of lien on certain assets will get second-priority excluded assets would be shared by all senior liens on assets that are significant and may have unsecured creditors on a pro rata basis. meaningful excess collateral value. For exam- An evaluation of whether foreign sub- ple, this is often the case when secured debt col- sidiaries would also be likely to file for bank- lateralized by a first lien on all noncurrent ruptcy is also required, because this would assets also takes a second-priority lien on work- likely increase the cost of the bankruptcy ing capital assets that are already pledged to process and create potential multijurisdic- support an asset-based revolving credit facility. tional issues that could impact lender recov- Significant domestic or foreign non-guaran- ery rates. The involvement of foreign courts tor entities must be identified because these in a bankruptcy process presents a myriad of entities have not explicitly promised to repay complexities and uncertainties. For these the debt. Thus, the portion of enterprise value same reasons, however, U.S.-domiciled bor- derived from these subsidiaries does not rowers that file for bankruptcy seldom also directly support the rated debt. As a result, file their foreign subsidiaries without a spe- debt and certain nondebt claims at these sub- cific benefit or reason for doing so. sidiaries have a structurally higher priority Consequently, we generally assume that for- claim against the subsidiary value. eign subsidiaries of U.S. borrowers do not file Accordingly, the portion of the company’s for bankruptcy unless there is a compelling enterprise value stemming from these sub- reason to assume otherwise, such as a large sidiaries must be estimated and treated sepa- amount of foreign debt that needs to be rately in the distribution of value to creditors. restructured to enable the company to emerge This requires an understanding of the break- from bankruptcy. When foreign subsidiaries out of a company’s cash flow and assets. are expected to file bankruptcy, our analysis Because these subsidiaries are still part of the will be tailored to incorporate the particulars enterprise being evaluated, any equity value of the relevant bankruptcy regimes.

Standard & Poor’s ● A Guide To The Loan Market September 2011 43 Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

Intercreditor issues may affect the distri- would succeed in persuading the court to do bution of value and result in deviations so. As such, our analysis does not evaluate from “absolute priority” (i.e., maintenance the likelihood of substantive consolidation, of the relative priority of the claims, subject though we acknowledge that this risk could to structural and contractual considera- affect recoveries in certain cases. tions, so that a class of claims will not receive any distribution until all classes Assigning recovery ratings above it are fully satisfied), which is We estimate recovery rates by dividing the assumed by Standard & Poor’s methodol- portion of enterprise or liquidation value pro- ogy. In practice, however, Chapter 11 bank- jected to be available to cover the debt to ruptcies are negotiated settlements and the which the recovery rating applies, by the esti- distribution of value may vary somewhat mated amount of debt (principal and pre- from the ideal implied by absolute priority petition interest) and pari passu claims for a variety of intercreditor reasons, outstanding at default. We then map the including, in the U.S., “accommodations” recovery rate to our recovery rating chart to and “substantive consolidation.” determine the issue and recovery ratings. Accommodations refer to concessions Standard & Poor’s accompanies its recovery granted by senior creditors to junior ratings with written recovery reports, which claimants in negotiations to gain their identify the simulated payment default, valua- cooperation in a timely restructuring. We tion assumptions, and other factors on which generally do not explicitly model for the recovery ratings are based. This disclosure accommodations because it is uncertain is intended to improve the utility of our whether any concessions will be granted, if analysis by providing investors with more those granted will ultimately have value information with which to evaluate our con- (e.g., warrants as a contingent equity clusions and to allow them to consider differ- claim), or whether the value will be mate- ent assumptions as they deem appropriate. rial enough to meaningfully affect our pro- jected recovery rates. Surveillance of recovery ratings Substantive consolidation represents a After our initial analysis at debt origination, potentially more meaningful deviation from we monitor material changes affecting the the distribution of value according to borrower and its debt and liability structure absolute priority. In a substantive consolida- to determine if the changes might also alter tion, the entities of a corporate group may be creditor recovery prospects. This is essential treated as a single consolidated entity for the given the dynamic nature of credit in general purposes of a bankruptcy reorganization. and default and recovery modeling in particu- This effectively would eliminate the credit lar. Therefore, a fundamental component of support provided by unsecured guarantees or recovery analysis is periodic and event spe- the pledge of intercompany loans or sub- cific surveillance designed to monitor devel- sidiary stock, and dilutes the recovery oping risk exposures that might affect prospects of creditors that relied on these fea- recovery. Any material changes to our default tures to the benefit of those that did not. and recovery ratings or analysis will be dis- Even the threat of substantive consolidation closed in updates to our recovery reports. may result in a negotiated settlement that Factors that could impact our default and could affect recovery distribution. While sub- recovery analysis or ratings include: stantive consolidation can meaningfully ● Acquisitions and divestitures; impact the recovery prospects of certain cred- ● Updated valuation assumptions; itors, it is a discretionary judicial doctrine ● Shifts in the profit and cash flow contri- that is only relevant in certain situations. It is butions of borrower, guarantor, or non- difficult to predict whether any party would guarantor entities; seek to ask a bankruptcy court to apply it in ● Changes in debt or the exposure to non- a specific case, or the likelihood that party debt liabilities;

44 www.standardandpoors.com ● Intercreditor dynamics; and to consider disaggregated analyses for proba- ● Changes in bankruptcy law or case histories. bility of default and recovery given default. We also believe our recovery analysis may provide investors insight into how a com- Conclusion pany’s debt and organizational structure may We believe that our recovery ratings are bene- affect recovery rates. ● ficial because they allow market participants

Standard & Poor’s ● A Guide To The Loan Market September 2011 45 Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

Appendix: U.S. Industrials Analysis Of Claims And Estimation Of Amounts

This appendix covers Standard & Poor’s ana- prospects by allowing companies to restruc- lytical considerations regarding the treatment ture their operations and preserve the value of bankruptcy-specific and other nondebt of their business. As a result of these uncer- claims in our default and recovery analysis of tainties, estimating the impact of a DIP facil- U.S.-domiciled Industrials borrowers. Our ity is generally beyond the scope of our approach endeavors to consider the bor- analysis, even though we recognize that DIP rower’s particular facts and circumstances, as facilities may materially impact recovery well as the expected impact on the claims as prospects in certain cases. a result of the simulated default scenario. Administrative expenses. Administrative Still, the potential amount of many of these expenses relate to professional fees and other claims is highly variable and difficult to pre- costs associated with bankruptcy that are dict. In addition, these claims are likely to required to preserve the value of the estate disproportionately affect the recovery and complete the bankruptcy process. These prospects of unsecured creditors because costs must be paid prior to exiting bank- most of these claims would be expected to ruptcy, making them effectively senior to be classified as general unsecured claims in those of all other creditors. The dollar bankruptcy. This contributes to the histori- amount and materiality of administrative cally higher standard deviation of recovery claims usually correspond to the company’s rates for unsecured lenders (relative to size and the complexity of its capital struc- secured lenders). ture. We expect that these costs will be less While these issues make projecting recov- for simple capital structures that can usually ery rates for unsecured debt challenging, we negotiate an end to a bankruptcy quickly and believe that an understanding of the analytical may even use a pre-packaged bankruptcy considerations related to these claims can help plan. Conversely, these costs are expected to investors make better decisions regarding an be greater for large borrowers with complex investment’s risks and recovery prospects. Our capital structures where the insolvency recovery reports endeavor to comment on our process is often characterized by protracted assumptions regarding the types and amounts multiple party disputes that drive up bank- of the claims as appropriate. ruptcy costs and diminish lender recoveries. When using an enterprise value approach, Bankruptcy-specific priority claims our methodology estimates the value of these Debtor in possession financing. DIP facilities claims as a percentage of the borrower’s are usually super-priority claims that enjoy emergence enterprise value as follows: repayment precedence over unsecured debt ● Three percent for capital structures with and, often, secured debt. However, it is one primary class of debt; exceedingly difficult to accurately quantify ● Five percent for two primary classes of the size or likelihood of DIP financing or to debt (first- and second-lien creditors may forecast how DIP financing may affect the be adversaries in a bankruptcy proceeding recovery prospects for different creditors. and are treated as separate classes by This is because the size or existence of a theo- Standard & Poor’s); retical DIP commitment is unpredictable, DIP ● Seven percent for three primary classes of borrowings at emergence may be substan- debt; and tially less than the DIP commitment, and ● Ten percent for certain complex capital such facilities may be used to fully or par- structures. tially repay some pre-petition secured debt. When using a discrete asset valuation Furthermore, the presence of DIP financing approach, these costs may be implicitly might actually help creditor recovery accounted for in the orderly liquidation value discounts used to value a company’s assets.

46 www.standardandpoors.com Other nondebt claims estimates for these claims will be disclosed in Taxes. Various U.S. government authorities our recovery reports. successfully assert tax claims as either admin- Regulatory and litigation claims. These istrative, priority, or secured claims. However, claims are fact- and borrower-specific and are it is very difficult to project the level and sta- expected to be immaterial for the vast major- tus of such claims at origination (e.g., tax dis- ity of issuers. For others, however, they may putes en route to default are extremely hard play a significant role in our simulated to predict). We also expect that, while such default scenario and represent a sizable liabil- claims will normally be paid before senior ity that impairs the recovery prospects of secured claims, their overall amount is sel- other creditors. Borrowers that fall into this dom material enough to impact lender recov- category may be in the tobacco, chemical, eries. Therefore, we acknowledge that tax building materials, environmental services, claims may indeed be priority claims, but we mining, or pharmaceutical industries. Even generally do not, at origination, reduce our within these sectors, however, we are most expectation for lenders’ recovery by estimat- likely to factor these issues into our analysis ing the amount of potential tax claims. in a meaningful way when a borrower is Swap termination costs. The Bankruptcy either already facing significant exposure to Code accords special treatment for counter- these liabilities or is unlikely to default with- parties to financial contracts, such as swaps, out a shock of this type to its business (such repurchase agreements, securities contracts, as a high speculative-grade-rated company and forward contracts, to ensure continuity with low to moderate leverage and relatively in the financial markets and to avoid systemic stable cash flow). risk (so long as both the type of contract and After determining whether it is reasonable the type of counterparty fall within certain to include such claims in our default and statutory provisions). In addition to not being recovery analysis, we are left with the chal- subject to the automatic stay that generally lenge of sizing the claims and determining precludes creditors from exercising their how they might impact creditor recovery remedies against the debtor, financial contract prospects. Unfortunately, the case history is counterparties have the right to liquidate, ter- very limited in this area and does not offer minate, or accelerate the contract in a bank- clear guidelines on how to best handle these ruptcy. Most currency and interest rate swaps inherent uncertainties. As such, we tailor our related to secured debt are secured on a pari approach on a case-by-case basis to the bor- passu basis with the respective loans. Other rower’s specific circumstances to help us reach swaps are likely to be unsecured. While we an appropriate solution. When significant, our acknowledge the potential for such claims, approach and assumptions will be outlined in quantifying such claims will usually be our recovery report so that investors can eval- impractical and beyond the scope of our uate our treatment, and consider alternative analysis at origination. That said, making assumptions if desired, as part of their invest- estimates for these claims may be more prac- ment decision. We note that claims in this cat- tical in surveillance as a company approaches egory would typically be expected to have bankruptcy and the potential impact of these general unsecured status in a bankruptcy, types of claims becomes clearer. although they may remain ongoing costs of a Cash management obligations. Obligations reorganized entity and thus reduce the value under automated clearing house programs available to other creditors. and other cash management services provided Securitizations. Standard accounts receivable by a borrower’s banks may be incremental to securitization programs involve the sale of cer- its exposure to its bank lenders under its tain receivables to a bankruptcy-remote special credit facilities. In some cases, these obliga- purpose entity in an arms length transaction tions may be material and may be secured on under commercially reasonable terms. The a pari passu basis by the bank collateral. assets sold are not legally part of the debtor’s When we are aware of these situations, our estate (although in some circumstances they

Standard & Poor’s ● A Guide To The Loan Market September 2011 47 Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

may continue to be reported on the company’s the company’s normal working capital cycle balance sheet for accounting purposes), and (and, thus, are already accounted for in our the securitization investors are completely valuations using market multiples or DCF). reliant on the value of the assets they pur- For firms expected to liquidate, an estimate chased to generate their return. As a result, the of accounts payable will be made, with the securitization investors do not have any amount treated as an unsecured claim. recourse against the estate, although the sale Leases. U.S. bankruptcy law provides com- of the assets may affect the value available to panies the opportunity to accept or reject other creditors. When a discrete asset valua- leases during the bankruptcy process (for tion approach is used and the sold receivables commercial real property leases, the review continue to be reported on the company’s bal- period is limited to 210 days, including a ance sheet, we will consider the securitized one-time 90-day extension, unless the lessor debt from such programs to be a secured claim agrees to an extension). If a lease is accepted, with priority on the value from the receivables the company is required to keep rent pay- within the securitization. ments on the lease current, meaning that Securitizations may also be in the form of a there will be no claim against the estate. This future flow-type structure, which securitizes also allows the lessee to continue to use the all or a portion of the borrower’s future rev- leased asset, with the cash flow (i.e., value) enue and cash flow (typically related to par- derived from the asset available to support ticular contracts, patents, trademarks, or other creditors. other intangible assets), would have a claim If a lease is rejected, the company must dis- against our estimated valuation. Such transac- continue using the asset, and the lessor may tions effectively securitize all or a part of the file a general unsecured claim against the borrower’s future earnings, and the related estate. As a result, we must estimate a reason- claims would have priority claim to the value able lease rejection rate for the firm given the stemming from the securitized assets. This types of assets leased, the industry, and our claim would diminish the enterprise value simulated default scenario. Leases are typi- available to other corporate creditors. Such cally rejected for one of three reasons: transactions are typically highly individual- ● The lease is priced above market rates; ized, and the amount of the claims and the ● The leased asset is generating negative or value of the assets in our simulated default insufficient returns; or analysis are evaluated on a case-by-case basis. ● The leased asset is highly vulnerable to Trade creditor claims. Typically, trade cred- obsolescence during the term of the lease. itor claims are unsecured claims that would Our evaluation may ballpark the rejection rank pari passu with a borrower’s other unse- rate by assuming it matches the percentage cured obligations. However, because a bor- decline in revenue in our simulated default rower’s viability as a going concern hinges scenario or, if applicable, by looking at com- upon continued access to goods and services, mon industry lease rejection rates. If leases are many pre-petition claims are either paid in material, we may further evaluate whether the ordinary course or treated as priority our knowledge of a company’s portfolio of administrative claims. This concession to crit- leased assets is likely to result in a higher or ical trade vendors ensures that they remain lower level of unattractive leases (and rejec- willing to carry on their relationships with tions) in a default scenario. For example, if a the borrower during the insolvency proceed- company’s leased assets are unusually old, ings, which preserves the value of the estate underutilized, or priced above current market and enhances the recovery prospects for all rates, then a higher rejection rate may be war- creditors. Consequently, our analysis does not ranted. In practice, this level of refinement in make an explicit estimate for trade creditor our analysis will be most relevant when a claims in bankruptcy for companies that are company has a substantial amount of lease expected to reorganize, but rather, it assumes obligations and a significant risk of near-term that these costs continue to be paid as part of default. Uneconomical leases that are

48 www.standardandpoors.com amended through renegotiation in bankruptcy cation of retiree benefits. Because these types are considered to be rejected. of employee arrangements are not common in In bankruptcy, the amount of unsecured many industries, these liabilities would only claims from rejected leases is determined by be relevant for certain companies. Where rel- taking the amount of lost rental income and evant, the key issue is whether these obliga- subtracting the net value available to the lessor tions are likely to be renounced or changed by selling or re-leasing the asset in its next best after default, since no claim results if they are use. However, the deficiency claims of com- unaltered. Of course, employment-related mercial real estate lessors is further restricted claims are more likely to arise when a com- to the greater of one year’s rent or 15% of the pany is at a competitive disadvantage because remaining rental payments not to exceed three of the costs of maintaining these commit- years’ rent. Lessors of assets other than com- ments. Even then, some past bankruptcies mercial real property do not have their poten- suggest that some companies may not use the tial deficiency claims capped, but such leases bankruptcy process to fully address these are generally not material and are usually for problems. What is clear, however, is that relatively short periods of time. With these employment-related claims may significantly issues in mind, Standard & Poor’s quantifies dilute recoveries for the unsecured creditors lease deficiency claims for most companies by of certain companies and that these risks are multiplying their estimated lease rejection rate most acute for companies that are grappling by three times their annual rent. with burdensome labor costs. To reflect this However, there are a few exceptions to our risk, we are likely to include some level of general approach. Deficiency claims for leases employment-related claims for companies of major transportation equipment (e.g., air- where uncompetitive labor or benefits costs craft, railcars, and ships) are estimated on a are a factor in our simulated default scenario. case-by-case basis, with our assumptions dis- Collective bargaining agreement rejection closed in our recovery reports. This is neces- claims. A borrower that has collective bargain- sary because these lease obligations do not ing agreements (CBA), including above-market have their claims capped, may be longer wages, benefits, or work rules, is likely to seek term, and are typically for substantial to reject these contracts in a bankruptcy. In amounts. In addition, we use a lower-rent order to reject a CBA, the borrower must multiple for cases in which a company relies establish, and the bankruptcy court must find primarily on very short-term leases (three that the borrower has proposed, modifications years or less). Furthermore, we do not to the CBA that are necessary for its successful include any deficiency claim for leases held reorganization. In addition, the court must by individual asset-specific subsidiaries that find that all creditors and affected parties are do not have credit support from other entities treated fairly and equitably, that the borrower (by virtue of guarantees or co-lessee relation- has bargained fairly with the relevant union, ships) due to the lack of recourse against that the union rejected the proposal without other entities and the likelihood that these good cause, and that equity considerations subsidiaries are likely to be worthless if the clearly favor rejection. Proceedings to reject a leases are rejected. This situation was relevant CBA typically result in a consensual reduction in many of the movie exhibitor bankruptcies in wages and benefits, and modified work in the early 2000 time period. rules under a replacement or modified agree- Employment-related claims. Material unse- ment prior to the bankruptcy court’s decision cured claims may arise when a debtor rejects, on the motion to reject. terminates, or modifies the terms of employ- If a CBA were rejected, the affected ment or benefits for its current or retired employees would have unsecured claims for employees. Principally, these claims would damages that would be limited to one year’s arise from the rejection of labor contracts, compensation plus any unpaid compensa- the voluntary or involuntary termination of tion due under the CBA. However, if a CBA defined benefit pension plans, or the modifi- were modified through negotiation without

Standard & Poor’s ● A Guide To The Loan Market September 2011 49 Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

rejection, the damages for lost wages and care benefits, or benefits in the event of sick- benefits and modified work rules may not ness, accident, disability, or death. The be limited to this amount. requirements for modifying these benefits Pension plan termination claims. The abil- for plans covered under a union contract ity to terminate a defined benefit pension during bankruptcy are similar to the require- plan is provided under the U.S. Employee ments for the rejection of a CBA, but they Retirement Income Security Act (ERISA). may be modified by order of the bankruptcy Under ERISA, these plans may be terminated court without rejecting the plan or program voluntarily by the debtor as the plan sponsor, under which the benefits are provided in its or involuntarily by the Pension Benefit entirety. However, these obligations are Guaranty Corp. (PBGC) as the agency that often amended prior to bankruptcy for com- insures plan benefits. Typically, any termina- panies that are placed at a competitive dis- tion during bankruptcy will be a “distress ter- advantage because of these costs. As such, mination,” in which the plan assets are, or we must consider whether the borrower has would be, insufficient to pay benefits under modified, or is likely to modify, the benefits the plan. However, the bankruptcy of the prior to bankruptcy. plan sponsor does not automatically result in In the case of benefits provided to employ- the termination of its pension plans, and even ees that were not represented by unions, the underfunded plans may not necessarily be ter- borrower may be able to revise the benefits minated. For example, a borrower may elect prior to bankruptcy with little or no negotia- to maintain underfunded plans, or may not tion with the retirees. For union retirees, ben- succeed in terminating a plan, if it fails to efit modifications prior to bankruptcy likely demonstrate that it would not be able to pay would occur in the context of concessions in its debts and successfully reorganize unless negotiations with the relevant union. In either the plan is terminated. case, modifications prior to bankruptcy In a distress termination, the PBGC would not result in claims in bankruptcy that assumes the liabilities of the pension plan up could dilute recoveries. If the borrower to the limits prescribed under ERISA and gets reduces its retiree benefits liability prior to an unsecured claim in bankruptcy against the bankruptcy, further modifications in bank- debtor for the unfunded benefits. The calcula- ruptcy may result in a smaller unsecured tion of this liability is based on different claim than if it had entered the proceeding assumptions than the borrower’s reported lia- with a greater liability. If we conclude that bility in its financial statements. This, in addi- the borrower will modify its retiree benefits tion to the difficulty of predicting the funded prior to bankruptcy, our recovery analysis status of a plan at some point in the future, will consider the likely effect of that modifi- complicates our ability to accurately assess cation on the borrower’s reduced benefit lia- the value of these claims. bility in bankruptcy. Conversely, if we Retiree benefits modification claims. Non- conclude that these plans will be modified in pension retiree benefits are payments to bankruptcy, but not before, then the potential retirees for medical, surgical, or hospital liability will be more significant. ●

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