PRINT THIS PAGE Chaotic times in leveraged finance21/11/2007. Source: Nixon Peabody LLP. William D Egler 
William D Egler, counsel for business law firm Nixon Peabody, explains why private equity leverage is in a state of flux. A Chinese proverb states: 'It’s better to be a dog in a peaceful time than be a man in a chaotic period.' 'These are chaotic times in leveraged finance. If this article were to have been written six months ago, it would have been a discourse on the continuing race to the bottom (from a lender’s point of view) of the terms and conditions in a leveraged finance transaction.
'Private high yield', 'covenant lame', 'covenant lite', 'incurrence only' , 'PIK toggle': the nomenclature of laxity had become the everyday
conversation of the lender.
Of course, from a sponsor’s point of view, laxity is better termed as 'flexibility'. The holy grail of being unanswerable to the lending group (at least on financial performance) was obtainable: 'Compliance certificate? You don’t need no stinkin’ compliance certificate!' Transactions were being closed that allowed the borrower to designate operating subsidiaries to be removed from the collateral pool. Could the promissory note-only deal be far away?
As of August 2007, however, the leveraged finance market has been immersed in chaos. A dearth of investors for loans is the hallmark of the day. Is this a short-term dislocation, or is the market permanently changing?
The Sorcerer’s Apprentice
Once upon a time (about five years ago), leveraged finance was a fairly straightforward affair. A sponsor put up equity to purchase a company. A financial institution lent the money. The borrower pledged all of its assets to the senior lenders and agreed to maintain a certain level of financial performance during the term of the loan. And the markets saw these deals, and they were good.
Bankers, however, do not earn much money by making loans and collecting interest. Due to factors such as low returns in the public equity markets, vast pools of money were looking for investment opportunities. Secured debt in the leveraged finance market (or more prosaically, takeover financing for leveraged buy-outs) became an attractive investment: as the senior tranche bears interest at a floating interest rate, leveraged deals come with a built-in interest hedge.
Maintenance covenants allowed the financial performance of the borrower to be monitored. And the senior secured collateral position gave assurance that in the event of a default, there were hard assets from which the lenders might salvage (at least some of ) their investment.
The bankers began to match the surplus of funds to the need of the equity sponsors, but there were only so many institutional lenders to help funnel the pools of capital into the leveraged finance market. And so, like the sorcerer’s apprentice, the bankers summoned forth collateralized loan obligations (CLOs). By bringing together investors to soak up the excess cash floating around the capital markets, and directing that cash into the well of leveraged finance, the bankers were able to focus the surplus (cash) on the need (debt financing).
Invasion of the Body Snatchers
CLOs have become an indispensable feature of leveraged finance. In some respects, CLOs are like any other lender - they lend money based on an expected rate of return.
However, much like the pod people of the ’50s horror film, CLOs are not what they seem; nor do they need what traditional lenders need to survive. As a pool of investments, CLOs derive their value from an analysis of the assets in which they invest. After extensive testing and examination, the tranches of a CLO are structured so that they can be
rated at different levels of credit risk by the ratings agencies.
CLOs opened a new world of risk management to investors. Instead of investing in one type of industry, CLOs allowed investors looking for secured floating-rate returns to invest over a broad spectrum of industries, sectors, and economies.
Not surprisingly, as CLOs continued to multiply and increase liquidity in the leveraged finance market, sponsors and their advisors took advantage of an ever-deepening pool of cash.
As noted, the traditional leveraged finance banker monitored the financial performance of the borrower by means of financial maintenance covenants. However, CLO managers were not as interested in the maintenance and financial performance tests. As credit risk was spread over the investments in the underlying pool, the performance of any one
loan was not as material to the CLO manager as it would be to a banker that owned the loan directly.
As more money washed over the market, the sponsors were able to capitalise on the disinterest in maintenance and performance.
Ironically, it was these types of covenants that had, in part, made investing in leveraged finance transactions appealing. However, the absence of financial maintenance covenants could be overcome by structuring the CLOs so that they still had highly rated tranches. Thus,
deals with far less restrictive covenants were being closed by entities that maintained the same credit rating, even though the underlying asset class was deteriorating (at least on a comparative documentation basis) from the traditional leveraged finance model.
Never take sides against the Family
At the end of The Godfather, Michael Corleone tells his nefarious brother-in-law Carlo that 'today I settle all family business'. That day has come to the financial markets, at least those heavily dependent on structured products to boost liquidity.
In the aptly named sub-prime market for home mortgage loans, a number of funds have gone bankrupt. The ratings of even the highest tranches of such funds, in the end, meant nothing. For just as Carlo could not fool Michael, the structured products could not fool the market. Investing in assets of low quality has risks beyond what mere modeling
can show.
The financial models that underpin CLOs, and form the basis upon which the tranches are rated, are only as good as the information on which they are structured. At a time of historically low default rates for leveraged transactions, even the most dour analyst can stress test only within the bounds of currently received wisdom. Pricing and structuring of
CLOs are based on what has been famously described as 'known unknowns'.
The recent meltdown in the subprime market has cast a pall over the leveraged finance market. Much of the underlying structural analysis is being put to the test. The failure of the ratings of the tranches of the subprime funds to correctly indicate the real risk attached to such tranches has caused the money flowing into CLOs to freeze. Just as the apprentice was finally brought to heel by his sorcerer master, investors are beginning to suspect the ratings of the tranches of CLOs.
Any participant that has made money out of the ferocious competition to finance leveraged deals, will feel the lack of the CLOs’ participation in the market acutely. On the other hand, for lenders that want up-front fees and the monitoring of the financial performance of their credit risks, these could be the days of wine and roses.
Leverage - It's a good thing
In praise of leverage Archimedes remarked, 'Give me a place to stand, and I will move the Earth'. The fundamental principal of the leveraged finance market has not changed. Sponsors make money by investing their funds and using the lever of borrowed money to acquire a company.
The sponsor gets a higher return than by paying for all of the company with equity, and the lenders get up-front fees, interest, and, if all goes well, a return of their principal. Leverage works best when the 'place to stand' is terra firma. The terms and conditions of a leveraged deal are the best indicator of firmness: terms such as 'covenant lame', 'covenant lite', 'incurrence only' and 'PIK toggle' are all signs of a squishy place to stand—marsh land or worse yet potential quicksand. Whether the current market will continue to stiffen or revert back to the softening trend, only
time will tell.
Chaotic times? Indeed.
Nixon Peabody LLP is one of the largest multipractice law firms in the United States, with offices in fourteen cities and more than six hundred attorneys collaborating across fifteen major practice areas. The firm's size, diversity, and state-of-the-art information systems enable it to offer a comprehensive, integrated range of legal services to individuals and organizations of all sizes in local, state, national, and international matters. For further information please visit their website at www.nixonpeabody.com
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