the u.s. leveraged loan market - federal reserve bank of...
TRANSCRIPT
The U.S. Leveraged Loan Market Today’s drivers, tomorrow’s challenges
Meredith Coffey, LSTA
212-880-3019
Presentation Overview
Today’s Leveraged Loan Market
Tomorrow’s Regulatory Environment
What Might Happen When They Meet
2
Today’s Market
3
Setting the Stage: Federal Reserve buys assets…
And investors seek yield (and assets) elsewhere
4
0
500
1000
1500
2000
2500
3000
3500
400020
04-0
1-0
720
04-0
3-3
120
04-0
6-2
320
04-0
9-1
520
04-1
2-0
820
05-0
3-0
220
05-0
5-2
520
05-0
8-1
720
05-1
1-0
920
06-0
2-0
120
06-0
4-2
620
06-0
7-1
920
06-1
0-1
120
07-0
1-0
320
07-0
3-2
820
07-0
6-2
020
07-0
9-1
220
07-1
2-0
520
08-0
2-2
720
08-0
5-2
120
08-0
8-1
320
08-1
1-0
520
09-0
1-2
820
09-0
4-2
220
09-0
7-1
520
09-1
0-0
720
09-1
2-3
020
10-0
3-2
420
10-0
6-1
620
10-0
9-0
820
10-1
2-0
120
11-0
2-2
320
11-0
5-1
820
11-0
8-1
020
11-1
1-0
220
12-0
1-2
520
12-0
4-1
820
12-0
7-1
120
12-1
0-0
320
12-1
2-2
620
13-0
3-2
020
13-0
6-1
220
13-0
9-0
4
Fed
Ass
et
($B
ils.
)
Federal Reserve Balance Sheet
Source: Federal Reserve
Money flows into loan mutual funds…and AUM
Climbs
5 Source: Thomson Reuters LPC
Loan Mutual Fund Monthly Flows Loan Mutual Fund AUM
-1
0
1
2
3
4
5
6
7
8
9
Jan-1
2F
eb
-12
Ma
r-1
2A
pr-
12
Ma
y-1
2Jun-1
2Jul-
12
Aug-1
2S
ep-1
2O
ct-
12
No
v-1
2D
ec-1
2Jan-1
3F
eb
-13
Ma
r-1
3A
pr-
13
Ma
y-1
3Jun-1
3Jul-
13
Aug-1
3S
ep-1
3O
ct-
13
No
v-1
3
Lo
an
fu
nd
flo
ws (
$B
ils.)
0
20
40
60
80
100
120
140
160
180
Jan 2
00
7
Ma
y 2
00
7
Sep 2
007
Jan 2
00
8
Ma
y 2
00
8
Sep 2
008
Jan 2
00
9
Ma
y 2
00
9
Sep 2
009
Jan 2
01
0
Ma
y 2
01
0
Sep 2
010
Jan 2
01
1
Ma
y 2
01
1
Sep 2
011
Jan 2
01
2
Ma
y-1
2
Sep-1
2
Jan-1
3
Ma
y-1
3
Sep-1
3
Lo
an
Mu
tual F
un
d A
UM
($B
ils.)
CLO issuance climbs (but CLO AUM not moving as much)
6 Source: Thomson Reuters LPC, Citi
Monthly CLO issuance CLO AUM
0
50
100
150
200
250
300
350
Jun-11
Sep-11
Dec-11
Mar-12
Jun-12
Sep-12
Dec-12
Mar-13
Jun-13
Sep-13
CLO 1.0CLO 2.0
0
2
4
6
8
10
12
14
Jan-1
2
Feb
-12
Ma
r-1
2
Apr-
12
Ma
y-1
2
Jun-1
2
Jul-
12
Aug-1
2
Sep-1
2
Oct-
12
No
v-1
2
De
c-1
2
Jan-1
3
Feb
-13
Ma
r-1
3
Apr-
13
Ma
y-1
3
Jun-1
3
Jul-
13
Aug-1
3
Sep-1
3
Oct-
13
No
v-1
3
CL
O Issu
an
ce (
$B
ils.)
Institutional outstandings climb past Pre-Crisis
levels
7
Institutional Issuance vs. Outstandings
Source: S&P/LCD, S&P/LSTA Leveraged Loan Index
400
450
500
550
600
650
700
0
20
40
60
80
100
120
140
160
1Q
07
2Q
07
3Q
07
4Q
07
1Q
08
2Q
08
3Q
08
4Q
08
1Q
09
2Q
09
3Q
09
4Q
09
1Q
10
2Q
10
3Q
10
4Q
10
1Q
11
2Q
11
3Q
11
4Q
11
1Q
12
2Q
12
3Q
12
4Q
12
1Q
13
2Q
13
3Q
13
Iss.
($B
ils.
)
Ou
ts.
($B
ils)
Inst Loan Issuance
Inst Loan Outstandings
“Visible” demand outstrips supply by nearly $50
billion
8
Institutional Issuance vs. Outstandings
Source: S&P/LCD, S&P/LSTA Leveraged Loan Index
-50
0
50
100
150
200
250Jan-1
2
Feb
-12
Ma
r-1
2
Apr-
12
Ma
y-1
2
Jun-1
2
Jul-1
2
Aug-1
2
Sep-1
2
Oct-
12
No
v-1
2
De
c-1
2
Jan-1
3
Feb
-13
Ma
r-1
3
Apr-
13
Ma
y-1
3
Jun-1
3
Jul-1
3
Aug-1
3
Sep-1
3
Oct-
13
No
v-1
3
Am
ou
nt
($B
ils.)
Cumulative CLO/mutual fund demand
Cumulative change in outstandings
Impact on terms & conditions
9
There are more covenant lite institutional term loans
10
Covenant lite loan volume/share in the S&P/LSTA Leveraged Loan Index
Am
oun
t ($
Bils
)
Source: S&P/LSTA Leveraged Loan Index
0%
20%
40%
60%
80%
100%
0
50
100
150
200
250
300
350
400
450
500
550
600
650
Jan
-06
Ap
r-06
Jul-
06
Oct
-06
Jan
-07
Ap
r-07
Jul-
07
Oct
-07
Jan
-08
Ap
r-08
Jul-
08
Oct
-08
Jan
-09
Ap
r-09
Jul-
09
Oct
-09
Jan
-10
Ap
r-10
Jul-
10
Oct
-10
Jan
-11
Ap
r-11
Jul-
11
Oct
-11
Jan
-12
Ap
r-12
Jul-
12
Oct
-12
Jan
-13
Ap
r-13
Jul-
13
Oct
-13
Cov-lite vol
Cov-lite share
Sh
are
(%)
Covenant lite loan issuance now comprises half of new issue institutional loans – and 40% of outstanding loans
These loans do not have maintenance covenants, but do have incurrence covenants
Covenant lite loans returned because they performed well: Lower default incidence and higher recovery given default in
the crisis
New issue loans: Metrics are more bullish…
But not at 2007 levels
11
New Issue Debt/EBITDA Multiples New Issue Interest Coverage Ratio
Rat
io (
x:1)
Source: S&P/LCD/Capital IQ
2
2.5
3
3.5
4
4.5
5
5.5
6
6.5
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
1Q
-3Q
13
Debt/EBITDA of LC Lev Cos
Debt/EBITDA of LC LBOsR
atio
(x:
1)
1
1.5
2
2.5
3
3.5
4
4.5
1987
1988
1989
1990
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
1Q
-3Q
13
While debt/EBITDA multiples are climbing, coverage ratios are very strong
New issue loans: Institutional term loan spreads
Contracting, but well above pre-Crisis lows
12
BB/BB- rated institutional term loans
Source: S&P/LCD/Capital IQ
0
100
200
300
400
500
600
700
1Q
98
Ma
y-9
9Jan-0
0S
ep-0
0M
ay-0
1Jan-0
2S
ep-0
2M
ay-0
3Jan-0
4S
ep-0
4M
ay-0
5Jan-0
6S
ep-0
6M
ay-0
7Jan-0
8S
ep-0
8M
ay-0
9Jan-1
0S
ep-1
0M
ay-1
1Jan-1
2S
ep-1
2M
ay-1
3
All-i
n s
pre
ad
(b
ps)
LIBOR floor benefit
Amort OID
Straight Spread
B+/B rated institutional term loans
0
100
200
300
400
500
600
700
800
900
1000
1Q
98
Ma
y-9
9Jan-0
0S
ep-0
0M
ay-0
1Jan-0
2S
ep-0
2M
ay-0
3Jan-0
4S
ep-0
4M
ay-0
5Jan-0
6S
ep-0
6M
ay-0
7Jan-0
8S
ep-0
8M
ay-0
9Jan-1
0S
ep-1
0M
ay-1
1Jan-1
2S
ep-1
2M
ay-1
3
All-i
n s
pre
ad
(b
ps)
LIBOR Floor Benefit
Amort OID
Straight Spread
The Regulatory Environment: Risk retention & Leveraged Lending Guidance & Volcker, Oh My!
13
Risk Retention
14
CLOs are the biggest non-bank lender…
If they are no longer viable, what happens?...
Investor Market Share in Primary Institutional Loan Market
Source: S&P/Capital IQ/LCD 15
0%
10%
20%
30%
40%
50%
60%
70%
80%
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
1-3
Q1
3
Inve
sto
r p
rim
ary
mk
t sh
are
(%
)
Hedge funds/HY funds
Loan mutual funds
CLOs
Risk Retention Shutters CLOs: According to an
LSTA survey, market shrinks by more than 75%
The LSTA asked managers running 70% of U.S. CLOs whether they could manage CLOs if they were required to
retain 5% of the fair value of any new CLOs
According to the LSTA Survey, managers, who currently manage more than 500 CLOs, said they would only run
approximately 70 CLOs – in total – if the risk retention rules went into effect as originally written (left)
They estimated it would reduce the CLO market by 75% (right) …and this is before the disruptive horizontal
retention cash flow diversion language
16
509
69
0
100
200
300
400
500
600
CLOs currently under mgt How many CLOs could you doif you had to retain 5%?
0%
10%
20%
30%
40%
50%
60%
70%
80%
No Impact Shrink it 50% Shrink it 75% Stop italtogether
% o
f re
sp
on
den
ts
Impact on market's mgt
CLO managers say their
CLOs under mgt would drop 88%...
Managers estimate the overall
CLO market would shrink by 75%
Source: LSTA Manager Survey, July 2013
Without risk retention (yet), U.S. CLO formation has
recovered; European CLO formation has collapsed
U.S. CLO formation has recovered, bringing capital to U.S. companies
European CLO formation collapsed, due in part to risk retention rules
17
U.S. CLO formation has recovered European CLO formation has collapsed
Source: Thomson Reuters LPC Source: S&P/Capital IQ/LCD
0
20
40
60
80
100
120
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Jan-O
ct 20
13
U.S
. C
LO
fo
rmati
on
0
5
10
15
20
25
30
35
40
45
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Jan-N
ov
13
Eu
ro C
LO
issu
an
ce (€B
ils.
)
Performance: CLO note impairments have been all but
non-existent
Cumulative impairment rate from Jan 1996 to May 2012
Source: Moody’s Investors Service 18
Over the course of 17 years, the cumulative impairment rate of CLOs has been de minimus – less than 1.5% in
that entire time span
Losses will be lower than impairments, because impairments can include market value EOD, distressed
exchanges, etc., in addition to realized losses
Unimpaired 98.57%
Impaired 1.43%
Why should I care if the CLO market shrinks?
Scenario 1: Other credit providers do not step in… leveraged loan
market contracts…reducing availability of credit to non-IG borrowers
(particularly in the middle market)
Scenario 2: Other credit providers (such as HY bonds) do step in…but
magnitude of replacement depends on elasticity of demand… margins
increase…increasing the cost of credit to non-IG borrowers
Scenario 3: Other credit providers (such as loan mutual funds) do step
in…but this replaces match-funded investors with maturity
transforming investors…possibly increasing the volatility of the loan
asset class
19
Leveraged Lending Guidance
20
Leveraged Lending Guidance
Areas of explicit focus include (but are not limited to…)
Defining leveraged loans – leverage, purpose, HLT definition, RE secured loans, etc
Underwriting standards – delevering ability, covenants
Pipeline management
Enterprise valuation
Reporting and analytics
Risk rating loans
Deal sponsors
Stress testing
Particular areas of focus (or so we hear…)
Ability to amortize senior secured debt or 50% of all debt in 5-7 years
Covenant lite loans
Applies not just to loans held by banks, but also loans arranged (but not
held) by banks
Defining Concept (?): Banks should not underwrite loans they are not willing to hold
21
Institutional term loan pipeline being managed
tightly Institutional Loan Pipeline Below 2007 Levels…
Source: Thomson Reuters LPC 22
2007 2009 2011 2013
0
20
40
60
80
100
120
140
160
Jan
Ma
rA
pr
Jun
Aug
Oct
De
cJan
Ma
rM
ay
Jul
Sep
No
v
Feb
Apr
Jun
Aug
Oct
De
cJan
Ma
rM
ay
Jul
Sep
No
v
Feb
Apr
Jun
Aug
Oct
De
cJan
Ma
rM
ay
Jul
Sep
Oct
Feb
Apr
Jun
Jul
Sep
Pip
eli
ne (
$B
ils.
)
There definitely are more covenant lite institutional
term loans
23
Covenant lite loan volume/share in the S&P/LSTA Leveraged Loan Index
Am
oun
t ($
Bils
)
Source: S&P/LSTA Leveraged Loan Index
0%
20%
40%
60%
80%
100%
0
50
100
150
200
250
300
350
400
450
500
550
600
650
Jan
-06
Ap
r-06
Jul-
06
Oct
-06
Jan
-07
Ap
r-07
Jul-
07
Oct
-07
Jan
-08
Ap
r-08
Jul-
08
Oct
-08
Jan
-09
Ap
r-09
Jul-
09
Oct
-09
Jan
-10
Ap
r-10
Jul-
10
Oct
-10
Jan
-11
Ap
r-11
Jul-
11
Oct
-11
Jan
-12
Ap
r-12
Jul-
12
Oct
-12
Jan
-13
Ap
r-13
Jul-
13
Oct
-13
Cov-lite vol
Cov-lite share
Sh
are
(%)
Covenant lite loan issuance now comprises half of new issue institutional loans – and 40% of outstanding loans
These loans do not have maintenance covenants, but do have incurrence covenants
They returned because they performed well: Lower default incidence and higher recovery given default in the crisis
Leveraged Lending Guidance and the SNC Review
0
100
200
300
400
500
600
700
2007 2008 2009 2010 2011 2012 2013
Loss
Doubtful
Substandard
Special Mention
In the 2013 SNC Review, Classified Assets decreased, but Criticized Assets increased
This was primarily driven by an increase in Special Mention loans
SNC Review referenced the Leveraged Lending Guidance…and observed that a “focused review of leveraged loans
found material widespread weaknesses in underwriting practices, including excessive leverage, inability to amortize debt
over a reasonable period, and a lack of meaningful financial covenants.”
42% of leveraged loans were criticized
24
Criticized assets (2007-2013) Criticized assets (2012-2013)
Am
t ($
Bils
.)
Source: 2013 SNC Review
0
20
40
60
80
100
120
140
160
180
Special Mention Substandard Doubtful Loss
2012
2013
Am
t ($
Bils
.)
How might Leveraged Lending Guidance impact the
leveraged market?
Background: The HLT designation from the early 1990s helped launch
the institutional term loan market
What is happening with the market today?
Generally…mass confusion
What might ultimately happen?...
Banks figure out how to comply; the market continues?
Banks back away from leveraged lending; the leveraged finance market shrinks?
Banks back away from leveraged lending; senior secured floating rate market develops?
Banks back away from leveraged lending; non-bank originators step in?
25
…But longer term, regulation may
drive the evolution (or devolution) of
the leveraged loan market
26
Ultimately, today’s leveraged loan market is
simply responding to supply and demand
cues…