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Opinion CLOs
Lenders hit by LMEs will eventually have to increase the cost of capital
by Leland Hart
Leland Hart
Partner
Warwick Capital Partners
Chipping away at what has made loans successful has a cost
Gentlemen, we have the only legal monopoly in the country and we’re f***ing it up.” Ted Turner, then owner of the Atlanta Braves, spoke those words in relation to how baseball owners were squandering their privileged position in control of the nation’s pastime and not managing it effectively.
The history of the leveraged loan market, in this case specifically the broadly syndicated loan (BSL) market, is one of gradual evolution combined with truly enviable performance. According to the JPM Loan Index, loan returns have been positive for 25 of the past 26 years. Driving this consistency are two main contributors: the floating interest rate structure and the senior position loans enjoy in a corporation’s capital structure. The seniority is the quality that has been relied upon in times of trouble and dislocation. It is also the characteristic that Ted Turner would point to today to remind this audience that we are f***ing it up.
Loans have won on liquidity and resilience
Since the advent of the syndicated loan market and the consistent institutionalisation of the buyer base, loans have become more liquid, more transparent and more understood by the various purchasing constituencies. The buyer base, including the retail market, has been conditioned to appreciate their resiliency in times of dislocation. This has been regularly attributed to the senior position in the pecking order during not just payment defaults but also during amendments, adjustments and typical corporate finance machinations.
The certainty afforded by being a senior secured lender means an investor could provide borrowers with capital at a lower cost than could a junior bond buyer. History, maths, Nelson and the rating agencies all support the difference in required risk premium of loans versus high yield bonds.
The arrival and increasing frequency of liability management exercises (LMEs — or WMDs!) is turning a semi-efficient process into one of subjectivity and uncertainty, by pitting partners within the same seniority class against one another — generally to the benefit of non-senior secured parties.
In their current form, LMEs often exist to transfer value from the most senior lending class to a subset of the senior secured lending class or more junior lending classes — as well as to the law firms creating ‘lender groups’ from thin air, and financial sponsors which historically have been the last in line to be paid during work-out scenarios.
Senior lenders are footing a bill that historically was not theirs to pick up. This is being clearly reflected in lower recovery rates for BSLs of late and will undoubtedly be reflected in increased return expectations by those investors evaluating the loan asset class. Moody’s recently reported the four-year average recovery rate has fallen to 61% from the 73% historic average. The ascribable value of a borrower before and after an LME does not change, it is a zero-sum game. But there are net winners outside of the senior secured group when the foundation is turned upside down.
Loose terms increase risk in the BSL market
While the BSL marketplace is exhibiting regressive behaviour in the LME context, it is rapidly evolving in other areas when it comes to the tools and services available to evaluate documentation/covenants, portfolio construction and trading options. The difference between managing a pool of collateral consisting of loans versus one of high yield bonds has never been smaller. Layer in the inevitable AI-related solutions to problems that don’t exist, and soon the positive relationship of loans with high yield bonds risks being whittled down to a level of insignificance.
It is only a matter of time until the rating agencies update their criteria on a loan-by-loan basis to reflect the fact that LMEs, which are born of loose documentation and willing co-conspirators, impact both the chance of a default occurring as well as the recovery rate after an incident.
This is not meant as a castigation of the investor class or blatant hypocrisy. Rather, it is a heads-up to borrowers, their counsels, underwriting banks and others that have successfully relied on the availability of efficiently priced institutional capital from the BSL market for over two decades. Chipping away at the foundation of what has made loans successful has a cost — even if it is rarely apparent during a strong market.
Hopefully the professionals involved in bringing new loans to the market will more seriously consider during the documentation phase if some of their requests are truly in the spirit of a senior secured structure — just as the buyer community needs to start pricing such flexibility into their required returns.