How have all coupon deals evolved? –

The Recent Past:

1999-2000It was subordinated debt lenders, not borrowers, who first moved away from warrants. In the late 1990s, many weak LBO’s generated no warrant gains. Therefore, many subordinated lenders started asking for higher coupons and offered to take fewer warrants in return. Expected lender IRR’s stayed level, but coupon levels rose from 12 or 13 percent to 16 percent or higher.

2000-2001All coupon subordinated debt structures attracted sponsors because of the refinancing potential. Higher cash and PIK coupons did not reduce total available leverage (which was set by senior lenders as a multiple of EBITDA, not free cash flow.) Sponsors saw that these structures could allow low cost refinancings of high cost debt without permanent equity dilution if company performance improved (which it generally did) or if availability of senior debt improved, which in fact it did.

Fast growing publicly traded mezzanine providers, like the Business Development Companies (BDCs), promoted all coupon structures and used low prepayment premiums as an additional tool to gain market share. Since traditional mezzanine funds can only put money to work once before returning it to investors, early prepayment is a big disadvantage for those funds. Meanwhile, shareholders of publicly traded subordinated debt lenders focus almost exclusively on current yield, so capital gains from warrants and average duration of portfolio investments are less important. The more flexible providers (especially those who could recycle investments that were repaid early) used low prepayment premiums to make it much harder for traditional funds to compete.

This was a major shift. Private mezzanine providers typically speak with great pride about the superior protections that they get over holders of public high yield bonds. Yet for the first time, prepayment protection became dramatically stronger for investors in public high yield bonds than for investors in private subordinated debt or for the public shareholders of the subordinated debt oriented BDC’s!

Importantly, all-in costs of subordinated debt dropped from 19-21% to 15-18% for middle market deals.

The Present: Lower cash coupon warrant deals seem to be regaining lost marketshare. More sponsors are recognizing that all coupon subordinated debt transactions sometimes reduce total leverage available, lower potential sponsor IRR’s and hurt post-closing flexibility. Many sponsors and junior lenders are returning to a partnership mentality. Subordinated debt BDC’s and other all coupon subordinated lenders are fighting to keep market share, but more and more sponsors are seeing the benefits of the lower cash coupons of subordinated debt with warrants.

The Future:

Late 2004The massive wave of prepayments of deals done in 2001, 2002 and early 2003 will probably convince even the most yield hungry publicly traded subordinated debt lenders (or their shareholders) that it is hard to replace good assets fast enough. Without higher prepayment premiums and/or warrant gains, it will be hard for all coupon investors to earn enough dollars of profits from good deals to maintain their returns.

2005+ As the cycle matures, credit losses on subordinated debt investments will start to rise. Some major subordinated debt lenders who have relied on all coupon structures might have serious performance problems from credit losses on a relatively small number of deals. Their gains from the good deals-with no warrants and little prepayment protection-may not provide enough dollars of profit to offset the credit losses. Sponsors may choose to avoid these lenders out of concerns over lender stability.