During the past two years, the LBO market has suffered through its slowest period since the early 1990s. LBO volume (completed deals) totaled $12.2 billion during the first three quarters of 2002, down 31% from the same period in 2001 and down 64% from 2000. But activity is looking up for the fourth quarter as corporate distress creates LBO opportunities. In fact, capital markets desks at the investment banks report that sponsors are as busy now as they been in at least two years.
Needless to say, the market is not poised to return to the heady days of 1999 the IPO market is not strong enough to support such frenzied activity. With so many large companies facing liquidity problems or accounting and regulatory scrutiny, however, activity has picked up significantly.
The big question is whether the financing will be there to support all of this activity. This year the high-yield market has had patches of superb liquidity, thin spreads and deep demand. It has also had some of the worst stretches that market has known since the dark days of 1991. Unfortunately, the market was looking grim as the fourth quarter opened. On the heels of four modest weekly inflows, the high-yield market suffered a $1.4 billion outflow during the last full week of September, according to AMG Data Services. With money running out of the asset class, high-yield spreads soared to levels not seen in more than 10 years. Indeed, high-yield spreads spiked during the last week of September to an 11-year high of 984 basis points over Treasurys, according to the Merrill Lynch High-Yield Master Index.
The other leg of LBO financing, the leveraged loan market, also moved into the fourth quarter on a shaky footing. Banks, of course, remain the most reluctant of investors, coming into loans only if the package of fees and other business together make the credit attractive usually at a price of 96 or 97 cents on the dollar and a spread in the Libor plus 300-350 basis point range. Even with such attractive rates, though, it’s hard to attract more than $200 million to any one credit unless there is sufficient support from European banks or arrangers willing to write big tickets. This leaves smaller, club loans in relatively good shape if you can line up the usual suspects of financial companies and banks.
But for larger loans, capacity is now almost exclusively dependent on the institutional loan market. And coming into the fourth quarter, this market was looking a little worse for wear. This is critical now with at least six big loans including QwestDex (estimated at $1.5 billion total and $700 million institutional), RR Donnelly ($1 billion total/$700 million institutional) and Vivendi’s prospective sale of Houghton Mifflin (too early for a reading) on the runway for October and November.
You need look no further than the new-issue spreads to see that market technicals, which issuers so heavily favored in the first half, deteriorated sharply in the third quarter. In June, BB/BB- institutional spreads hit a four-year low of L+248, on average. By September, the average spread for these issuers soared by 77 bps to L+325. The trend is further illustrated by the 206 bps drop in the average secondary bid for large institutional loans during the third quarter, to 97.19% of par from 99.25%.
There’s no mystery here. In recent months, and particularly in September, inflows into institutional accounts slowed considerably. Institutional loan repayments, far and away the largest component of fund flows, collapsed in September as the high-yield bond market cooled. During the month, repayments totaled just $716 million, compared to an average repayment of $4.95 billion during the first eight months of the year. Add to September’s repayment number $420 million of CLO issuance and subtract $447 million of estimated Prime fund redemptions and inflows totaled just $689 million during the month. New-issue volume easily exceeded this number by $2.4 billion in September at $3.1 billion.
In the loan market, capital markets desks reckon that institutional loan capacity is, at the outside, in the $750 million range if a great issuer brings a compelling loan to market. For loans that are less blessed, capacity is likely to be a good deal lower. And the marginal loans will likely fall by the wayside unless technicals improve.
Steve Miller is Managing Director of Portfolio Management Data