A torrent of refinancing activity has hit the private equity marketplace in the new year, including many loans that are covenant-lite.
Among the portfolio companies refinancing their debt are the children’s retailer
Some of the refinanced loans were negotiated as recently as November, in an indication of how quickly credit conditions have improved for borrowers.
And in some cases, the revised terms are sufficiently better for the borrower so that ratings agencies are upgrading their credit ratings. Indeed, by cutting their cost of capital and pushing out the maturity dates of the loans, the refinancings are improving the long-term prospects of the portfolio companies and potentially boosting the ultimate returns to the sponsors.
“Rates are low now. They are going to go up,” said Ronald Kahn, a managing director at the Chicago investment bank Lincoln International LLC and head of its credit advisory service. “Why not refinance now? If you’re a CFO, you’d be crazy not to.”
Certainly low rates are a factor for investors in credit; Bill Gross, co-CIO of the big bond investor PIMCO, complained in a commentary this month about low Treasury yields, urging investors instead to look at the higher returns of asset classes including bank loans and corporate high-yield bonds, which he called “safe spreads.”
Another factor is the surge of activity at the end of 2010, as dealmakers tried to close transactions before an expected 2011 increase in capital gains taxes (averted at the last minute when President Obama and Congress agreed to extend the lower rates). As a result, the new year began with more than the usual seasonal lull in deal activity, reducing the supply of borrowers in the market seeking financing.
Not everyone is sanguine about the burgeoning market in high-yield debt. Moody’s Investors Service said in a report this month that $690 billion of speculative-grade debt, including term loans and bonds issued by sponsor-backed companies, is due to mature over the next five years, including $280 billion due in 2014 alone.
The credit markets seem to be operating “‘normally,’ or close to it,” more than a year after the credit crisis eased from brutal 2008 and 2009 conditions, Moody’s said.
“However, the looming maturity wall could run into trouble if credit markets slow down,” Kevin Cassidy, a senior credit officer at Moody’s and an author of the report, said in a statement. “The sluggish economic recovery, high unemployment rate, and the possibility of rising interest rates are key risk factors, especially for lower-rated debt.”
For now, at least, that doesn’t seem to be a problem.
To get one measure of lenders’ hunger to do deals, consider the renewed popularity of covenant-lite loans. According to Thomson Reuters LPC, which covers the loan market, covenant-lite loan volume this year has already reached $4.7 billion. In all of 2010, volume totaled only $5.6 billion.
Company managers and the sponsors that back them tend to favor covenant-lite arrangements, because they give the portfolio companies more flexibility in how they use their cash. On the other hand, lenders tend to dislike such deals because they raise the risks of nonpayment.
Lenders do not expect the surge to fade anytime soon, Thomson Reuters LPC said. “If loan demand continues to outweigh supply and covenant-lite issuance continues at this same pace seen, volume for the year could be trending back to the levels we last saw in 2007 of $57 billion.”
For instance, Gymboree Corp., taken private last fall by Bain Capital, kicked off February by announcing that it planned to refinance an $820 million term loan, eliminating maintenance covenants and capital expenditure covenants and extending the maturity by three months. The price for this deal: 12.5 basis points on the loan, raising the rate to LIBOR plus 412.5 bps. On the other hand, that was offset somewhat by pricing the loan at par rather than at a slight discount.
Another portfolio company, Dunkin’ Brands—which is sponsored by a consortium including Bain Capital, The Carlyle Group and THL Partners—is pricing a six-year, $1.25 billion term loan at LIBOR plus 300-325 with a 1.25 percent Libor floor, where as recently as last November, a seven-year term loan priced at LIBOR plus 425 with a 1.5 percent Libor floor.
And Realogy Corp, a holding company for real estate agencies that is backed by Apollo Management, was able to land a $2.5 billion senior secured term loan due 2016, extended from 2013 for the price of 125 bp increase in spread to LIBOR plus 425. The new loan completed a complex restructuring of the troubled Realogy’s capital structure; in January, the company had pushed out the maturities on some of its debt and expanded the use of junior convertible notes.
As a result, Standard & Poor’s Ratings Services raised its corporate credit rating on Realogy one notch to ‘CCC,’ admittedly still a highly speculative grade, but—even so—an upgrade. As Emile Courtney, S&P’s credit analyst, said in a statement: “The upgrade reflects Realogy’s improved liquidity profile following the closing of the transactions, which decreased the level of senior secured first-lien debt in the company’s capital structure.”