Reinvigorated Lenders Preserve Loan Returns

After two years of letting sponsors dictate the terms of financing arrangements, lenders with capital are increasingly calling the shots. With greater ability to set the terms, active debt providers have dusted off the toolbox of 2002 and 2003 for a variety of loan pricing guarantees, including so-called “LIBOR floors” and generous flex language.

Lenders began changing their terms after the London Interbank Offered Rate, a composite benchmark rate that serves as the interest rate foundation for leveraged loans, fell to near historic lows during the last three months. New deals aren’t getting negotiated today without LIBOR floors, which set a minimum interest rate for floating-rate debt. Unclosed deals, too, are being renegotiated with LIBOR floors to pacify lenders nervous about creating a syndicate to buy up LBO-backed paper.

The fixed-bottom floors have bases between 3 percent to 4 percent, said Stephen Gaines, managing director at sell-side investment bank KPMG Corporate Finance. Meanwhile, flex language, which gives debt providers leeway to change terms on the fly to find willing buyers for new issuances, typically adds another 1 percent to 2 percent to the interest rates of senior financing packages.

Examples of LIBOR floors can be found in the financing for last month’s bankruptcy exits of auto parts makers Dana Corp. and Delphi Corp., which relied on LIBOR floors of 3.00 percent and 4.00 percent, respectively.

Deals drawn up before the New Year are also being renegotiated according to these new terms. Hellman & Friedman’s $2.7 billion buyout of Goodman Global Holdings, originally agreed to in October without a LIBOR floor, now has a floor of 3.25 percent.

A similar renegotiation took place for the October buyout of the paper and packaging assets of Boise Cascade by Aldabra 2 Acquisition Corp., a blank-check company backed by buyout firm Terrapin Partners LLC. The deal was negotiated in September without a debt commitment. A month later, Goldman Sachs Credit Partners pledged $1.18 billion in senior debt financing that included a 4.00 percent LIBOR Floor.

To buyout pros, a fixed-bottom LIBOR means more expensive debt. To lenders, however, it preserves returns on debt tied to the fluctuating benchmark interest rate. Interest rates on individual leveraged loans float based on LIBOR, which is itself based on a three-month average of global central bank interest rates. Following deep cuts from both the U.S. Federal Reserve and the Bank of England, LIBOR rates took a nosedive, plummeting from around 5.50 percent to 3.00 percent in less than 90 days. As of March 11, it hovered at 2.86 percent.

Further interest rate cuts could be on the way, as indicated by Federal Reserve Chairman Ben S. Bernanke last month. To be sure, LIBOR rates have been lower: In 2003, the benchmark rate bordered on 1.20 percent. At that time, LIBOR dropped gradually over the previous two years; this year’s three-month plummet sent lenders scrambling to save their yields.

“Investors expect absolute returns,” said Ivan Zinn, founder of hedge fund Atalaya Capital Management. “Just because LIBOR went from 5.50 to 3.00 (percent) doesn’t mean investors change those expectations.”

In addition to LIBOR floors, lenders are demanding wider flex language in order to scare up buyers for new issuances. Goodman Global’s $800 million term loan launched at LIBOR plus 375 basis points, but, in order to close, underwriters bumped up the spread to 425 basis points above LIBOR. Typical flex language on leveraged loans, even in the middle market, gives debt providers pricing leeway of 100 bps to 200 bps, sources told Buyouts.

Flex language isn’t just about increasing the pricing. There’s also structural flex language that gives the arranger discretion to let a syndicate’s buyers choose where they want to be in the capital structure.

One source at a syndication desk told Buyouts of a recent deal in which, under prior conditions, the senior debt would have been 3x EBITDA. To make the debt more appetizing to buyers, however, the debt arranger offered 2x EBITDA in a traditional senior term loan plus 1x in “last-out” senior debt. This tranche resides just below the senior debt and is secured by exactly the same assets. But it carries an interest rate 200 bps more than the regular senior tranche because it would get repaid after the traditional senior-note holders.

Debt agreements today also include more conventional structural flex language that allows a debt arranger to turn a piece of senior paper into second-lien or mezzanine notes in order to offer a higher interest rate and therefore lure a potential buyer.

Sponsors aren’t exactly tickled by the new pricing hurdles from their banks, according to Jeff Kilrea, a managing director at mid-market lender CapitalSource. “Initially it was a visceral reaction of concern,” he said.

But one buyout pro, who said he hasn’t seen a deal without some combination of lending restrictions, conceded that the newly reintroduced terms are a “a sign of the times.”—E.G.