Leveraged Loan Markets

Transcription

1 Leveraged Loan Markets Reflecting Thus Far & Themes For Investing In Debt Via Secondary Trades October 28 by Sachin Sarnobat (917)

2 Preface Over the last several years, private equity, a word that was once whispered by hushed voices has now become common parlance. The leveraged buyout boom of the last several years made kings out of private equity players, but the king-makers in this boom were the institutional, leveraged loan investors. Sadly, they are the ones who are left holding the bag after the kings abdicated with the treasury. Beginning in 23, institutional players began dominating the leveraged loan market. Cheap liquidity raised via the CLO structures was the main driver and eventually created excess supply. Innovations in the credit derivatives market led investors to believe that risk was truly being held by those who could afford it. The main impact of these developments was wafer thin credit spreads and later, loose lending standards. Concurrently with these developments, the so called decade of moderation ushered in global growth and a decoupling of the restof the world from the American growth engine. The side effect of this optimism was robust growth projections and unbridled consumer spending that supported capital spending by corporations. Asset bubbles took over and attracted additional pools of capital from the public as well as private markets. As the asset bubble burst, the 27/8 credit crisis created a wide spread dislocation in the leveraged loan market because of fundamental as well as technical reasons. This report seeks to identify some of the structural nuances and understand implications of this dislocation from a secondary debt investors standpoint. This report is divided into the following sections: Key implications of the last several years(p3) Broad investment themes (p9) How did we get here?(p13) Corporate Issuers vs. LBOs (p21) Demand & supply technical factors(p25) Spreads & recovery by sector(p29) Analysis of secondary trading data(p33) I look forward to your comments. Thank you for this opportunity. Sachin Sarnobat October 28 New York 2

3 Key Implications of The Last Several Years 3

4 1. Increase In First Lien Leverage Under-collateralization, Decreased Visibility, Value Leakage, Over-Levered Cash Flows Institutional Lenders Inadvertently Subverted The Practical Intent of Low Cost Leveraged Loans Features Practical Intent What Changed Implications Fully secured on a first lien basis Preserve value for investors even in a case of a downside scenario Depends on the lenders attestation of asset values and liquidation values Usually a cushion between the liquidation value and the amount of debt is provided Global asset bubble, inflated underlying asset values Under-collateralization Maintenance Covenants Provide investors comfortthat the borrower is adhering to its operating plan and is inline in achieving the business objectives that were outlined when the money was loaned Incase the company deviates from operating plan, investors have a hammer to force the company to come to the table and adjust/compensate investors for the increased risk Looser covenantswith greater head room Fewer covenants Covenant-lite loans Decreased visibility ofcompany operating performance for investors Lower likelihood of intervention will in advance of distress Cash Flow Sweeps Cash flowsweeps are designed to force the company to de-lever and hence minimize the principal-agent problem by providing debt discipline Creates value for junior capital as the sweeps reduce secured claims on the underlying asset over time Lower cash flow sweeps with looser step-ups Equity markets were ready and willing to provide liquidity to take private companies public Management couldnow try to take on Hail Mary projects thus increasing the risk of destroying capital Increased sponsor ownership provides incentive to use available cash flow for restricted payments, causing value leakage to debt investors Sources of equity proceeds have dried up Fraction ofthe entire capital structure Traditionally, secured first lien leveragewith maintenance covenants formed a small fraction of the capital structure This ensured that companies were able to meet maintenance covenants even with significant deviations from operating plan, but the presence of the maintenance covenants kept them on track Bond heavy structure with a small first lien loan component provided a borrower with a solid defensive structure to withstand downturns, but at the same time, optimize cost of capital by availing of cheap debt capital via leveraged loans Leveragedloans because the dominant part of the capital structure Good quality companies that are overlevered on a first lien basis Companies that needed a bond-heavy defensive, structure were now levered to the hilt with maintenance covenants 4

5 2. Lower Recovery Values & Higher Default Rates Recoveries Will Be Closer to Those for Unsecured Loans because of Under-collateralization Recovery Rates Could Between 5-6 Discounted Recovery Rates By Instrument Type ( ) Secured Unsecured Revolvers Term Loans Sr. Bonds Subordinated Bonds Historically from , nominal recoveries have been 8 and discounted recoveries have been about 7 cents on the dollar for secured term loans The difference between nominal and discounted recovery rates is the time value from the pre-petition date from when the borrower halts interest payments to the time of recovery 24 Driving Factors & Implications Loan loss varies from cycle to cycle and in this cycle will depend: Quality of loans and intrinsic credit quality Under-collateralization due to overvalued assets and over-levered cash flows Level of subordination at the time of default An increased use of asset based and nonrecourse debt has left highly liquid assets like inventory and receivables encumbered Severity of downturn Depth of current recession is expected to be worse than the previous ones and asset values will take longer to recover Expected market value of defaulted assets Lack of liquidity for buyers could force more liquidations versus bankruptcy reorganizations Maintenance covenants (or lack thereof) This cycle this aspect will determine how soon lenders will be able to intervene and prevent collateral and recovery value erosion The current loan spreads imply a average default rate of 2% at 5% recovery rates Room for significant upside if default rate are lower or recovery rate are higher or both See p37 for additional analysis Source: S&P Fixed Income Research; US Recovery Study: Liquidity Avalanche Propels Recovery Rates Into Stratosphere, February 27 Various public news sources. 5

6 3. Lax Covenant Structures Based On Bullish Projections Companies Will Need Lender Support For Amendments / Waivers Covenant Headroom Increased Year One Debt/EBITDA Headroom as a Percentage of Covenant Level for LBOs 3% 2% 1% % 24% 19% 25% 23% Effective Covenant Cushions Will Now Be Tighter Illustrative Covenant Calculations 27% 26% 23% 28% ($,mm) Yr. Yr.1 Yr.2 Yr.3 Projected EBITDA $1 $12 $132 $139 growth 2% 1% 5% Interest $5. $45. $4. $35. Projected Covenant 2.x 2.7x 3.3x 4.x Headroom or Cushion 25% 3% 35% 35% Threshold EBITDA (1) 25% $75. $84. $85.8 $9.1 Covenant Level 1.5x 1.9x 2.1x 2.6x Realistic Projected EBITDA $85 $89 $98 $13 Discount 15% 26% 26% 26% revised growth 5% 1% 5% Realistic Covenant 1.7x 2.x 2.5x 2.9x Threshold EBITDA $85 $89 $98 $13 Actual Cushion 15% 26% 26% 26% Decrease In Cushion (1%) (4%) (9%) (9%) 24% 17% Q- 3Q8 Lenders Will Have Negotiating Leverage Lender Consent Required For Waivers/Amendments Given that most of the loans have been trading well below par, any amendment/waiver request is likely to be expensive For transactions that actually have covenants, slightly looser covenants will probably NOTbe the key issue Covenants were based on bullish projections, and given more sober revised outlooks the cushions will now be much tighter Liquidity management will be critical for companies that had planned to invest and grow sales Given the much greater leverage on the companies, positive cash flow and access to liquidity could be an issue The credit crunch will make raising new debt capital difficult Management will have to work with lenders to secure covenant amendments/waivers as well as secure additional external sources of financing (1) Minimum EBITDA required to comply with covenant requirements, 6

7 Case Study: Dana Corp. Value of Covenants The Auto Supplier Completed an Expensive Amendment Seeking Covenant Relief Lenders Can Extract Value + Readjust Terms Par paydown + coupon +upfront fees + LIBOR Floor Company proposal in return for covenant amendment $1 million pay down at par as part of the economics of the amendment. 5 bps spread increase that would take pricing to L+425 3% LIBOR floor extension 15 bps fee on post-paydown outstandings Having Covenants Is Critical For Value Capture Term Loan trading under 7 / Total Leverage Covenant of 2.9x Breached The automotive supplier is projecting year-end noncompliance with the covenants on its term loan The company was in compliance with the 3.1x totalleverage test as of Sept. 3 However, the leverage covenant is due to step down to 2.9x on March 31, 29, with additional step-downs in subsequent quarters The term loan is quoted at 63.5/65.5 with the entire auto sector is under pressure Company Situation Weak earnings indicative of sector underperformance $1.43 billion term loan was put in place in conjunction with Dana s exit from Chapter 11 earlier this year The loan is currently priced at L+375 and includes a 3% LIBOR floor for two years The paper was issued at a 9 OID Dana (BB-/B1 corporate) announced significantly weak results Third-quarter EBITDA of $15 million was $111 million below results for the same period in 27. Lower production and higher steel costs of $14 million more than account for this reduction Results also included higher pricing, cost savings, and unfavorable currency changes Dana is planning up to 1 additional plant closures in 29 and 21, and it has expanded its targeted 28 workforce reduction to 5, from 3, YTD EBITDA of $29 million vs. $373 million for the same period in 27 Full-year sales of $8.2 billion and EBITDA of $3 million expected Dana maintaining large cash reserves to preserve access to liquidity The auto supplier had a $1. billion cash balance at Sept. 3, including $18 million that it drew during October from its $65 million revolving credit Free cash flow of negative $151 million for the third quarter was about the same as that during the same period in 27 7

8 4. Thin Equity Cushions With No Sponsor Support Private Equity Sponsors Will Act In Their Self Interest, Often To The Detriment of Lenders Asset Values Increased 12.x 1.x 5% 4% 3% 2% Average Purchase Price Multiples Of LBO Transactions 8.x 6.x 4.x 2.x.x With Lower Equity Cushions Average Equity Contributed As % of Total Purchase Price 28% Public-to-Private 3% All Other 32% 31% 31% % % 31% 31% Q- 3Q8 Equity/EBITDA Others Sub Debt/EBITDA Senior Debt/EBITDA Total 38% Q- 3Q8 Other Peoples Money Sponsor Ownership Will Act Against Debt Holder Interest Unprecedented availability of cheap liquidity led tight equity cushions in recent LBO transactions Eq. In the Tribune transaction, the present value of the tax savings was presented to the debt investors as part of the equity cushion The tax savings were only important as long as Tribune was earning positive taxable income As the business performance has gone south, the present value of the tax savings has diminished Sponsors acting to maximize returns to their limited partner investors, do not have enough skinin-the-game Equity investors can usually intervene in troubled companies and support the going concern value by providing liquidity and recapitalizing the business The main motivation is to preserve the residual value of the equity holders Sponsors have taken the opposite path by going down the dividend-recapitalization route Companies that have been over-levered because of sponsor dividends will face challenges in terms of raising additional equity capital Source: S&P LCD Comps 8

9 5. Access to Take-Out Capital Determines Returns Today Take-Out Capital Supply is Lower Than Initially Invested, But Will Grow Over Time With GDP Type Source Requirements for Target Investment Internal Organic Cash Flows - Strong franchise values that sustain through the cycle - Access to liquidity Desirable (Higher Rated) Equity Markets - Franchise value can support growth Take-Out Capital Available External Debt Markets Ch-11 Reorganization - Well known issuer that has good relationships with debt investors - Availability of DIP Financing - Customer lock-in and influence over suppliers that preserves value through the reorganization - Access to public/private capital markets for bankruptcy exit Ch-7 Liquidation Limited Access None Ch-7 Liquidation - Easily separable assets - Readily identifiable buyer - No access to incremental liquidity - Excess capacity in industry - Weak competitive position - Fundamental industry restructuring Less Desirable (Lower Rated)? 9

10 Broad Investment Themes 1

11 Investment Themes Relevant In Current Environment Theme Sector Related Issues Company Related Issues Discretionary Consumer Spending Discretionary consumer spending that drives almost 7% of the US GDP was significantly over estimated Capitalexpenditures that were committed to before the crisis could cause significant over-supply Avoid sectors that were levered forrobust consumer spending cash flows Avoid sectors that have fixed costs and high capital expenditures Commodity vs. differentiated value proposition Differentiated value proposition needs to be sustained, quality driven, non-discretionary and important to customer s competitive advantage Recession The recession trough could be much deeper than past recessions and last much longer Pick defensive sectorsthat serve a core customer base that provide critical services Even if margins decline, ability of companies to avoid negative cash flows will determine survivors Pick companies with highdegree of variable costs that can be cut as sales decline Capital structures will need to be defensive Liquidity Banks are undercapitalized and access to liquidity will be severely constrained Pick sectors that are not capital intensive Additionally, because of asset-light nature, these sectors should have strong brands, proprietary intangible assets, value-added service oriented components Company should have revolving credit facilities as well as room under its credit agreements/indentures that offer flexibility to execute asset based lending agreements CapitalSpending Capitalspending will be deferred because of lack of financing Pick sectors that need capitalexpenditures based on replacement cycles Pickcompanies with access to liquidity over the next several years with reliable counterparties Backlog drivenindustries with strong credit worthy customers Marginal Producers Marginal producers will be disproportionately hit Sectors where capacity utilization affects pricing will favor level utilization companies even if they are not the lowest cost producers Producersthat supply the last x% of demand at premium pricing will be affected Obsolescenceof Business Models Sectors likeauto, Residential Homes, that relied heavily on availability of financing will have to be restructured Complementary industries will suffer Too muchuncertainty for non-investment grade, highly levered borrower Need to look to collateral values of the market leader in these sectors Smaller players could be squeezed from not being able to re-write the rules of the game to their favor 11

12 Investment Themes Relevant In Current Environment Theme Sector Related Issues Company Related Issues Sponsors In a distressed scenario, sponsors should be able to provide equity injections to keep the business solvent Certain sectors such as retail, chemicals saw dividend recapitalizations mere months after the companies were taken private Sponsorsshould have enough skin-in-the-game to care, else if the sponsor has taken a dividend off the table then solvency in a distressed scenario could lead to bankruptcy fairly quickly US vs.non-us Revenues Exposure to fast growing Asian markets Sectors that are regionally serviced/supplied via a local franchise Market leadership in fastgrowing markets and access to liquidity to support market share growth Bankruptcy Even if bankruptcy is the optimal answer to keep going-concernvalue, current downturn might depress asset values, and not provide liquidity to potential buyers If entiresector is distressed, then bankruptcy reorganization could lead to liquidation versus a sale and might not maximize value Company need to be in jurisdictions that are friendly to enforcing on liens and where bankruptcy reorganization does not cause value leakage to junior capital Size Mega-LBOslike TXU and HCA would not have happened without the level of cheap liquidity Great companies with premium franchise value even if leverage is a concern Mega-LBOs in toxic sectors like Autos, Financials willbe challenging to execute successfully and exit Any governmental intervention increases uncertainty Needto verify underlying collateral value and structure that will enable lenders to capture that value for par payback on the secured loan Mega-LBO candidates were market leaders in their space and provided strong, stable cash flows Need to verify that sponsors have skin-in-game and are pre-dividend recapitalization These companies will make excellent IPO candidates when the equity markets open again Structure Covenant-lite, PIK Toggles, Incurrence Term Loans Needstrong understanding of the sector as well as company to understand the level of distress Lack of covenants will add a level of complexity to negotiate with borrower Working Capital Working capital management will be focus of most management teams Sectors that traditionally involved supplier financing will get squeezed because suppliers lines of credit will no longer be able to support them Strong customerpower will require suppliers to finance inventories at their own expense 12

13 What Makes An Ideal Target for Debt Investments? Strategic Analysis of Company vis-à-vis Buyers, Suppliers & End-Consumers Suppliers Ideal TargetCo Buyers or Customers End-Consumer Largenumber of smaller suppliers that are commodity pricing driven Excess capacity in supplier industry Specialized suppliers dependent on specific industry demand Suppliers that have access to vendor financing facilities to provide credit lines to TargetCo Located close to TargetCo and provides lock-in In a recession scenario, the ideal TargetCo will have: Customer lock-in via contracts in the right industries Customer switching costs that need cash expenditure Companies that help their customers achieve and sustain cost competitiveness Ability to assume a greater number of buyer activities more efficiently and cross sell additional services to enhance revenue Ability to find new, alternative product markets Constant utilization companies will have lower costs even though smaller competitor s grow faster during the upturn Strong regional franchise Industries that do not have a need for extensive marketing/advertising Low working capital needs because of well capitalized buyers Lean operations with non-critical operating activities outsources to lowest cost producer Experienced management team that has seen a previous downturn No adverse regulatory pressures Defensive capital structure with presence of bonds to minimize maintenance covenants Product Focus Product focused companies specialize in anapplication of their technology across various industries Industry Focus Industry specialistsprovide a broad range of services for a tailored to a particular industry and depend on the health of that industry and related industries that support it Smaller than Company Profitable, well capitalized Replacement cycle driven Depends on TargetCo to provide goodsor services critical to its competitive advantage with endconsumer Quality driven needs Customization driven with heavy interaction between respective teams Small portion of end product costs Ability to out-source additional services to TargetCo Avoid customers that could demand specific performance and potentially renegotiate contracts in a bankruptcy scenario Demands differentiated product based on sustained value proposition Cost of low-quality is high Few substitutes Not discretionary buyer Stable base of necessity driven buying behavior Replacementneed or maintenance driven buying pattern In case of service industries, recession resistant needs like healthcare services Geography of endconsumer will play a factor Ideal players would have: Quasi-monopolistic markets Proprietary technology Complex product or patents Some economies of scale that prevent industry specialists from competing with them and allow them to be lowest cost producers If product is simple, cost focused customer If product is complicated, quality focused customer, but without need for extensive customization Variable costs that can be cut at short notice with decreased revenues Ideal players would have: Industry leadership, market share, brand Customer demanding specialization, customization Complex assets like factories that need significant investments Oligopolistic markets that understand the dynamics of capacity driven pricing because fixed costs create penalty for underutilization Should not be marginal producer 13

14 How Did We Get Here? 14

15 Leveraged Loan & High-Yield Bond Volumes Institutional Ownership Fueled Leveraged Loan Issuance and The Subsequent Debt Boom Pre-23 Banks Dominated The Leveraged Loan Market, But Institutional Demand Took Over And Multiplied from # Transactions Without Upfront Fees Institutional Volume Outstanding: $1,338bn Institutions First Lien Second Lien Sr Secured Sr Unsecured Subordinated Institutional Bank $14B $8B 121 $12B 17 $7B Banks $6B 149 $1B $5B $8B 119 $4B $6B 121 $3B % $2B $4B % $1B $2B 376 $B YTD 7/8 $B YTD 7/8 The Demand/Supply Mismatch and Increased % Institutional Ownership, Led To Looser Lending Standards 41 % 9% 41 % % 75% 5% 25% % # Transactions Without Upfront Fees Is an Indicator of Demand Vs. Supply Q8 86% 93% 86% 67% % % % 1% 36% Q8 4% % % Institutional Ownership of Leveraged Paper 6% 5% 44% 4% 3% 2% 1% % Jun-96 Oct-97 Mar-99 Jul- Nov-1 Apr-3 Aug-4 Jan-6 May-7 Oct-8 15

16 Mega-Accounts Lead To Mega-LBOs As The Market Was Overrun by Cheap Liquidity, Deals Grew Increasingly Ambitious & Issuer Friendly The Top 1 Accounts Got Larger Top 1, 1-2, 2-3 Account By Size ($,mm) Increased Number of Institutional Investors Investor Groups that Made 1 or More Primary Commitments Each Year Top 1 Accounts By Size 11-2th Account by Size 21-3th Account By Size Q Q8 resulting In Mega-LBOs i.e. Companies That Would Not Have Experienced Those Levels of Debt Number Of LBOs (#) 2 $5 million-$1 billion $1-2 Billion $2-5 billion $5 billion or more Q-3Q7 1Q-3Q8 Source: S&P LCD Comps 16

17 Debt Multiples & Covenants Over Time Increase In First Lien Leverage With Loose Covenants Incurred In A Bullish Market First Lien Leverage Increased To Levels Only Second to x 8.x Sub Debt/EBITDA Other Sr Debt/EBITDA SLD/EBITDA FLD/EBITDA 6.x 4.x 2.x Total Debt First Lien.x Q7 1Q8 2Q8 3Q Number of Covenants Dropped Below Three Number of Covenants (Excludes Covenant-Lite Transactions) Q- 3Q8 Note: For years Sub Debt/EBITDA reflects all Non Bank Debt/EBITDA Criteria: Pre-1996: L+25 and Higher; 1996 to Date: L+225 and Higher; Media Loans Excluded; There were too few deals in 1991 to form a meaningful sample and 6% had Two or Fewer Covenants % of Covenants (Excludes Covenant-Lite Transactions) 2 or less 3 4 or more 1% 15% 15% 25% 33% 75% 46% 28% 41% 82% 75% 77% 75% 69% 62% 66% 5% 42% 39% 37% 25% 24% 57% 2% 23% 44% 18% 28% 33% 14% 18% 19% 4% 6% 5% 6% 1% 13% 11% 17% % Q-3Q8 17

18 Leverage & Coverage Multiples As The Market Was Overrun by Liquidity, Deals Grew Increasingly Ambitious & Issuer Friendly Leverage Multiples Increased As Companies Levered Themselves With Tighter Interest Coverage Total Leverage Interest Coverage <3.x 3.x-3.99x 4.x x 5.x x 6.x x >7.x $5B 73 $4B $3B $2B $1B $B 27 Dec-1 Dec-2 Dec-3 Dec-4 Dec-5 Dec-6 Dec-7 Jun-8 $5B $4B $3B $2B $1B $B <1.5x 1.5x -2.99x 3.x -3.99x >4.x Dec-1 Dec-2 Dec-3 Dec-4 Dec-5 Dec-6 Dec-7 Jun-8..But At The Same Time Relied On IPO Proceeds From Equity Markets To Pay Down Debt Excess Cash Flow Sweeps $6B $5B % Sweep 5% Sweep 75% Sweep 1% Sweep 11 $4B 12 $3B $2B $1B $B Q8 Equity Issuance Recapture $6B % Sweep 5% Sweep 75% Sweep 1% Sweep $5B $4B $3B $2B $1B $B Q8 Source: S&P LCD Comps 18

19 Debt Innovations Like Cov-Lite& PIK Toggle Loans Competition To Deploy Capital Led To Sponsors To Push The Envelope on Structure Approximately $9billion of Covenant-Lite Loans Are Currently Outstanding Par Volume of Covenant Loans Currently Outstanding $1bn 92 $75bn $5bn $25bn -- Dec-4 Dec-5 Jan-6 Feb-6 Mar-6 Apr-6 May-6 Jun-6 Jul-6 Aug-6 Sep-6 Oct-6 Nov-6 Dec-6 Jan-7 Feb-7 Mar-7 Apr-7 May-7 Jun-7 Jul-7 Aug-7 Sep-7 Oct-7 Nov-7 Dec-7 Jan-8 Feb-8 Mar-8 Apr-8 May-8 Jun-8 Jul-8 Aug-8 Sep-8 Oct-8 Covenant-Lite Term Loans Trade at a Discount To Comparable Credits Average Nominal Spread (bps) 275 L+257bps 25 32bps L+225bps Covenant-Lite All Other First-Lien 175 Jan-6 Apr-6 Jul-6 Oct-6 Jan-7 Apr-7 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 Source: S&P LCD Comps & Markit. Average Bid bps 7 Covenant-Lite All Other First-Lien Jan-6 Apr-6 Jul-6 Oct-6 Jan-7 Apr-7 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 19

20 Why Do Cove-Lites/PIK-Toggles Trade At A Discount? Lenders Dislike Lack of Visibility, Cannot Capture Waiver/Amendment Fees or Adjust Terms Approximately $1billion of Covenant-Lite Loans Are Currently Outstanding Lack of covenants are adverse to debt value because they complicate the principal-agent problem and delay identifying potential issues to lenders 1. Delay extracting value from the borrower as consent fees because of technical amendments 2. Prevent renegotiating the terms of the debt structure to adjusted for the revised risk profile 3. Since secured loan covenants tend to be breached first, prevents the lenders from intervening and helping the management correct course 4. Borrower may decide to stay the course and cause value leakage from the collateral until a point of no-return 5. Lack of visibility of when default will hit, adds to lender apprehension as lenders cannot manage their risk and exit position before the borrower is in a serious default Covenant-Lite Loans Preclude The Lender From Capturing Amendment & Covenant Relief Fees Average Covenant Relief Amendment Fee (bps) Average Covenant Relief Spread Increase (bps) 8bps 7bps 6bps 5bps 4bps 3bps 2bps 1bps bps 63 25bps 2bps 15bps 1bps 5bps bps 164 Source: S&P LCD Comps & Markit. 2

21 Lastly, Ratings Were Issued In A Bull Market Loans Are Notched Up Based On Historical Recovery Rates All BB Loans Are Not Born Equal Loan Or Facility Based Ratings Are Higher Loan Ratings Could Overestimate Recovery Value LBOs were structured to a single B corporate rating and a BB loan rating Ratings considered should be corporate ratings rather than facility ratings Due to the recent trend of highly levered LBOs, debt service and access to liquidity will be important Loan ratings incorporate the positive effects of the security and liens on recovery value in case of bankruptcy Borrower default is tightly correlated to corporate ratings Loan/Facility Ratings & Spreads Average Secondary Spread Based On Loan Ratings L+3,2bps L+2,7bps L+2,2bps L+1,7bps L+1,2bps L+7bps L+2bps 1,88 1,265 1,456 1,728 2,653 3,176 BB+ BB BB- B+ B B- Loan / Facility Based Ratings 5% 5% $15B $1B $5B $B BBB+BBB BBB-BB+ BB BB- B+ B B- CCC+CCCCCC- CC C D NR..But Corporate Ratings Will Also Be Important Corporate Credit Ratings 2% 8% $2B 157 $15B $1B $5B $B BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CC D NR Note: Includes loans that are priced and those that are not priced. Vast majority are institutional tranches. Secondary Spread calculations assume discount from par is amortized evenly over a three-year life. 21

22 Corporate Issuers vs. LBOs 22

23 Large Corporate Issuances Peaked In 27 The LBO Boom Also Allowed Corporate Issuers To Avail The Same Loose Covenants $13 billion of Volume in 27 Commentary $,Bn of Corporate Transactions that Were Opportunistic Refinancings $16B $14B $12B $1B $8B $6B $4B $2B $B Average of $78mm Per Transaction in 27 #Corporate Transactions that Were Opportunistic Refinancings As the large Mega-LBOs were being structured, large corporate opportunistic refinancings peaked in 27 These transactions structured similar to LBO transactions, but had lower leverage and higher coverage ratios The current environment allows for investing in a select pool of corporate loans that are direct competitors of the companies that were LBOed, but have much more flexibility from a capital structure standpoint Source: S&P LCD Comps & Markit. 23

24 Corporate Vs. LBO Corporate Transactions Have Been 1.1x Turns Less Levered With.8x Increased Coverage Total Debt/EBITDA Senior Secured Debt/EBITDA EBITDA/Cash Interest EBITDA - Capex/Cash Interest LBO Corporate LBO Corporate LBO Corporate LBO Corporate 1Q-3Q8 4.9x 3.7x 1.2x 4.2x 2.9x 1.3x 3.x 4.4x (1.4x) 2.3x 3.x (.8x) x 4.9x 1.3x 5.5x 4.4x 1.1x 2.1x 3.x (.8x) 1.6x 2.4x (.8x) x 4.4x 1.x 4.6x 3.9x.7x 2.3x 3.1x (.8x) 1.9x 2.4x (.5x) x 4.3x 1.x 4.x 3.6x.4x 2.7x 3.6x (.9x) 2.1x 2.7x (.6x) 25-7 Avg. 5.6x 4.5x 1.1x 4.7x 3.9x.7x 2.4x 3.2x (.8x) 1.9x 2.5x (.6x) x 4.3x.6x 3.3x 3.1x.2x 3.4x 4.x (.6x) 2.6x 2.8x (.2x) x 4.1x.6x 2.8x 2.7x.1x 3.1x 3.7x (.6x) 2.5x 2.5x.x 22 4.x 4.x.x 2.5x 2.7x (.2x) 3.2x 3.6x (.4x) 2.4x 2.4x (.x) x 4.x.x 2.7x 2.6x.1x 2.7x 3.2x (.5x) 2.x 1.8x.2x 2 4.2x 4.2x (.x) 3.2x 2.8x.4x 2.3x 3.x (.7x) 1.6x 1.8x (.2x) x 4.6x.1x 3.2x 3.2x (.x) 2.3x 2.9x (.6x) 1.7x 1.5x.1x x 5.x.4x 3.2x 3.4x (.1x) 2.1x 2.6x (.5x) 1.2x 1.3x (.1x) x 5.4x.3x 4.x 3.6x.5x 2.x 2.3x (.3x) 1.2x 1.2x.1x 24

25 Dangerous Precedent or New Buyer Base? Citadel Broadcasting Redeems Loan At Below Than Par Value via a Modified Dutch Auction Lenders Need To Be Careful About Hidden Traps Win-Win versus Giving Away Upside Corporate borrowers who do not have onerous cash flow sweeps like LBO buyers have the ability to use the excess cash flow to request an amendment for a buyback below par As the secondary market gets weaker and liquidity is drying up, a greater number of lenders could be tempted This is a dangerous precedent because it not only changes the dynamics of the leveraged loan institutional structure, but also creates incentive for the borrower to be opportunistic about redeeming debt below par Transaction Overview $1.5Bn Covenant-Lite Term Loan Purpose Industry Deal Size Corporate Rating(at close) Loan Rating(at close) TLB (Flex) Merger; Along with an RC and TLa, backs the merger of the Citadel Broadcasting with Disney's ABC Radio Holdings. Radio; Domestic mid-market radio franchise. $1535mm B+/Ba3 B+/Ba3 Institutional Break Price 1.25% $1535M/L (-12.5 bps) Citadel Capitalized On Absence of Buyers Loans generally have no provision for the borrower or any of the affiliates of the borrower to redeem the loan at less than par value via a Dutch auction tender The concept of tendering for a debt instrument by the borrower below par is not new and is used extensively by issuers of unsecured and subordinated bonds when the bonds are trading below par This provides liquidity to existing debt holders who are willing to give up value in exchange for the ability to exit their respective positions Citadel Broadcasting sought an amendment that allowed the borrower to purchase its loans at a price below par as part of a modified Dutch auction Under terms of that amendment, the issuer had the ability to approach investors up to three times over 9 days to repurchase as much as $2 million of its TLA and TLB Citadel Broadcasting bought back just over $149 million of senior debt after completing an amendment in March that allowed the company to purchase up to $2 million of its loans at a price below par as part of a modified Dutch auction Citadel paid an average of just under 81 to repurchase paper whereas Citadel s TLB was quoted at 45/47 recently Citadel s lenders do not have an excess cash flow recapture provision, and the company s covenants were flexible Lenders would not be entitled to the pay down and the issuer could easily dividend out its cash on hand 25

26 Demand & Supply Technical Factors 26

27 Demand & Supply Technical Factors Lack of Capital Has Severely Curtailed Demand For Leveraged Loans Prices Will Continue to Have Downward Pressure The four main pillars of loan market technicals have crumbled over the past year, in the face of the ongoing bear market 1. CLOs: Year to date, managers have priced $13.5 billion of new vehicles, down from $83 billion during the same period last year Many TRS and market value CLOs because of structure mandates, are hitting selling trigger points as asset values fall further depressing valuations 2. Prime Funds: Withdrawal of assets by retail investors are bleeding the prime funds. Through September investors withdrew $6.4 billion, versus $1.8 billion of net inflows during the first nine months of last year. 3. Repayments: Repayment rates have slowed to alltime lows Repayments for the year to date totaled $43.9 billion, down 67% from the same period in 27, when issuers repaid $133 billion. 4. Institutional fund raising: Year-to-date fundings total $85 billion, down 7% from the same period last year, versus an increase of $144 billion during the same period in 27 Demand/Supply Mismatch About $15 billion has been withdrawn from the institutional loan market and unless this amount is replenished, prices will not return to par The marginalseller of loans has been the mark-to-market account (market value CLOs, TRS line, hedge funds) that remain vulnerable to redemptions $42bn Demand Supply 27

28 Repayment Rates Have Slowed To a Trickle Companies Are Conserving Cash To Ride The Downturn And Are Only Delaying Default Repayment Rates Dropped from $16bn to about $6bn per year as of October, 28 Monthly & Rolling12-month repayment amounts ($,billions) $3B $27B $24B $21B $18B $15B $12B $9B $6B $3B $B Repayment amount Rolling-12mo Jan-1 May-1 Sep-1 Jan-2 May-2 Sep-2 Jan-3 May-3 Sep-3 Jan-4 May-4 Sep-4 Jan-5 May-5 Sep-5 Jan-6 May-6 Sep-6 Jan-7 May-7 Sep-7 Jan-8 May-8 Sep-8 $2B $15B $1B $5B $B Decrease In Repayments Highlights the Severity of Potential Underlying Issues Companies need to deleverage to avoid default Majority of the companies that raised debt capital especially via LBOs over the last few years, were over levered with fixed charges being a strong demand on cash flow Deleveraging is the key attribute that will keep the companies from default since growth in EBITDA will be difficult to achieve because of the global slowdown and rationalization of both GDP and sector growth projections Looser maintenance covenants and lower cash flow sweep requirements are allowing the companies to avoid triggering default A lack of ongoing repayments indicates that when fate catches up and performance erodes to a thin cushion to default 1. the deviations from projected operating plan will be significant and, 2. there will be a greater amount of claims on assets of lower value Source: S&P LCD Comps & Markit. 28

29 28 Has Been A Year Of Net Capital Withdrawal CLOs Were the Overwhelming Driver of Institutional Demand from Estimated Cash Inflows into Institutional Accounts By Account Type $1.B CLO Issuance CLO Pipeline Change Prime Funds $8.B $6.B $4.B $2.B $.B -$2.B YTD8 Institutional Net Cash Flows less Change in Outstandings $12B $1B $8B $6B $4B $2B $B -$2BJan-1 Jul-1 Jan-2 Jul-2 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 -$4B -$6B -$8B -$1B -$12B Source: S&P LCD Comps & Markit. 29

30 Spreads & Recovery by Sector 3

31 Secondary Spreads & Recovery Values On Default Food Products, Healthcare, Industrials, Chemicals, Utilities Will Be Defensive Sectors BB & B Rated Loan Secondary Spreads 2,819 2,92 2,925 L+3,bps 1,917 1,962 1,991 2,35 2,212 2, L+2,25bps ,122 1,146 1,312 1,323 1, L+1,5bps L+75bps B Food Prdts Healthcare Containers/Glass Utilities Industrials Leisure Chemicals Retailers Electrical Broadcasting Gaming & Lodging Publishing Auto Home Building Recovery Values On Default Food Prdts Healthcare Containers/Glass Utilities Industrials Leisure Chemicals Retailers Electrical Broadcasting Gaming & Lodging Publishing Auto Home Building Weak Consumer Spending + Low Collateral Value Discretionary Consumer + RE Exposure Even though historical recovery values are high for Gaming & Lodging, recent real estate boom could lower these values. Significant risks in light of government intervention Source: S&P LCD Comps & Markit. 31

32 Sub-Sectors Sorted By Sharpe Ratio Attractive Sectors Are Highlighted In Grey Criteria relevant to debt investors: Risk/return ratio measured by Sharpe Ratio Recovery values in even of downturn Liquidity provided by secondary market as measured by the par amount outstanding Size of company within sector as measured by the average size of loan The Sharpe Ratio and Standard Deviation were calculated based on trading data over from January 22 YTD October Sector Number Par (mm) Bid Avg. Size Stdev Sharpe Recovery Clothing - Textiles 13 $3, 76.7 $23 5.2% 8% 62.3 Nonferrous Metals - Minerals 13 4, % 69% 59. Oil And Gas 5 22, % 63% Aerospace and Defense 3 9, % 59% Industrial Equipment 3 8, % 55% 65.3 Chemicals And Plastics 52 27, % 52% 82.8 Electronics - Electrical 41 17, % 49% 53.9 Telecom 43 34, % 46% 45.3 Food And Drug Retailers 11 5, % 35% 79.7 Utilities 54 4, % 34% 7.3 Conglomerates 17 5, % 34% Financial Intermediaries 3 25, % 32% Business Equipment and Services 61 3, % 32% Industrials , % 29% 7.3 Healthcare 97 55, % 25% 62.6 Containers and Glass Products 21 9, % 25% 62.3 Forest Products 14 11, % 23% Food Products 33 13, % 2% 79.5 Leisure Goods-Activities -Movies 41 18, % 19% 76.1 Surface Transport 18 6, % 12% 62.6 Retailers (Not Food And Drug) 34 19, % 12% 55.1 Lodging And Casinos 44 26, % 11% 81.1 Home Furnishings 23 5, % 11% 53.9 Cable and Satellite TV 24 23, % 1% 85.3 Food Service 3 1, % % 76.1 Automotive 53 38, % (3%) 79.5 Building And Development 6 22, % (5%) 53.9 Beverage & Tobacco 11 3, % (7%) 76.1 Publishing 63 4, % (7%) 55. Cosmetics - Toiletries 15 4, % (1%) Radio And Television 41 24, % (1%) 85.3 Media , % (2%) 32

33 What Sectors Will Have Access To Liquidity? Asset Based Lending Is A Source of Capital That Can Be Raised During A Downturn Lenders Look To Value of Specific, Easily Liquidated Collateral And Can Provide Liquidity Asset Based Loans As a % of Total Leveraged Loan Volume 25% 2% 17.7% 15% 1% 5% 5.% 3.3% 7.7% 5.1% 6.2% 13.3% 8.6% 9.7% 4.8% 3.6% 7.2% 6.2% 4.6% 4.1% 8.5% 11.3% 7.9% 14.1% % 1Q4 2Q4 3Q4 4Q4 1Q5 2Q5 3Q5 4Q5 1Q6 2Q6 3Q6 4Q6 1Q7 2Q7 3Q7 4Q7 1Q8 2Q8 YTD3Q8 The Asset Based Lending Market is Used More By Some Industries Than Others ($ in millions) 15, 12,5 1, 7,5 5, 2, ,216 1,294 1,676 1,961 2,136 3,192 6,59 7,632 7,883 8,416 11,655 Source: S&P LCD Comps & Markit. 33

34 Analysis of Secondary Trading Data 34

35 Performance & Ratings Based Pricing Defaults & Non-Performance Haven t Hit Secondary Pricing of Loans Average Bid Based On Performing Vs. Non-Performing (1) Loans Performing Loans Index All Loans Index 7 12/96 6/97 12/97 6/98 12/98 6/99 12/99 6/ 12/ 6/1 12/1 6/2 12/2 6/3 12/3 6/4 12/4 6/5 12/5 6/6 12/6 6/7 12/7 6/8 Average Bid Based On Ratings Shows The Gap Widening, But Technical Reasons Have Dominated Current BB Index Current B Index 65 12/96 6/97 12/97 6/98 12/98 6/99 12/99 6/ 12/ 6/1 12/1 6/2 12/2 6/3 12/3 6/4 12/4 6/5 12/5 6/6 12/6 6/7 12/7 6/8 Source S&P/LSTA Leveraged Loan Index and Merrill Lynch High-Yield Index (HA) 35

36 Relative Value: Bonds Vs Loans From a Relative Value Perspective, Secured Loans Seem To Undervalued Unsecured Bonds Traded Below Secured Loans In the Last Cycle Weighted Average Bid Price For Leveraged Loans & High Yield Bonds Loans Bonds Dec-98 Jun-99 Dec-99 Jun- Dec- Jun-1 Dec-1 Jun-2 Dec-2 Jun-3 Dec-3 Jun-4 Dec-4 Jun-5 Dec-5 Jun-6 Dec-6 Jun-7 Dec-7 But This Cycle Has Seen Tight Correlated Moves That Imply Technical Selling Pressure Dec-98 Jun-99 Dec-99 Jun- Dec- Jun-1 Dec-1 Jun-2 Dec-2 Jun-3 Dec-3 Jun-4 Dec-4 Jun-5 Jun-8 Dec-5 Jun-6 Dec-6 Jun-7 Dec-7 Jun-8 Correlation Between Price Movements of Leveraged Loans & High Yield Bonds Source S&P/LSTA Leveraged Loan Index and Merrill Lynch High-Yield Index (HA) 36

37 Relative Value: Bonds Vs Loans Leveraged Loans Are Yielding Spreads That Exceed Those Seen In The Last Cycle Differential Between Unsecured & Secured Paper is ~32bps at Absolute Rates Well Above 1.% L+155 L+135 L+115 L+95 L+75 L+55 Loan Spread to Maturity Bond Swapped to Worst L+1,111bps L+79bps 32 bps L+35 L+15 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan- Jul- Jan-1 Jul-1 Jan-2 Jul-2 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 The spread between secured loans and bonds accounts for: Security package, priority and liens Tighter maintenance covenants Ongoing compliance and reporting covenants Cash flow sweeps Recovery values on default or credit loss given default Historically, spreads between secured versus unsecured paper have been around 218bps A 32bps spread between secured vs. unsecured either implies much lower recovery values or under pricing of unsecured bonds on a relative value basis Source S&P/LSTA Leveraged Loan Index and Merrill Lynch High-Yield Index (HA) Note: Loan Spreads are spreads to 18-month call if average bid is par or higher, 2 years if average bid is 98 but less than par and 3 years if the average bid is less than 98 but greater than 92 and 4 years if the average bid is less than 92 37

38 Higher Default Rates and Lower Recovery Rates The Spread of 1,166bps on the LSTA Index Implies that Recovery Values Will Be Lower Than 7% Current Default Rate is 3.27% Lagging 12-months Default Rate by Number of Issuers 9% 8% 7% 6% 5% 4% 3% 2% 1% % Dec-98 Dec-99 Dec- Dec-1 Dec-2 Dec-3 Dec-4 Dec-5 Dec-6 Dec-7 Recovery Rates of 5% Are More Likely Lagging 12-months Default Rate by Number of Issuers Recovery Rates LSTA Spread 25% 5% 7% 9% L+5 4% 6% 1% 31% 75 7% 11% 19% 56% 1,166 13% 2% 33% 98% 1,25 14% 21% 35% 16% 3.27% Implied Default Rates Average Nominal Spread of the S&P/LSTA Index L+28bps Historical Average Default Rate 3.% Historical Loss Given Default 3.% Average Credit Loss 9bps Average Effective Spread 19 Historical Return from % Spread to Maturity of the LSTA 1,166 Less: Effective Spread (19) Risk Premium 976 Average Recovery Secured Loans 7% Loss Rate 3% Implied Default Rate = Risk Premium/Loss Rate 33%

39 Implied Default Rates Vs. Recovery Rates (RR) Current Trading Levels Imply a 2% Default Rate Assuming a 5% Recovery Rate Imputed Default Rate and Lagging 12-Month Default Rate 35% 7%RR 5%RR 5%RR+125bps Actual Rate 33% 3% 25% 2% 2% 17% 15% 1% 5% 3.3% % Oct-98 May-99 Dec-99 Jul- Feb-1 Sep-1 Apr-2 Nov-2 Jun-3 Jan-4 Aug-4 Mar-5 Oct-5 May-6 Dec-6 Jul-7 Feb-8 Sep-8 39

40 As With Fine Wine, Vintage Of Loans Matters 27 Vintage Loans Were Mostly Trading Below Par Distribution of Secondary Loan Bid Price By Vintage Of Loan Several Mega-LBOs were structured in 26 but never hit the market until 27 These were deals that were over-levered and pushed the envelope with covenant-lite structures 1% The loans issued earlier than 23 trade at a discount because probability of default increases with the age of the loan instrument 91% As the liquidity boom took off, several LBOs that were structured in early part of the cycle were good quality credit with well structured covenant and reasonable leverage reflected in trading behavior in loans of that vintage 9% 87% 91% 75% 67% 64% 66% 61% 76% 75% 5% 25% % % -- 6% 3% 3% 4% 24% 2% 7% 21% 2% 11% 13% 2% 12% 18% 1% 2% 2% % % 9% % -- % 12% % -- % 24% % 7% 1% 2% 24% 7% % /31/28 Less Than or More Source: S&P LCD Comps. 4

41 DISCLAIMER These discussion materials are presented solely for the purpose of demonstrating analytical and critical thinking abilities. Data used this in these materials was based on trial subscriptions provided by Capital IQ, S&P LCD Comps, Bloomberg, Markit and other public data sources that need a fully paid subscription and are used in good faith. These materials may not be reproduced without the written permission of the author. 41