First aid or last resort?

The economic recovery of 2003 did not drag everybody with it and the combination of cash-strapped firms and an increased investor appetite for risk has made rescue finance an attractive proposition – and , as John Hintze reports, a competitive market

Last November marked a watershed in the area of rescue financing. That was the month that Mission Energy Holdings International secured $700 million in loans, taking the notion of aggressive pricing and indirect collateral to a new level.

The deal was designed to appeal to two types of investor: on the one hand lenders familiar with the intricacies of project finance and the complexities of the international laws affecting collateralized assets, and on the other investors adept at making short-term, risky investments.

The demand created by these two relatively specialized investor bases was three times the $700 million size of the loan. Investors that beat around the bush found themselves left out of the deal. One banker at a Japanese firm, which was already a lender to a Mission subsidiary, tells US Credit that he was waiting until the weekend to review the loan documents, but by then it was already too late.

Indeed, the demand was such that the deal was subsequently increased in size by $100 million, at a spread 50 basis points less than the original 550bp over Libor, and at the same time the discount on the paper was ratcheted up half a point, to 99.5% of par.

Rescue financings have existed as long as liquidity crises. However it is only in the past few years that a new investor base – namely hedge funds and investors accustomed to riskier, shorter-term credits – has begun to supplant the house banks as lenders of last resort. Since late 2002, Standard & Poor’s records almost 40 such deals.

More than half of those financings were for energy companies. In the wake of the collapse of Enron many companies in the sector, already burdened with weak balance sheets, were forced to develop new structures. The trend quickly spread to other sectors; the worsening economic environment, falling equity markets, and a succession of allegations over the credibility of companies’ audited accounts had made many traditional lenders – banks and bond investors – unwilling to extend further financing to weak borrowers.

The solution that emerged was to attract a new type of senior lender. One of the earliest large-scale rescue financings to attract widespread participation from non-traditional lenders was for CenterPoint Energy, in November 2002. In September, it had spun off its subsidiary, Reliant Energy, which soon faced accounting issues.

Another subsidiary, CenterPoint Energy Houston Electric, was at the time rated triple-B and had a chunk of debt due in mid-November that needed to be refinanced so the parent could in turn refinance a total of $4.7 billion. This subsidiary was seeking $1.3 billion from lenders. But until Reliant’s accounting issues were resolved, CenterPoint’s financial statements could not be properly audited, making an SEC filing impossible and so eliminating the option of a bond offering. Lending banks also hesitated, so the arrangers – CSFB, Deutsche Bank, and Bank of America – marketed the deal largely to hedge funds and other non-traditional senior lenders, like high-yield funds.

The deal was completed – but at a price; at par investors received 975bp over Libor even though it was secured by the first mortgage bonds of the regulated subsidiary, CenterPoint Energy Houston Electric. Nevertheless, CenterPoint’s funding crisis was averted and the company survived.

Since the CenterPoint deal, non-traditional lenders have begun to accept lower spreads and less in the way of collateral. By August last year, term loans totaling $215 million for Aquila Canada were being priced at 425bp over Libor and collateralized at the holding company level – no longer secured by fixed assets but rather by stock in subsidiaries holding those assets.

Desperate donors

Investors’ growing appetite for risk at a time when both interest rates and corporate spreads over Treasuries are low has enabled companies to become increasingly aggressive on price and less generous on collateral.

Christopher Donnelly, a director at S&P Leveraged Commentary & Data, which tracks the leveraged loan market, notes that the average spread to maturity for large institutional loans, of which rescue loans are a subset, plummeted to 265bp over Libor in early December, from 307bp over in July and 337bp over last January.

“The spreads are coming in on everything, and we’ve seen rescue deals repriced. Some are even being repriced alongside the larger market,” says Donnelly. One example is automotive company Accuride, which faced a maturing revolver and amortization on a term loan.

Through Citigroup it completed a rescue deal in June comprising a new $50 million revolver and a $190 million second-lien (ie, subordinate to those with the first claim on assets) term loan. Fitting into the rescue category, this loan priced at 625bp over Libor, and was issued at 98 cents in the dollar with a 2% Libor floor. It left an existing term loan in place, priced at 400bp over Libor. In December, however, it was expected to cut pricing on the second-lien term loan to 525bp over Libor and eliminate the floor, as well as chop pricing on the other term loan to 325bp over Libor.

Accuride was not unusual in this respect. Last year, leveraged loans were sometimes repriced only months after they had been issued, at margins that had been chopped by 100bp or more. The Mission Energy financing represents the culmination of this yearlong pattern.

As well as falling yields the collateral on rescue loans has also continued to move further away from the hard assets. In October last year, Levi Strauss secured $500 million in financing via a term loan, which provided a claim on all assets, and $650 million in an asset-based revolver, which had a claim on hard assets. The term loan’s claims refer to such intangibles as the brand. “What they’re really betting on is that the Levi brand has value, and that it will not be liquidated,” says one institutional investor who looked at the deal. “The structures are getting more complex, and access to the collateral more removed.”

Nevertheless, despite the lack of hard assets as collateral and Levi having a troublesome split rating – BB- from Standard & Poor’s and Caa1 from Moody’s – it paid 687.5bp on the term loan, substantially less than the 725bp that was initially suggested.

The Mission Energy deal took this trend away from tangible collateral a step further. The deal was collateralized largely on stock in overseas assets, and often stock representing only a portion of the assets, since many foreign governments do not permit 100% ownership of local assets. So in order to fully understand the consequences of bankruptcy for Mission, a lender would have to understand the law in each country where the assets are domiciled. Few lenders, much less lightly staffed hedge funds, can do that. Nevertheless, the deal was a smashing success, attracting a combination of hedge funds and other institutional investors.

However, as the credit cycle continues to turn positive, prolonging the attractive aspects of rescue financing, the success or otherwise of potential deals may ultimately turn on whether their key elements satisfy borrowers’ other financial needs.

It may also depend on whether those deals – in an environment of increasingly aggressive terms – remain attractive enough to investors.

A fickle finger

Moving into 2004, the fate of the rescue finance market remains unclear. Some investors say they are in it for the long haul, although sources estimate there are 10 or fewer non-traditional lenders that regularly invest in such deals. It is anybody’s guess how many hedge or high-yield funds have invested in rescue-type loans. The more established names that have dabbled in the market include Chicago-based Citadel Investment Group, Cerberus Capital Management, Soros Investment Capital Management in New York, and Silver Point Capital based in Greenwich, Connecticut.

In fact, the latter actually helped arrange a Chapter 11 exit financing for Safety-Kleen in early December, and is less keen on viewing itself as a hedge fund these days. A spokesperson for the firm says it sees itself staying in the rescue finance market in the long term, a growing sign of the potential for the market to develop into a fully fledged asset.

Another specialty investment boutique that takes a long-term view on the rescue finance arena is Back Bay Capital, a division of FleetBoston that does its own origination and underwriting of rescue finance deals and shares due diligence and portfolio accounting responsibilities with the bank.

Edward Sisken, the chief operating officer of BankBoston Retail Finance and co-head of Back Bay, distinguishes Back Bay from hedge funds because it focuses on what he refers to as junior secured debt, rather than employing a wide range of investment strategies to capitalize on market discrepancies. He also hesitates to associate Back Bay too closely with rescue finance, because while the junior secured structure is typically a part of rescue finance, it can address borrowers’ other financing needs as well.

Sisken describes junior secured debt as a “supplement” to bank facilities that becomes attractive to borrowers when banks decline further lending without more first-claim collateral. Back Bay and other non-traditional lenders instead look to the intangible enterprise value – like the Levi’s brand – or the M&A value.

In a simplified way, M&A value can be estimated by multiplying Ebitda by five or six times. So, for example, Levi’s $500 million Ebitda in 2002 translates into an M&A value of approximately $2.5 billion. The second-lien nature of its $650 billion term loan makes it subordinate to the $500 million revolver but ahead of the unsecured debt. Thus the M&A value is more than two times the secured debt, giving the term loan investors assurance that their capital will be paid back.

“There are two fundamental credit criteria investors are looking at,” says Jim Finch, managing director of global syndicated finance at Credit Suisse First Boston, which has led numerous deals in this market. “Am I comfortable that my collateral coverage is sufficient to make me whole? And is there sufficient cashflow to service the debt? The art to this is balancing the two sides. If there’s more cashflow, then there can be less collateral, and vice versa.”

Back Bay’s Sisken says the firm’s seven-strong staff has invested in 45 such deals over the past five years. “This is a new way of lending money that seems to be relatively favorable in terms of the risk/return dynamics. We had junk bonds before, and this is a relatively new form of financing for other types of lenders, like hedge funds.”

A flying start

Given that most companies are likely to find themselves facing financing hurdles at some stage in their life cycle, rescue financings will probably continue, although 2003’s rash of deals may prove hard to match. “Most companies took care of their looming maturities this year,” says Shelly Lombard, credit analyst at Gimme Credit, a fixed-income analysis firm, adding that such companies took advantage of record low interest rates.

Richard Thayer, managing director at JPMorgan, says that companies’ stock prices have improved dramatically since early 2003, providing more of a capital cushion and assuaging banks’ concerns about low equity values. Rising stock prices could also divert hedge funds’ attentions to more lucrative corners of the market, lessening demand for rescue finance paper. Hedge funds, however, have increased dramatically in number over the last few years and they remain flush with capital. “Whether hedge funds will [participate in rescue financing deals] is a function of the structure and yield of the deal,” Thayer says.

In some cases, it may still be worthwhile for borrowers to pay a premium for the flexibility of junior secured debt, as well as the ability to pay down that debt without the steep penalties usually attached to bond deals and the lack of warrants accompanying mezzanine financing. Aquila’s first deal was not junior secured because it was the only secured debt, but the concept was similar. When Aquila was in need of rescue financing, Rick Dobson, the firm’s chief financial officer, says he chose the covenant-light term loan over debt from traditional banks because he reasoned that maneuverability was more important than cost at that time. He acknowledges, however, that it is “not the cheapest financing, so it’s probably most appropriate for a company facing liquidity problems.”

Rescue financing for the purpose of rescuing a company with liquidity problems will certainly continue into 2004. But this year promises to also provide rescue financing-style deals that are based on ‘good news’ investment opportunities, such as companies emerging from bankruptcy or selling assets as they reposition themselves in their markets.

Those deals, too, will require financing. In fact, Back Bay’s Sisken says the firm has provided “probably half a dozen” junior secured financings in the last year or two to support acquisitions. Typically in these situations, he says, there are no bonds creating an over-leveraged situation, putting a more positive spin on what has in many cases been seen as a financing structure of last resort.

“What’s happened is banks have tightened their standards for doing loans for acquisitions and have become more conservative,” says Sisken. “So Back Bay will provide junior secured loans to help provide money beyond what the banks will provide.” Unregulated hedge funds, in fact, can provide whatever kind of capital a company needs, literally investing across the capital structure, from equity to debt.

“Last year’s rescue financings helped issuers stop the bleeding,” says CSFB’s Finch. “We’ll continue to see deals in 2004 – not necessarily rescues – but the investor pool will be looking for a wider range of senior debt, equity, and junior debt from which to choose.”

Early in 2003 Aquila, an energy company based in Kansas City, Missouri, was seeking to return to its utility roots after an unpleasant foray into the merchant energy market. The company had nearly $400 million in an unsecured revolver coming due in April and other debt obligations it wanted to refinance. But its rating had fallen below investment grade and its stock price hovered in the $1 range. Lenders were understandably wary. “We were fairly confident that we could have rolled that transaction as a one-year secured facility, with our 19 banks. But I believe we would have had a couple of institutions at the bottom of our banking tier that might have been difficult,” says Rick Dobson, Aquila’s CFO. “Nobody had collateral [on the existing loans], and the banks would have asked for every stick of collateral in the place [on the new loan],” adds Dobson. “And they also would have published numerous covenants, so any failure and they could have taken the collateral and gotten their money back.” The company opted instead for a $430 million rescue term loan. It still had to provide a first lien on the collateral, and it did not have the ability to draw down and pay back the revolver, which could have saved it $30 million or more in annual interest payments by Dobson’s estimate. But the non-traditional lenders flooding into the deal – it was five times oversubscribed – only required Aquila to maintain a debt to total capitalization ratio of 75% for 2003 and 70% for 2004 onward. That freed up the company to pursue its reorganization plan without the constraints of a commercial bank syndicate. For example, Aquila held a 20-year lease to purchase power from a plant and sell it on the open market, but that market no longer existed and Aquila wanted out of the merchant business anyway. It had been negotiating to buy the lease for $110 million, but the banks would have wanted most of that sum to pay down the loan instead. So the lease would have continued to cost the company $43 million a year while providing no revenue. The term loan, instead, allowed it to pursue those repositioning initiatives. “I believe a bank loan would have stalled us for at least a year,” says Dobson. “These changes would have required 100% consensus from bank lenders.” The credit, rated B+, was priced at 575bp over Libor with a 3% Libor floor, for all-in costs of 8.75%. That figure could still drop to 8% if the firm achieves certain collateral requirements.