The fourth quarter of 2009 may ultimately be viewed as a turning point for the capital markets.  Following months of steady decline in both debt and equity trading, a significant rally has taken hold in both markets.  The Loan Syndication and Trading Associations’ Leveraged Loan Index, which tracks the performance of institutional leveraged loans, has risen 42 percent through three quarters, while the Standard & Poor’s (S&P) 500 has risen nearly 57 percent since its March 2009 low. 

Whether these gains can be maintained will be an important indicator of investor confidence and future loan volume. Through the 3rd quarter of 2009, loan issuance has been anemic at just $99 billion, according to S&P’s Leveraged Commentary and Data (LCD). The majority of this volume (60 percent) was financed through existing lending groups and only 40 percent was considered new money. By comparison, leveraged lending peaked in 2007 with $705 billion of volume, 76 percent of which was new money.

Turnaround finance has not been immune, particularly exit financings. While debtor-in-possession (DIP) financings continue to find support on a defensive basis from existing lenders, investor depth for exit financings has proven more challenging. However, good companies with strong credit profiles and significant unencumbered assets have been successful in raising new capital.

Return of the Primary Debt Markets
In the fourth quarter of 2008, many investors seemed to be avoiding the primary market--choosing instead to invest in quality companies trading at deep discounts in the secondary loan market. The recent rally in the secondary market has dramatically lowered yields, and as a result, the primary market is now attracting more investor dollars. Although many deals continue to be comprised of the borrower’s current lending group, a number of transactions have successfully raised new money from lenders who were not a part of the company’s previous bank syndicate.

Recently, the market has seen a proliferation of asset-based deals, as lenders look for greater security in uncertain times. However, a number of less structured, cash flow transactions have completed successful syndications. This is driven primarily by better credit ratings and liquidity in the high yield market. Investors, in both club transactions and more broadly syndicated deals, continue to focus on parameters such as leverage, structure, pricing and ratings -- a key component for many institutional investors.

Factors Affecting Market Depth
The broader cash flow market has benefitted from greater liquidity as the return of M&A has driven repayments, leaving some investors flush with cash. As a result, the high yield bond market has been very active. At the same time, some high yield bond investors have shifted into the loan market to find similar yields with greater security. When syndicating, several deals have been oversubscribed resulting in final pricing being below guidance indicated at the launch of the syndication. In addition, some institutional investors who employ leverage have re-entered the market. This is driven by the need to re-invest principal repayments prior to expiration of their re-investment periods. Fully funded term loan facilities are finding pockets of demand. However, raising capital for revolving credit facilities remains challenging. These facilities often have limited or no usage, making investor returns unattractive. Banks continue to be the only material source for these facilities, and are reluctant to commit significant capital to support them without the benefit of revenues from ancillary services, such as treasury management. As a result, the size of revolving credit facilities continues to contract.

DIPs and PORs – Playing Defense
As banks and institutions have begun to show some willingness to finance DIPs and plan-of-reorganizations (POR), market depth has slowly improved. Although the U.S. and Canadian governments have become the largest DIP lenders through their proactive involvement in the Chapter 11 proceedings of General Motors ($33 billion) and Chrysler ($4.5 billion), most DIP financings continue to be largely defensive in nature. Market depth for additional money contributed by existing or new lenders in the DIP space continues to be expensive, with investors typically requiring mid- to high-teen percentage returns. To help improve the willingness of current syndicate members to commit new capital, a number of larger ($500+ million) 2009 DIPs have used a roll-up feature. This allows pre-petition lenders to obtain super-priority status for a part of their pre-petition exposure in proportion to new dollars pledged to the borrower’s DIP facility.

Recent exit financings have fared well in the market as investors have welcomed companies exiting bankruptcy that have used the reorganization process to appropriately restructure their balance sheets and operations. Several moderately leveraged companies exiting from bankruptcy have found adequate depth in both the asset-based revolver and cash flow term loan markets. Where investor depth has been insufficient, some companies have successfully completed their balance sheet restructurings by reinstating pre-petition debt, often with modified terms for both pricing and structure.

Counterbalancing Defaults
The S&P/LSTA Leverage Loan Index default rates have continued to increase throughout 2009, however, the rate of increase has slowed. The 12-month lagging default rate by principal amount reached 9.96 percent at the beginning of the fourth quarter of 2009, up from 3.75 percent at the end of the first quarter of the year . Although the default rate is expected to increase in the near-term, re-financings executed in the bond market, as well as the recent success of loan amendments and extensions, sub-par debt buybacks and distressed exchanges may provide a counterbalance.

Indicators of Stability
Since the market lows in mid-March, investors have shown a willingness to participate as broader market indices have rallied. Investor confidence remains a key component to maintaining participation in the market. Below are a few market indicators that could influence investor confidence and participation:

1. Secondary trading levels and spreads — As seen in fourth quart of 2008 and first quarter of 2009, low secondary trading levels can impact the level of activity in the primary syndicated loan market as investors assess the relative value of investing in other debt opportunities. Investors chose to purchase securities trading at depressed levels in the secondary market because of the high yielding returns, instead of investing in the primary market where issues are purchased close to par with little upward price potential. At the end of the fourth quarter of 2008, the S&P/LSTA Leveraged Loan Index was trading in the low-60s2 and the average discounted secondary spread on single B loans was L+2,381 , bps. In contrast, by the end of the third quarter of 2009, the S&P/LSTA Leveraged Loan Index was trading in the high-80s2 and the average discounted secondary spread on single B loans was L+7292,3 bps. As trading levels have risen, new issues have become more attractive. A drop in secondary trading levels could cause investors to revisit strategies employed before mid-March of this year.

2. Libor Rates and Floors — As of the beginning of the fourth quarter, Libor rates sit at their lowest levels ever. Three-month Libor is 29 basis points, which represents a 453 basis points decrease since its recent peak in October 2008. Continued depressed Libor levels have lowered interest costs overall and allowed some issuers to avoid defaults. However, low Libor levels have also negatively impacted the relative value of loans, making loans a less attractive investment, particularly given the inability of loan investors to finance their assets. Increased Libor rates may imperil some issuers with liquidity issues but will positively impact the relative value of loans. While Libor floors have been consistently utilized in new issues as a way to insure a minimum return, some recent transactions have been completed without them.

3. Recent stability in the $55 trillion credit default swap (CDS) market — Earlier this year, the cost of default insurance rose dramatically, driven largely by the lack of transparency and clarity around which counterparties are deemed to be creditworthy by investors. The subsequent decline in the cost of these “insurance” policies signaled improved investor confidence in one another. A sudden rise in CDS insurance could signal market instability and cause investors to become even more cautious with their capital.

DIP financings will likely remain challenging for the foreseeable future, especially for over leveraged companies and those with no clear exit strategy. It will be interesting to see if the recent pockets of newfound market liquidity will help companies operating with tight liquidity and pending debt maturities avoid potential bankruptcy filings through successful out-of-court balance sheet restructurings. Conversely, companies with good stories, who have used the Chapter 11 process to properly restructure their balance sheets and improve their operations, should be in a position to take advantage of the newfound market liquidity. Investors, eager to put uncommitted funds to work, are likely to continue to provide capital to the primary markets as long as there are some positive signs that the economy is on track for a stable recovery. However, indications to the contrary could cause investors to quickly retreat and await stronger signals of an economic upturn.

Thomas Miele (thomas.miele@ge.com) is managing director, GE Capital Markets. Randal Jean-Baptiste (randal.jean-baptiste@ge.com) is vice president, GE Capital Markets. Both have extensive experience in syndicated finance for GE Capital, Restructuring Finance, a leading provider of senior secured loans to distressed companies supporting Chapter 11 filings, plan-of-reorganizations and out-of-court restructurings. GElending.com