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A Guide to the

Loan Market
September 2010

Stay connected with S&P Ratings and See pages 50 and 51 for
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I don’t like surprises—especially
in my leveraged loan portfolio.
That’s why I insist on Standard & Poor’s
Bank Loan & Recovery Ratings.

All loans are not created equal. And distinguishing the well secured from those that
aren’t is easier with a Standard & Poor’s Bank Loan & Recovery Rating. Objective,
widely recognized benchmarks developed by dedicated loan and recovery analysts,
Standard & Poor’s Bank Loan & Recovery Ratings are determined through
fundamental, deal-specific analysis. The kind of analysis you want behind you when
you’re trying to gauge your chances of capital recovery. Get the information you need.
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A Guide To The
Loan Market
September 2010
Copyright © 2010 by Standard & Poor’s Financial Services LLC (S&P) a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.

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To Our Clients
tandard & Poor’s Ratings Services is pleased to bring you the 2010-2011 edition of our

S Guide to the Loan Market, which provides a detailed primer on the syndicated loan
market along with articles that describe the bank loan and recovery rating process as
well as our analytical approach to evaluating loss and recovery in the event of default.
We have seen the evolution of the leveraged loan market from traditional relationship lend-
ing to its current position as a fully developed asset class within the capital markets. As part of
that market development, loan ratings have become a staple of the leveraged loan market and
are now assigned to about three-quarters of newly issued loans.
In 2003, Standard & Poor’s introduced a new rating—the Recovery Rating—to complement its
traditional loan rating. Whereas the loan rating, since its introduction in 1995, has always incor-
porated the likelihood of loss and recovery along with its evaluation of the likelihood of default,
the recovery rating focuses exclusively on loss and recovery prospects in the event of default.
We now assign recovery ratings to all speculative-grade loans and bonds that we rate, along
with our traditional ratings. As of press time, Standard & Poor’s has recovery ratings on the
debt of more than 1,200 companies. We also produce detailed recovery rating reports on most
of them, which are available to syndicators and investors. (To request a copy of a report on a
specific loan and recovery rating, please refer to the contact information below.)
In addition to rating loans, we offer a wide range of other services for loan market partici-
pants, including:
● Data and commentary: Standard & Poor’s Leveraged Commentary & Data (LCD) unit is the

leading provider of real-time news, statistical reports, market commentary, and data for
leveraged loan and high-yield market participants.
● Loan price evaluations: Standard & Poor’s Evaluation Service provides price evaluations for

leveraged loan investors.


● Recovery statistics. Standard & Poor’s LossStats(tm) database is the industry standard for

recovery information for bank loans and other debt classes.


If you want to learn more about our loan market services, all the appropriate contact information
is listed in the back of this publication. We welcome questions, suggestions, and feedback of all kinds
on our products and services, and on this Guide, which we update annually. We publish a free
weekly update, by e-mail, of all the loan ratings that we issue. To be put on the subscription list, or
to obtain a PDF version of this report, please e-mail your name and contact information to
dominic_inzana@standardandpoors.com or call (1) 212-438-7638. You can also access that report
and many other articles, including this entire Guide To The Loan Market in electronic form, on our
Standard & Poor’s loan and recovery rating website: www.bankloanrating.standardandpoors.com.

Steven Miller William Chew

Standard & Poor’s ● A Guide To The Loan Market September 2010 3


Contents
A Syndicated Loan Primer 7

Rating Leveraged Loans: An Overview 30

Criteria Guidelines For Recovery Ratings On Global Industrials


Issuers’ Speculative-Grade Debt 35

Key Contacts 50

Standard & Poor’s ● A Guide To The Loan Market September 2010 5


A Syndicated Loan Primer

Steven C. Miller syndicated loan is one that is provided by a group of lenders


New York
(1) 212-438-2715
steven_miller@standardandpoors.com
A and is structured, arranged, and administered by one or
several commercial or investment banks known as arrangers.
Starting with the large leveraged buyout (LBO) loans of the
mid-1980s, the syndicated loan market has become the dominant
way for issuers to tap banks and other institutional capital
providers for loans. The reason is simple: Syndicated loans are
less expensive and more efficient to administer than traditional
bilateral, or individual, credit lines.

At the most basic level, arrangers serve the rowers will effectively syndicate a loan them-
time-honored investment-banking role of rais- selves, using the arranger simply to craft doc-
ing investor dollars for an issuer in need of uments and administer the process. For
capital. The issuer pays the arranger a fee for leveraged issuers, the story is a very different
this service, and, naturally, this fee increases one for the arranger, and, by “different,” we
with the complexity and riskiness of the loan. mean much more lucrative. A new leveraged
As a result, the most profitable loans are loan can carry an arranger fee of 1% to 5%
those to leveraged borrowers—issuers whose of the total loan commitment, generally
credit ratings are speculative grade and who speaking, depending on the complexity of the
are paying spreads (premiums above LIBOR transaction and how strong market conditions
or another base rate) sufficient to attract the are at the time. Merger and acquisition
interest of nonbank term loan investors, typi- (M&A) and recapitalization loans will likely
cally LIBOR+200 or higher, though this carry high fees, as will exit financings and
threshold moves up and down depending on restructuring deals. Seasoned leveraged
market conditions. issuers, by contrast, pay radically lower fees
Indeed, large, high-quality companies pay for refinancings and add-on transactions.
little or no fee for a plain-vanilla loan, typi- Because investment-grade loans are infre-
cally an unsecured revolving credit instrument quently used and, therefore, offer drastically
that is used to provide support for short-term lower yields, the ancillary business is as
commercial paper borrowings or for working important a factor as the credit product in
capital. In many cases, moreover, these bor- arranging such deals, especially because many

Standard & Poor’s ● A Guide To The Loan Market September 2010 7


A Syndicated Loan Primer

acquisition-related financings for investment- LIBOR+275 or $15 million at LIBOR+250.


grade companies are large in relation to the At the end of the process, the arranger will
pool of potential investors, which would con- total up the commitments and then make a
sist solely of banks. call on where to price the paper. Following
The “retail” market for a syndicated loan the example above, if the paper is vastly over-
consists of banks and, in the case of lever- subscribed at LIBOR+250, the arranger may
aged transactions, finance companies and slice the spread further. Conversely, if it is
institutional investors. Before formally undersubscribed even at LIBOR+275, then
launching a loan to these retail accounts, the arranger will be forced to raise the spread
arrangers will often get a market read by to bring more money to the table.
informally polling select investors to gauge
their appetite for the credit. Based on these
discussions, the arranger will launch the
Types Of Syndications
credit at a spread and fee it believes will There are three types of syndications: an
clear the market. Until 1998, this would underwritten deal, a “best-efforts” syndica-
have been it. Once the pricing was set, it tion, and a “club deal.”
was set, except in the most extreme cases. If
the loan were undersubscribed, the Underwritten deal
arrangers could very well be left above their An underwritten deal is one for which the
desired hold level. Since the Russian debt arrangers guarantee the entire commitment,
crisis roiled the market in 1998, however, and then syndicate the loan. If the arrangers
arrangers have adopted market-flex lan- cannot fully subscribe the loan, they are
guage, which allows them to change the forced to absorb the difference, which they
pricing of the loan based on investor may later try to sell to investors. This is easy,
demand—in some cases within a predeter- of course, if market conditions, or the credit’s
mined range—as well as shift amounts fundamentals, improve. If not, the arranger
between various tranches of a loan, as a may be forced to sell at a discount and,
standard feature of loan commitment let- potentially, even take a loss on the paper. Or
ters. Market-flex language, in a single the arranger may just be left above its desired
stroke, pushed the loan market, at least the hold level of the credit. So, why do arrangers
leveraged segment of it, across the Rubicon, underwrite loans? First, offering an under-
to a full-fledged capital market. written loan can be a competitive tool to win
Initially, arrangers invoked flex language to mandates. Second, underwritten loans usually
make loans more attractive to investors by require more lucrative fees because the agent
hiking the spread or lowering the price. This is on the hook if potential lenders balk. Of
was logical after the volatility introduced by course, with flex-language now common,
the Russian debt debacle. Over time, how- underwriting a deal does not carry the same
ever, market-flex became a tool either to risk it once did when the pricing was set in
increase or decrease pricing of a loan, based stone prior to syndication.
on investor reaction.
Because of market flex, a loan syndication Best-efforts syndication
today functions as a “book-building” exer- A “best-efforts” syndication is one for which
cise, in bond-market parlance. A loan is origi- the arranger group commits to underwrite less
nally launched to market at a target spread than the entire amount of the loan, leaving
or, as was increasingly common by the late the credit to the vicissitudes of the market. If
2000s, with a range of spreads referred to as the loan is undersubscribed, the credit may
price talk (i.e., a target spread of, say, not close—or may need major surgery to clear
LIBOR+250 to LIBOR+275). Investors then the market. Traditionally, best-efforts syndica-
will make commitments that in many cases tions were used for risky borrowers or for
are tiered by the spread. For example, an complex transactions. Since the late 1990s,
account may put in for $25 million at

8 www.standardandpoors.com
however, the rapid acceptance of market-flex been gathered, the agent will formally market
language has made best-efforts loans the rule the deal to potential investors.
even for investment-grade transactions. The executive summary will include a
description of the issuer, an overview of the
Club deal transaction and rationale, sources and uses,
A “club deal” is a smaller loan (usually $25 and key statistics on the financials.
million to $100 million, but as high as $150 Investment considerations will be, basically,
million) that is premarketed to a group of management’s sales “pitch” for the deal.
relationship lenders. The arranger is generally The list of terms and conditions will be a
a first among equals, and each lender gets a preliminary term sheet describing the pricing,
full cut, or nearly a full cut, of the fees. structure, collateral, covenants, and other
terms of the credit (covenants are usually
negotiated in detail after the arranger receives
The Syndication Process investor feedback).
The information memo, or “bank book” The industry overview will be a description
Before awarding a mandate, an issuer might of the company’s industry and competitive
solicit bids from arrangers. The banks will position relative to its industry peers.
outline their syndication strategy and qualifi- The financial model will be a detailed
cations, as well as their view on the way the model of the issuer’s historical, pro forma,
loan will price in market. Once the mandate is and projected financials including manage-
awarded, the syndication process starts. The ment’s high, low, and base case for the issuer.
arranger will prepare an information memo Most new acquisition-related loans kick off
(IM) describing the terms of the transactions. at a bank meeting at which potential lenders
The IM typically will include an executive hear management and the sponsor group (if
summary, investment considerations, a list of there is one) describe what the terms of the
terms and conditions, an industry overview, loan are and what transaction it backs.
and a financial model. Because loans are not Management will provide its vision for the
securities, this will be a confidential offering transaction and, most important, tell why
made only to qualified banks and accredited and how the lenders will be repaid on or
investors. If the issuer is speculative grade and ahead of schedule. In addition, investors will
seeking capital from nonbank investors, the be briefed regarding the multiple exit strate-
arranger will often prepare a “public” version gies, including second ways out via asset
of the IM. This version will be stripped of all sales. (If it is a small deal or a refinancing
confidential material such as management instead of a formal meeting, there may be a
financial projections so that it can be viewed series of calls or one-on-one meetings with
by accounts that operate on the public side of potential investors.)
the wall or that want to preserve their ability Once the loan is closed, the final terms are
to buy bonds or stock or other public securi- then documented in detailed credit and secu-
ties of the particular issuer (see the Public rity agreements. Subsequently, liens are per-
Versus Private section below). Naturally, fected and collateral is attached.
investors that view materially nonpublic infor- Loans, by their nature, are flexible docu-
mation of a company are disqualified from ments that can be revised and amended
buying the company’s public securities for from time to time. These amendments
some period of time. require different levels of approval (see
As the IM (or “bank book,” in traditional Voting Rights section below). Amendments
market lingo) is being prepared, the syndicate can range from something as simple as a
desk will solicit informal feedback from covenant waiver to something as complex as
potential investors on what their appetite for a change in the collateral package or allow-
the deal will be and at what price they are ing the issuer to stretch out its payments or
willing to invest. Once this intelligence has make an acquisition.

Standard & Poor’s ● A Guide To The Loan Market September 2010 9


A Syndicated Loan Primer

The loan investor market three major ratings agencies and impose a
There are three primary-investor consisten- series of covenant tests on collateral man-
cies: banks, finance companies, and institu- agers, including minimum rating, industry
tional investors. diversification, and maximum default basket.
Banks, in this case, can be either a com- By 2007, CLOs had become the dominant
mercial bank, a savings and loan institution, form of institutional investment in the lever-
or a securities firm that usually provides aged loan market, taking a commanding 60%
investment-grade loans. These are typically of primary activity by institutional investors.
large revolving credits that back commercial But when the structured finance market
paper or are used for general corporate pur- cratered in late 2007, CLO issuance tumbled
poses or, in some cases, acquisitions. For and by mid-2010, CLO’s share had fallen to
leveraged loans, banks typically provide roughly 30%.
unfunded revolving credits, LOCs, and— Prime funds are how retail investors can
although they are becoming increasingly less access the loan market. They are mutual
common—amortizing term loans, under a funds that invest in leveraged loans. Prime
syndicated loan agreement. funds were first introduced in the late 1980s.
Finance companies have consistently repre- Most of the original prime funds were contin-
sented less than 10% of the leveraged loan uously offered funds with quarterly tender
market, and tend to play in smaller deals— periods. Managers then rolled true closed-end,
$25 million to $200 million. These investors exchange-traded funds in the early 1990s. It
often seek asset-based loans that carry wide was not until the early 2000s that fund com-
spreads and that often feature time-intensive plexes introduced open-ended funds that were
collateral monitoring. redeemable each day. While quarterly redemp-
Institutional investors in the loan market tion funds and closed-end funds remained the
are principally structured vehicles known as standard because the secondary loan market
collateralized loan obligations (CLO) and does not offer the rich liquidity that is sup-
loan participation mutual funds (known as portive of open-end funds, the open-end funds
“prime funds” because they were originally had sufficiently raised their profile that by
pitched to investors as a money-market-like mid-2010 they accounted for 25% or so of
fund that would approximate the prime rate). the loan assets held by mutual funds.
In addition, hedge funds, high-yield bond
funds, pension funds, insurance companies, Public Versus Private
and other proprietary investors do participate
In the old days, the line between public and
opportunistically in loans.
private information in the loan market was a
CLOs are special-purpose vehicles set up to
simple one. Loans were strictly on the private
hold and manage pools of leveraged loans.
side of the wall and any information trans-
The special-purpose vehicle is financed with
mitted between the issuer and the lender
several tranches of debt (typically a ‘AAA’
group remained confidential.
rated tranche, a ‘AA’ tranche, a ‘BBB’
In the late 1980s, that line began to blur as
tranche, and a mezzanine tranche) that have
a result of two market innovations. The first
rights to the collateral and payment stream in
was more active secondary trading that
descending order. In addition, there is an
sprung up to support (1) the entry of non-
equity tranche, but the equity tranche is usu-
bank investors in the market, such as insur-
ally not rated. CLOs are created as arbitrage
ance companies and loan mutual funds and
vehicles that generate equity returns through
(2) to help banks sell rapidly expanding port-
leverage, by issuing debt 10 to 11 times their
folios of distressed and highly leveraged loans
equity contribution. There are also market-
that they no longer wanted to hold. This
value CLOs that are less leveraged—typically
meant that parties that were insiders on loans
3 to 5 times—and allow managers more flexi-
might now exchange confidential information
bility than more tightly structured arbitrage
with traders and potential investors who were
deals. CLOs are usually rated by two of the

10 www.standardandpoors.com
not (or not yet) a party to the loan. The sec- banks have received negative or positive
ond innovation that weakened the public-pri- information that is not yet public.
vate divide was trade journalism that focuses In recent years, there was growing concern
on the loan market. among issuers, lenders, and regulators that
Despite these two factors, the public versus this migration of once-private information
private line was well understood and rarely into public hands might breach confidential-
controversial for at least a decade. This ity agreements between lenders and issuers
changed in the early 2000s as a result of: and, more importantly, could lead to illegal
● The explosive growth of nonbank investors trading. How has the market contended with
groups, which included a growing number these issues?
of institutions that operated on the public ● Traders. To insulate themselves from violat-

side of the wall, including a growing num- ing regulations, some dealers and buyside
ber of mutual funds, hedge funds, and even firms have set up their trading desks on the
CLO boutiques; public side of the wall. Consequently,
● The growth of the credit default swaps mar- traders, salespeople, and analysts do not
ket, in which insiders like banks often sold receive private information even if some-
or bought protection from institutions that where else in the institution the private data
were not privy to inside information; and are available. This is the same technique
● A more aggressive effort by the press to that investment banks have used from time
report on the loan market. immemorial to separate their private invest-
Some background is in order. The vast ment banking activities from their public
majority of loans are unambiguously private trading and sales activities.
financing arrangements between issuers and ● Underwriters. As mentioned above, in most

their lenders. Even for issuers with public primary syndications, arrangers will pre-
equity or debt that file with the SEC, the pare a public version of information mem-
credit agreement only becomes public when it oranda that is scrubbed of private
is filed, often long after closing, as an exhibit information like projections. These IMs
to an annual report (10-K), a quarterly report will be distributed to accounts that are on
(10-Q), a current report (8-K), or some other the public side of the wall. As well, under-
document (proxy statement, securities regis- writers will ask public accounts to attend a
tration, etc.). public version of the bank meeting and dis-
Beyond the credit agreement, there is a raft tribute to these accounts only scrubbed
of ongoing correspondence between issuers financial information.
and lenders that is made under confidentiality ● Buy-side accounts. On the buy-side there

agreements, including quarterly or monthly are firms that operate on either side of the
financial disclosures, covenant compliance public-private fence. Accounts that operate
information, amendment and waiver requests, on the private side receive all confidential
and financial projections, as well as plans for materials and agree to not trade in public
acquisitions or dispositions. Much of this securities of the issuers for which they get
information may be material to the financial private information. These groups are often
health of the issuer and may be out of the part of wider investment complexes that do
public domain until the issuer formally puts have public funds and portfolios but, via
out a press release or files an 8-K or some Chinese walls, are sealed from these parts of
other document with the SEC. the firms. There are also accounts that are
In recent years, this information has leaked public. These firms take only public IMs
into the public domain either via off-line con- and public materials and, therefore, retain
versations or the press. It has also come to the option to trade in the public securities
light through mark-to-market pricing serv- markets even when an issuer for which they
ices, which often report significant movement own a loan is involved. This can be tricky to
in a loan price without any corresponding pull off in practice because in the case of an
news. This is usually an indication that the amendment the lender could be called on to

Standard & Poor’s ● A Guide To The Loan Market September 2010 11


A Syndicated Loan Primer

approve or decline in the absence of any Brief descriptions of the major risk fac-
real information. To contend with this issue, tors follow.
the account could either designate one per-
son who is on the private side of the wall to Default risk
sign off on amendments or empower its Default risk is simply the likelihood of a bor-
trustee or the loan arranger to do so. But it’s rower’s being unable to pay interest or princi-
a complex proposition. pal on time. It is based on the issuer’s financial
● Vendors. Vendors of loan data, news, and
condition, industry segment, and conditions in
prices also face many challenges in manag- that industry and economic variables and
ing the flow of public and private informa- intangibles, such as company management.
tion. In generally, the vendors operate Default risk will, in most cases, be most visibly
under the freedom of the press provision of expressed by a public rating from Standard &
the U.S. Constitution’s First Amendment Poor’s Ratings Services or another ratings
and report on information in a way that agency. These ratings range from ‘AAA’ for the
anyone can simultaneously receive it—for a most creditworthy loans to ‘CCC’ for the
price of course. Therefore, the information least. The market is divided, roughly, into two
is essentially made public in a way that segments: investment grade (loans rated ‘BBB-’
doesn’t deliberately disadvantage any party, or higher) and leveraged (borrowers rated
whether it’s a news story discussing the ‘BB+’ or lower). Default risk, of course, varies
progress of an amendment or an acquisi- widely within each of these broad segments.
tion, or it’s a price change reported by a Since the mid-1990s, public loan ratings have
mark-to-market service. This, of course, become a de facto requirement for issuers that
doesn’t deal with the underlying issue that wish to tap the leveraged loan market, which,
someone who is a party to confidential as noted above, is now dominated by institu-
information is making it available via the tional investors. Unlike banks, which typically
press or prices to a broader audience. have large credit departments and adhere to
Another way in which participants deal internal rating scales, fund managers rely on
with the public versus private issue is to ask agency ratings to bracket risk and explain the
counterparties to sign “big-boy” letters overall risk of their portfolios to their own
acknowledging that there may be information investors. As of mid-2007, then, roughly three-
they are not privy to and they are agreeing to quarters of leveraged-loan volume carried a
make the trade in any case. They are, effec- loan rating, up from 45% in 1998 and virtu-
tively, big boys and will accept the risks. ally none before 1995.
The introduction of loan credit default
swaps into the fray (see below) adds another Loss-given-default risk
wrinkle to this topic because a whole new
Loss-given-default risk measures how severe a
group of public investors could come into
loss the lender would incur in the event of
play if that market catches fire.
default. Investors assess this risk based on the
collateral (if any) backing the loan and the
Credit Risk: An Overview amount of other debt and equity subordinated
Pricing a loan requires arrangers to evaluate the to the loan. Lenders will also look to
risk inherent in a loan and to gauge investor covenants to provide a way of coming back to
appetite for that risk. The principal credit risk the table early—that is, before other credi-
factors that banks and institutional investors tors—and renegotiating the terms of a loan if
contend with in buying loans are default risk the issuer fails to meet financial targets.
and loss-given-default risk. Among the primary Investment-grade loans are, in most cases, sen-
ways that accounts judge these risks are ratings, ior unsecured instruments with loosely drawn
credit statistics, industry sector trends, manage- covenants that apply only at incurrence, that
ment strength, and sponsor. All of these, is, only if an issuer makes an acquisition or
together, tell a story about the deal. issues debt. As a result, loss given default may

12 www.standardandpoors.com
be no different from risk incurred by other ing a loan in a desirable sector, like telecom
senior unsecured creditors. Leveraged loans, in the late 1990s or healthcare in the early
by contrast, are, in virtually all cases, senior 2000s, can really help a syndication along.
secured instruments with tightly drawn main- Also, defensive loans (like consumer prod-
tenance covenants, that is, covenants that are ucts) can be more appealing in a time of eco-
measured at the end of each quarter whether nomic uncertainty, whereas cyclical
or not the issuer takes any action. Loan hold- borrowers (like chemicals or autos) can be
ers, therefore, almost always are first in line more appealing during an economic upswing.
among pre-petition creditors and, in many
cases, are able to renegotiate with the issuer Sponsorship
before the loan becomes severely impaired. It Sponsorship is a factor too. Needless to say,
is no surprise, then, that loan investors histori- many leveraged companies are owned by one
cally fare much better than other creditors on or more private equity firms. These entities,
a loss-given-default basis. such as Kohlberg Kravis & Roberts or
Carlyle Group, invest in companies that have
Credit statistics leveraged capital structures. To the extent
Credit statistics are used by investors to help that the sponsor group has a strong following
calibrate both default and loss-given-default among loan investors, a loan will be easier to
risk. These statistics include a broad array of syndicate and, therefore, can be priced lower.
financial data, including credit ratios measur- In contrast, if the sponsor group does not
ing leverage (debt to capitalization and debt to have a loyal set of relationship lenders, the
EBITDA) and coverage (EBITDA to interest, deal may need to be priced higher to clear the
EBITDA to debt service, operating cash flow market. Among banks, investment factors
to fixed charges). Of course, the ratios may include whether or not the bank is party
investors use to judge credit risk vary by to the sponsor’s equity fund. Among institu-
industry. In addition to looking at trailing and tional investors, weight is given to an individ-
pro forma ratios, investors look at manage- ual deal sponsor’s track record in fixing its
ment’s projections and the assumptions behind own impaired deals by stepping up with addi-
these projections to see if the issuer’s game tional equity or replacing a management team
plan will allow it to pay its debt comfortably. that is failing.
There are ratios that are most geared to assess-
ing default risk. These include leverage and
coverage. Then there are ratios that are suited
Syndicating A Loan By Facility
for evaluating loss-given-default risk. These Most loans are structured and syndicated to
include collateral coverage, or the value of the accommodate the two primary syndicated
collateral underlying the loan relative to the lender constituencies: banks (domestic and
size of the loan. They also include the ratio of foreign) and institutional investors (primarily
senior secured loan to junior debt in the capi- structured finance vehicles, mutual funds, and
tal structure. Logically, the likely severity of insurance companies). As such, leveraged
loss-given-default for a loan increases with the loans consist of:
size of the loan as a percentage of the overall ● Pro rata debt consists of the revolving

debt structure so does. After all, if an issuer credit and amortizing term loan (TLa),
defaults on $100 million of debt, of which $10 which are packaged together and, usually,
million is in the form of senior secured loans, syndicated to banks. In some loans, how-
the loans are more likely to be fully covered in ever, institutional investors take pieces of
bankruptcy than if the loan totals $90 million. the TLa and, less often, the revolving
credit, as a way to secure a larger institu-
Industry sector tional term loan allocation. Why are these
tranches called “pro rata?” Because
Industry is a factor, because sectors, naturally,
arrangers historically syndicated revolving
go in and out of favor. For that reason, hav-

Standard & Poor’s ● A Guide To The Loan Market September 2010 13


A Syndicated Loan Primer

credit and TLas on a pro rata basis to from other capital markets activities, like
banks and finance companies. bonds, equities, or M&A advisory work.
● Institutional debt consists of term loans This process has had a breathtaking result
structured specifically for institutional on the leveraged loan market—to the point
investors, although there are also some that it is an anachronism to continue to call it
banks that buy institutional term loans. a “bank” loan market. Indeed, by the late
These tranches include first- and second- 2000s, banks were increasingly reluctant to
lien loans, as well as prefunded letters of participate in broadly syndicated loans, prefer-
credit. Traditionally, institutional tranches ring to husband capital for more profitable use,
were referred to as TLbs because they were like asset-based lending or consumer lending.
bullet payments and lined up behind TLas. Of course, there are certain issuers that can
Finance companies also play in the leveraged generate a bit more; as of mid-2010, these
loan market, and buy both pro rata and insti- include issuers with a European or even a
tutional tranches. With institutional investors Midwestern U.S. angle. Naturally, issuers
playing an ever-larger role, however, by the late with European operations are able to better
2000s, many executions were structured as tap banks in their home markets (banks still
simply revolving credit/institutional term loans, provide the lion’s share of loans in Europe),
with the TLa falling by the wayside. and, for Midwestern issuers, the heartland
remains one of the few U.S. regions with a
deep bench of local banks.
Pricing A Loan In What this means is that the spread offered
The Primary Market to pro rata investors is important, but even
Pricing loans for the institutional market is a more important, in most cases, is the amount
straightforward exercise based on simple of other, fee-driven business a bank can cap-
risk/return consideration and market techni- ture by taking a piece of a loan. For this rea-
cals. Pricing a loan for the bank market, son, issuers are careful to award pieces of
however, is more complex. Indeed, banks bond- and equity-underwriting engagements
often invest in loans for more than pure and other fee-generating business to banks
spread income. Rather, banks are driven by that are part of its loan syndicate.
the overall profitability of the issuer relation-
ship, including noncredit revenue sources. Pricing loans for institutional players
For institutional investors, the investment
Pricing loans for bank investors decision process is far more straightforward,
Since the early 1990s, almost all large com- because, as mentioned above, they are
mercial banks have adopted portfolio-man- focused not on a basket of revenue, but only
agement techniques that measure the returns on loan-specific revenue.
of loans and other credit products relative to In pricing loans to institutional investors,
risk. By doing so, banks have learned that it’s a matter of the spread of the loan relative
loans are rarely compelling investments on a to credit quality and market-based factors.
stand-alone basis. Therefore, banks are reluc- This second category can be divided into
tant to allocate capital to issuers unless the liquidity and market technicals (i.e.,
total relationship generates attractive supply/demand).
returns—whether those returns are measured Liquidity is the tricky part, but, as in all
by risk-adjusted return on capital, by return markets, all else being equal, more liquid
on economic capital, or by some other metric. instruments command thinner spreads than
If a bank is going to put a loan on its balance less liquid ones. In the old days—before insti-
sheet, then it takes a hard look not only at the tutional investors were the dominant investors
loan’s pricing, but also at other sources of rev- and banks were less focused on portfolio
enue from the relationship, including noncredit management—the size of a loan didn’t much
businesses—like cash-management services and matter. Loans sat on the books of banks and
pension-fund management—and economics stayed there. But now that institutional

14 www.standardandpoors.com
investors and banks put a premium on the ● A revolving credit (within which are
ability to package loans and sell them, liquid- options for swingline loans, multicurrency-
ity has become important. As a result, smaller borrowing, competitive-bid options, term-
executions—generally those of $200 million out, and evergreen extensions);
or less—tend to be priced at a premium to the ● A term loan;

larger loans. Of course, once a loan gets large ● An LOC; and

enough to demand extremely broad distribu- ● An acquisition or equipment line (a

tion, the issuer usually must pay a size pre- delayed-draw term loan).
mium. The thresholds range widely. During A revolving credit line allows borrowers to
the go-go mid-2000s, it was upwards of $10 draw down, repay, and reborrow. The facility
billion. During more parsimonious late-2000s acts much like a corporate credit card, except
$1 billion was considered a stretch. that borrowers are charged an annual com-
Market technicals, or supply relative to mitment fee on unused amounts, which drives
demand, is a matter of simple economics. If up the overall cost of borrowing (the facility
there are a lot of dollars chasing little prod- fee). Revolvers to speculative-grade issuers
uct, then, naturally, issuers will be able to are often tied to borrowing-base lending for-
command lower spreads. If, however, the mulas. This limits borrowings to a certain
opposite is true, then spreads will need to percentage of collateral, most often receiv-
increase for loans to clear the market. ables and inventory. Revolving credits often
run for 364 days. These revolving credits—
called, not surprisingly, 364-day facilities—
Mark-To-Market’s Effect are generally limited to the investment-grade
Beginning in 2000, the SEC directed bank loan market. The reason for what seems like an
mutual fund managers to use available mark- odd term is that regulatory capital guidelines
to-market data (bid/ask levels reported by sec- mandate that, after one year of extending
ondary traders and compiled by credit under a revolving facility, banks must
mark-to-market services like Markit Loans) then increase their capital reserves to take
rather than fair value (estimated prices), to into account the unused amounts. Therefore,
determine the value of broadly syndicated banks can offer issuers 364-day facilities at a
loans for portfolio-valuation purposes. In lower unused fee than a multiyear revolving
broad terms, this policy has made the market credit. There are a number of options that
more transparent, improved price discovery can be offered within a revolving credit line:
and, in doing so, made the market far more 1. A swingline is a small, overnight borrow-
efficient and dynamic than it was in the past. ing line, typically provided by the agent.
In the primary market, for instance, leveraged 2. A multicurrency line may allow the bor-
loan spreads are now determined not only by rower to borrow in several currencies.
rating and leverage profile, but also by trading 3. A competitive-bid option (CBO) allows
levels of an issuer’s previous loans and, often, borrowers to solicit the best bids from its
bonds. Issuers and investors can also look at syndicate group. The agent will conduct
the trading levels of comparable loans for mar- what amounts to an auction to raise funds
ket-clearing levels. What’s more, market senti- for the borrower, and the best bids are
ment is tied to supply and demand. As a result, accepted. CBOs typically are available only
new-issue spreads rise and fall far more rapidly to large, investment-grade borrowers.
than in the past, when spreads were more or 4. A term-out will allow the borrower to con-
less the same for every leveraged transaction. vert borrowings into a term loan at a given
conversion date. This, again, is usually a
feature of investment-grade loans. Under
Types Of Syndicated
the option, borrowers may take what is
Loan Facilities
outstanding under the facility and pay it
There are four main types of syndicated off according to a predetermined repay-
loan facilities:

Standard & Poor’s ● A Guide To The Loan Market September 2010 15


A Syndicated Loan Primer

ment schedule. Often the spreads ratchet down for a given period to purchase specified
up if the term-out option is exercised. assets or equipment or to make acquisitions.
5. An evergreen is an option for the bor- The issuer pays a fee during the commitment
rower—with consent of the syndicate period (a ticking fee). The lines are then repaid
group—to extend the facility each year for over a specified period (the term-out period).
an additional year. Repaid amounts may not be reborrowed.
A term loan is simply an installment loan, Bridge loans are loans that are intended to
such as a loan one would use to buy a car. provide short-term financing to provide a
The borrower may draw on the loan during a “bridge” to an asset sale, bond offering,
short commitment period and repays it based stock offering, divestiture, etc. Generally,
on either a scheduled series of repayments or bridge loans are provided by arrangers as
a one-time lump-sum payment at maturity part of an overall financing package.
(bullet payment). There are two principal Typically, the issuer will agree to increasing
types of term loans: interest rates if the loan is not repaid as
● An amortizing term loan (A-term loans, or expected. For example, a loan could start at a
TLa) is a term loan with a progressive spread of L+250 and ratchet up 50 basis
repayment schedule that typically runs six points (bp) every six months the loan remains
years or less. These loans are normally syn- outstanding past one year.
dicated to banks along with revolving cred- Equity bridge loan is a bridge loan pro-
its as part of a larger syndication. Starting vided by arrangers that is expected to be
in 2000, A-term loans became increasingly repaid by secondary equity commitment to a
rare, as issuers bypassed the less-accommo- leveraged buyout. This product is used when
dating bank market and tapped institu- a private equity firm wants to close on a deal
tional investors for all or most of their that requires, say, $1 billion of equity of
funded loans. which it ultimately wants to hold half. The
● An institutional term loan (B-term, C-term, arrangers bridge the additional $500 million,
or D-term loans) is a term loan facility which would be then repaid when other
carved out for nonbank, institutional sponsors come into the deal to take the $500
investors. These loans came into broad usage million of additional equity. Needless to say,
during the mid-1990s as the institutional this is a hot-market product.
loan investor base grew. Until 2001, these
loans were, in almost all cases, priced higher
than amortizing term loans, because they
Second-Lien Loans
had longer maturities and back-end–loaded Although they are really just another type of
repayment schedules. The tide turned, how- syndicated loan facility, second-lien loans are
ever, in late 2001, and through 2007 the sufficiently complex to warrant a separate sec-
spread on a growing percentage of these tion in this primer. After a brief flirtation with
facilities into parity with (in some cases even second-lien loans in the mid-1990s, these
lower than) revolvers and A-term loans. This facilities fell out of favor after the Russian
is especially true when institutional demand debt crisis caused investors to adopt a more
runs high. When the market turns negative, cautious tone. But after default rates fell pre-
however, as it did in late 2007, institutional cipitously in 2003, arrangers rolled out sec-
spreads climb higher than pro rata spreads. ond-lien facilities to help finance issuers
This institutional category also includes sec- struggling with liquidity problems. By 2007,
ond-lien loans and covenant-lite loans, the market had accepted second-lien loans to
which are described below. finance a wide array of transactions, including
LOCs differ, but, simply put, they are guar- acquisitions and recapitalizations. Arrangers
antees provided by the bank group to pay off tap nontraditional accounts—hedge funds,
debt or obligations if the borrower cannot. distress investors, and high-yield accounts—as
Acquisition/equipment lines (delayed-draw well as traditional CLO and prime fund
term loans) are credits that may be drawn accounts to finance second-lien loans.

16 www.standardandpoors.com
As their name implies, the claims on collat- if collateral covers their claims, but does
eral of second-lien loans are behind those of not cover the claims of the second-lien
first-lien loans. Second-lien loans also typi- lenders. This may not be the case if the
cally have less restrictive covenant packages, loans are documented together and the
in which maintenance covenant levels are set first- and second-lien lenders are deemed a
wide of the first-lien loans. As a result, sec- unified class by the bankruptcy court.
ond-lien loans are priced at a premium to For more information, we suggest Latham &
first-lien loans. This premium typically starts Watkins’ terrific overview and analysis of sec-
at 200 bps when the collateral coverage goes ond-lien loans, which was published on April
far beyond the claims of both the first- and 15, 2004 in the firm’s CreditAlert publication.
second-lien loans to more than 1,000 bps for
less generous collateral.
There are, lawyers explain, two main ways
Covenant-Lite Loans
in which the collateral of second-lien loans Like second-lien loans, covenant-lite loans are
can be documented. Either the second-lien really just another type of syndicated loan
loan can be part of a single security agree- facility. But they also are sufficiently different
ment with first-lien loans, or they can be part to warrant their own section in this primer.
of an altogether separate agreement. In the At the most basic level, covenant-lite loans
case of a single agreement, the agreement are loans that have bond-like financial
would apportion the collateral, with value incurrence covenants rather than traditional
going first, obviously, to the first-lien claims maintenance covenants that are normally
and next to the second-lien claims. part and parcel of a loan agreement. What’s
Alternatively, there can be two entirely sepa- the difference?
rate agreements. Here’s a brief summary: Incurrence covenants generally require that
● In a single security agreement, the second- if an issuer takes an action (paying a divi-
lien lenders are in the same creditor class as dend, making an acquisition, issuing more
the first-lien lenders from the standpoint of debt), it would need to still be in compliance.
a bankruptcy, according to lawyers who So, for instance, an issuer that has an incur-
specialize in these loans. As a result, for rence test that limits its debt to 5x cash flow
adequate protection to be paid the collat- would only be able to take on more debt if,
eral must cover both the claims of the first- on a pro forma basis, it was still within this
and second-lien lenders. If it does not, the constraint. If not, then it would have
judge may choose to not pay adequate pro- breeched the covenant and be in technical
tection or to divide it pro rata among the default on the loan. If, on the other hand, an
first- and second-lien creditors. In addition, issuer found itself above this 5x threshold
the second-lien lenders may have a vote as simply because its earnings had deteriorated,
secured lenders equal to those of the first- it would not violate the covenant.
lien lenders. One downside for second-lien Maintenance covenants are far more restric-
lenders is that these facilities are often tive. This is because they require an issuer to
smaller than the first-lien loans and, there- meet certain financial tests every quarter
fore, when a vote comes up, first-lien whether or not it takes an action. So, in the
lenders can outvote second-lien lenders to case above, had the 5x leverage maximum
promote their own interests. been a maintenance rather than incurrence test,
● In the case of two separate security agree- the issuer would need to pass it each quarter
ments, divided by a standstill agreement, and would be in violation if either its earnings
the first- and second-lien lenders are likely eroded or its debt level increased. For lenders,
to be divided into two separate creditor clearly, maintenance tests are preferable
classes. As a result, second-lien lenders do because it allows them to take action earlier if
not have a voice in the first-lien creditor an issuer experiences financial distress. What’s
committees. As well, first-lien lenders can more, the lenders may be able to wrest some
receive adequate protection payments even concessions from an issuer that is in violation

Standard & Poor’s ● A Guide To The Loan Market September 2010 17


A Syndicated Loan Primer

of covenants (a fee, incremental spread, or title available, as is often the case for
additional collateral) in exchange for a waiver. smaller loans.
Conversely, issuers prefer incurrence ● The co-agent or managing agent is largely
covenants precisely because they are less a meaningless title used mostly as an award
stringent. Covenant-lite loans, therefore, for large commitments.
thrive only in the hottest markets when the ● The lead arranger or book runner title is a
supply/demand equation is tilted persuasively league table designation used to indicate
in favor of issuers. the “top dog” in a syndication.

Lender Titles Secondary Sales


In the formative days of the syndicated loan Secondary sales occur after the loan is closed
market (the late 1980s), there was usually and allocated, when investors are free to
one agent that syndicated each loan. “Lead trade the paper. Loan sales are structured as
manager” and “manager” titles were doled either assignments or participations, with
out in exchange for large commitments. As investors usually trading through dealer desks
league tables gained influence as a marketing at the large underwriting banks. Dealer-to-
tool, “co-agent” titles were often used in dealer trading is almost always conducted
attracting large commitments or in cases through a “street” broker.
where these institutions truly had a role in
underwriting and syndicating the loan. Assignments
During the 1990s, the use of league tables In an assignment, the assignee becomes a
and, consequently, title inflation exploded. direct signatory to the loan and receives inter-
Indeed, the co-agent title has become largely est and principal payments directly from the
ceremonial today, routinely awarded for what administrative agent.
amounts to no more than large retail commit- Assignments typically require the consent of
ments. In most syndications, there is one lead the borrower and agent, although consent may
arranger. This institution is considered to be be withheld only if a reasonable objection is
on the “left” (a reference to its position in a made. In many loan agreements, the issuer
tombstone ad). There are also likely to be loses its right to consent in the event of default.
other banks in the arranger group, which may The loan document usually sets a minimum
also have a hand in underwriting and syndi- assignment amount, usually $5 million, for
cating a credit. These institutions are said to pro rata commitments. In the late 1990s, how-
be on the “right.” ever, administrative agents started to break out
The different titles used by significant par- specific assignment minimums for institutional
ticipants in the syndications process are tranches. In most cases, institutional assign-
administrative agent, syndication agent, docu- ment minimums were reduced to $1 million in
mentation agent, agent, co-agent or managing an effort to boost liquidity. There were also
agent, and lead arranger or book runner: some cases where assignment fees were
● The administrative agent is the bank that
reduced or even eliminated for institutional
handles all interest and principal payments assignments, but these lower assignment fees
and monitors the loan. remained rare into 2010, and the vast majority
● The syndication agent is the bank that han-
was set at the traditional $3,500.
dles, in purest form, the syndication of the One market convention that became firmly
loan. Often, however, the syndication agent established in the late 1990s was assignment-
has a less specific role. fee waivers by arrangers for trades crossed
● The documentation agent is the bank that
through its secondary trading desk. This was
handles the documents and chooses the a way to encourage investors to trade with
law firm. the arranger rather than with another dealer.
● The agent title is used to indicate the lead
This is a significant incentive to trade with
bank when there is no other conclusive arranger—or a deterrent to not trade away,

18 www.standardandpoors.com
depending on your perspective—because a reference instruments. In June 2006, the
$3,500 fee amounts to between 7 bps to 35 International Settlement and Dealers
bps of a $1 million to $5 million trade. Association issued a standard trade confirma-
tion for LCDS contracts.
Primary assignments Like all credit default swaps (CDS), an
This term is something of an oxymoron. It LCDS is basically an insurance contract. The
applies to primary commitments made by off- seller is paid a spread in exchange for agree-
shore accounts (principally CLOs and hedge ing to buy at par, or a pre-negotiated price, a
funds). These vehicles, for a variety of tax loan if that loan defaults. LCDS enables par-
reasons, suffer tax consequence from buying ticipants to synthetically buy a loan by going
loans in the primary. The agent will therefore short the CDS or sell the loan by going long
hold the loan on its books for some short the CDS. Theoretically, then, a loanholder
period after the loan closes and then sell it to can hedge a position either directly (by buy-
these investors via an assignment. These are ing CDS protection on that specific name) or
called primary assignments and are effectively indirectly (by buying protection on a compa-
primary purchases. rable name or basket of names).
Moreover, unlike the cash markets, which
Participations are long-only markets for obvious reasons,
the CDS market provides a way for investors
A participation is an agreement between an
to short a loan. To do so, the investor would
existing lender and a participant. As the
buy protection on a loan that it doesn’t hold.
name implies, it means the buyer is taking
If the loan subsequently defaults, the buyer of
a participating interest in the existing
protection should be able to purchase the
lender’s commitment.
loan in the secondary market at a discount
The lender remains the official holder of the
and then and deliver it at par to the counter-
loan, with the participant owning the rights to
party from which it bought the LCDS con-
the amount purchased. Consents, fees, or min-
tract. For instance, say an account buys
imums are almost never required. The partici-
five-year protection for a given loan, for
pant has the right to vote only on material
which it pays 250 bps a year. Then in year 2
changes in the loan document (rate, term, and
the loan goes into default and the market
collateral). Nonmaterial changes do not
price falls to 80% of par. The buyer of the
require approval of participants. A participa-
protection can then buy the loan at 80 and
tion can be a riskier way of purchasing a loan,
deliver to the counterpart at 100, a 20-point
because, in the event of a lender becoming
pickup. Or instead of physical delivery, some
insolvent or defaulting, the participant does
buyers of protection may prefer cash settle-
not have a direct claim on the loan. In this
ment in which the difference between the cur-
case, the participant then becomes a creditor
rent market price and the delivery price is
of the lender and often must wait for claims to
determined by polling dealers or using a
be sorted out to collect on its participation.
third-party pricing service. Cash settlement
could also be employed if there’s not enough
Loan Derivatives paper to physically settle all LCDS contracts
Loan credit default swaps on a particular loan.
Traditionally, accounts bought and sold loans in Of course, as of this writing, the LCDS
the cash market through assignments and par- market was still in its infancy and therefore
ticipations. Aside from that, there was little syn- additional context is yet to come.
thetic activity outside over-the-counter total rate
of return swaps. By 2008, however, the market LCDX
for synthetically trading loans was budding. Introduced in 2007, the LCDX is an index of
Loan credit default swaps (LCDS) are stan- 100 LCDS obligations that participants can
dard derivatives that have secured loans as trade. The index provides a straightforward
way for participants to take long or short

Standard & Poor’s ● A Guide To The Loan Market September 2010 19


A Syndicated Loan Primer

positions on a broad basket of loans, as well ● 200 bps (L+250 minus the borrowing
as hedge their exposure to the market. cost of L+50) on the remaining amount
Markit Partners administers the LCDX, a of $9 million.
product of CDS Index Co., a firm set up by a The resulting income is L+250 * $1 million
group of dealers. Like LCDS, the LCDX plus 200 bps * $9 million. Based on the par-
Index is an over-the-counter product. ticipants’ collateral amount—or equity contri-
The LCDX will be reset every six months bution—of $1 million, the return is L+2020.
with participants able to trade each vintage If LIBOR is 5%, the return is 25.5%. Of
of the index that is still active. The index will course, this is not a risk-free proposition. If
be set at an initial spread based on the refer- the issuer defaults and the value of the loan
ence instruments and trade on a price basis. goes to 70 cents on the dollar, the participant
According to the primer posted by Markit will lose $3 million. And if the loan does not
(http://www.markit.com/information/affilia- default but is marked down for whatever rea-
tions/lcdx/alertParagraphs/01/document/LCD son—market spreads widen, it is down-
X%20Primer.pdf), “the two events that graded, its financial condition
would trigger a payout from the buyer (pro- deteriorates—the participant stands to lose
tection seller) of the index are bankruptcy or the difference between par and the current
failure to pay a scheduled payment on any market price when the TRS expires. Or, in an
debt (after a grace period), for any of the extreme case, the value declines below the
constituents of the index.” value in the collateral account and the partic-
All documentation for the index is posted ipant is hit with a margin call.
at: http://www.markit.com/information/affili-
ations/lcdx/alertParagraphs/01/document/LC
DX%20Primer.pdf.
Pricing Terms
Rates
Total rate of return swaps (TRS) Bank loans usually offer borrowers different
interest-rate options. Several of these options
This is the oldest way for participants to pur-
allow borrowers to lock in a given rate for
chase loans synthetically. And, in reality, a
one month to one year. Pricing on many
TRS is little more than buying a loan on mar-
loans is tied to performance grids, which
gin. In simple terms, under a TRS program a
adjust pricing by one or more financial crite-
participant buys the income stream created
ria. Pricing is typically tied to ratings in
by a loan from a counterparty, usually a
investment-grade loans and to financial ratios
dealer. The participant puts down some per-
in leveraged loans. Communications loans are
centage as collateral, say 10%, and borrows
invariably tied to the borrower’s debt-to-
the rest from the dealer. Then the participant
cash-flow ratio.
receives the spread of the loan less the finan-
Syndication pricing options include prime,
cial cost plus LIBOR on its collateral
LIBOR, CD, and other fixed-rate options:
account. If the reference loan defaults, the
● The prime is a floating-rate option.
participant is obligated to buy it at par or
Borrowed funds are priced at a spread over
cash settle the loss based on a mark-to-mar-
the reference bank’s prime lending rate.
ket price or an auction price.
The rate is reset daily, and borrowers may
Here’s how the economics of a TRS work,
be repaid at any time without penalty. This
in simple terms. A participant buys via TRS a
is typically an overnight option, because
$10 million position in a loan paying L+250.
the prime option is more costly to the bor-
To affect the purchase, the participant puts
rower than LIBOR or CDs.
$1 million in a collateral account and pays
● The LIBOR (or Eurodollar) option is so
L+50 on the balance (meaning leverage of
called because, with this option, the inter-
9:1). Thus, the participant would receive:
est on borrowings is set at a spread over
● L+250 on the amount in the collateral
LIBOR for a period of one month to one
account of $1 million, plus
year. The corresponding LIBOR rate is

20 www.standardandpoors.com
used to set pricing. Borrowings cannot be fees will be structured as a percentage of
prepaid without penalty. final allocation plus a flat fee. This hap-
● The CD option works precisely like the pens most often for larger fee tiers, to
LIBOR option, except that the base rate is encourage potential lenders to step up for
certificates of deposit, sold by a bank to larger commitments. The flat fee is paid
institutional investors. regardless of the lender’s final allocation.
● Other fixed-rate options are less common Fees are usually paid to banks, mutual
but work like the LIBOR and CD options. funds, and other non-offshore investors as
These include federal funds (the overnight an upfront payment. CLOs and other off-
rate charged by the Federal Reserve to shore vehicles are typically brought in after
member banks) and cost of funds (the the loan closes as a “primary” assignment,
bank’s own funding rate). and they simply buy the loan at a discount
equal to the fee offered in the primary
LIBOR floors assignment, for tax purposes.
As the name implies, LIBOR floors put a floor ● A commitment fee is a fee paid to lenders
under the base rate for loans. If a loan has a on undrawn amounts, under a revolving
3% LIBOR floor and three-month LIBOR credit or a term loan prior to draw-down.
falls below this level, the base rate for any On term loans, this fee is usually referred
resets default to 3%. For obvious reasons, to as a “ticking” fee.
LIBOR floors are generally seen during peri- ● A facility fee, which is paid on a facility’s
ods when market conditions are difficult and entire committed amount, regardless of
rates are falling as an incentive for lenders. usage, is often charged instead of a com-
mitment fee on revolving credits to invest-
Fees ment-grade borrowers, because these
facilities typically have CBOs that allow a
The fees associated with syndicated loans are
borrower to solicit the best bid from its
the upfront fee, the commitment fee, the
syndicate group for a given borrowing. The
facility fee, the administrative agent fee, the
lenders that do not lend under the CBO are
letter of credit (LOC) fee, and the cancella-
still paid for their commitment.
tion or prepayment fee.
● A usage fee is a fee paid when the utiliza-
● An upfront fee, which is the same as an
tion of a revolving credit falls below a cer-
original-issue discount in the bond market,
tain minimum. These fees are applied
is a fee paid by the issuer. It is often tiered,
mainly to investment-grade loans and gen-
with the lead arranger receiving a larger
erally call for fees based on the utilization
amount in consideration of its structuring
under a revolving credit. In some cases, the
and/or underwriting the loan. Co-under-
fees are for high use and, in some cases, for
writers will receive a lower fee, and then
low use. Often, either the facility fee or the
the general syndicate will likely have fees
spread will be adjusted higher or lower
tied to their commitment. Most often, fees
based on a pre-set usage level.
are paid on a lender’s final allocation. For
● A prepayment fee is a feature generally
example, a loan has two fee tiers: 100 bps
associated with institutional term loans.
(or 1%) for $25 million commitments and
This fee is seen mainly in weak markets as
50 bps for $15 million commitments. A
an inducement to institutional investors.
lender committing to the $25 million tier
Typical prepayment fees will be set on a
will be paid on its final allocation rather
sliding scale; for instance, 2% in year one
than on initial commitment, which means
and 1% in year two. The fee may be
that, in this example, the loan is oversub-
applied to all repayments under a loan or
scribed and lenders committing $25 million
“soft” repayments, those made from a refi-
would be allocated $20 million and the
nancing or at the discretion of the issuer
lenders would receive a fee of $200,000 (or
(as opposed to hard repayments made from
1% of $20 million). Sometimes upfront
excess cash flow or asset sales).

Standard & Poor’s ● A Guide To The Loan Market September 2010 21


A Syndicated Loan Primer

● An administrative agent fee is the annual fee deal and the arranger, to rally investors, may
typically paid to administer the loan (includ- then pay a quarter of this amount, or 0.50%,
ing to distribute interest payments to the to lender group.
syndication group, to update lender lists, An OID, however, is generally borne by the
and to manage borrowings). For secured issuer, above and beyond the arrangement
loans (particularly those backed by receiv- fee. So the arranger would receive its 2% fee
ables and inventory), the agent often collects and the issuer would only receive 99 cents for
a collateral monitoring fee, to ensure that every dollar of loan sold.
the promised collateral is in place. For instance, take a $100 million loan
An LOC fee can be any one of several offered at a 1% OID. The issuer would receive
types. The most common—a fee for standby $99 million, of which it would pay the
or financial LOCs—guarantees that lenders arrangers 2%. The issuer then would be obli-
will support various corporate activities. gated to pay back the whole $100 million,
Because these LOCs are considered “bor- even though it received $97 million after fees.
rowed funds” under capital guidelines, the fee Now, take the same $100 million loan offered
is typically the same as the LIBOR margin. at par with an upfront fee of 1%. In this case,
Fees for commercial LOCs (those supporting the issuer gets the full $100 million. In this
inventory or trade) are usually lower, because case, the lenders would buy the loan not at
in these cases actual collateral is submitted). par, but at 99 cents on the dollar. The issuer
The LOC is usually issued by a fronting bank would receive $100 million of which it would
(usually the agent) and syndicated to the pay 2% to the arranger, which would then pay
lender group on a pro rata basis. The group one-half of that amount to the lending group.
receives the LOC fee on their respective The issuer gets, after fees, $98 million.
shares, while the fronting bank receives an Clearly, OID is a better deal for the arranger
issuing (or fronting, or facing) fee for issuing and, therefore, is generally seen in more chal-
and administering the LOC. This fee is lenging markets. Upfront fees, conversely, are
almost always 12.5 bps to 25 bps (0.125% to more issuer friendly and therefore are staples
0.25%) of the LOC commitment. of better market conditions. Of course, during
the most muscular bull markets, new-issue
Original issue discounts (OID) paper is generally sold at par and therefore
This is yet another term imported from the requires neither upfront fees nor OIDs.
bond market. The OID, the discount from
par at loan, is offered in the new issue market Voting rights
as a spread enhancement. A loan may be Amendments or changes to a loan agreement
issued at 99 bps to pay par. The OID in this must be approved by a certain percentage of
case is said to be 100 bps, or 1 point. lenders. Most loan agreements have three lev-
els of approval: required-lender level, full
OID Versus Upfront Fees vote, and supermajority:
● The “required-lenders” level, usually just a
At this point, the careful reader may be won-
dering just what the difference is between an simple majority, is used for approval of
OID and an upfront fee. After all, in both nonmaterial amendments and waivers or
cases the lender effectively pays less than par changes affecting one facility within a deal.
● A full vote of all lenders, including partici-
for a loan.
From the perspective of the lender, actually, pants, is required to approve material
there isn’t much of a difference. But for the changes such as RATS (rate, amortization,
issuer and arrangers, the distinction is far term, and security; or collateral) rights,
more than semantics. Upfront fees are gener- but, as described below, there are occasions
ally paid from the arrangers underwriting fee when changes in amortization and collat-
as an incentive to bring lenders into the deal. eral may be approved by a lower percent-
An issuer may pay the arranger 2% of the age of lenders (a supermajority).

22 www.standardandpoors.com
● A supermajority is typically 67% to 80% critical difference between loans and bonds.
of lenders and is sometimes required for Bonds and covenant-lite loans (see above), by
certain material changes such as changes in contrast, usually contain incurrence covenants
amortization (in-term repayments) and that restrict the borrower’s ability to issue new
release of collateral. Used periodically in debt, make acquisitions, or take other action
the mid-1990s, these provisions fell out of that would breach the covenant. For instance,
favor by the late 1990s. a bond indenture may require the issuer to not
incur any new debt if that new debt would
push it over a specified ratio of debt to
Covenants EBITDA. But, if the company’s cash flow dete-
Loan agreements have a series of restrictions riorates to the point where its debt to EBITDA
that dictate, to varying degrees, how borrow- ratio exceeds the same limit, a covenant viola-
ers can operate and carry themselves finan- tion would not be triggered. This is because
cially. For instance, one covenant may require the ratio would have climbed organically
the borrower to maintain its existing fiscal- rather than through some action by the issuer.
year end. Another may prohibit it from tak- As a borrower’s risk increases, financial
ing on new debt. Most agreements also have covenants in the loan agreement become
financial compliance covenants, for example, more tightly wound and extensive. In general,
that a borrower must maintain a prescribed there are five types of financial covenants—
level of equity, which, if not maintained, gives coverage, leverage, current ratio, tangible net
banks the right to terminate the agreement or worth, and maximum capital expenditures:
push the borrower into default. The size of ● A coverage covenant requires the borrower

the covenant package increases in proportion to maintain a minimum level of cash flow
to a borrower’s financial risk. Agreements to or earnings, relative to specified expenses,
investment-grade companies are usually thin most often interest, debt service (interest
and simple. Agreements to leveraged borrow- and repayments), fixed charges (debt serv-
ers are often much more onerous. ice, capital expenditures, and/or rent).
The three primary types of loan covenants ● A leverage covenant sets a maximum level

are affirmative, negative, and financial. of debt, relative to either equity or cash
Affirmative covenants state what action the flow, with the debt-to-cash-flow level being
borrower must take to be in compliance with far more common.
the loan, such as that it must maintain insur- ● A current-ratio covenant requires that the

ance. These covenants are usually boilerplate borrower maintain a minimum ratio of cur-
and require a borrower to pay the bank inter- rent assets (cash, marketable securities,
est and fees, maintain insurance, pay taxes, accounts receivable, and inventories) to cur-
and so forth. rent liabilities (accounts payable, short-term
Negative covenants limit the borrower’s debt of less than one year), but sometimes a
activities in some way, such as regarding new “quick ratio,” in which inventories are
investments. Negative covenants, which are excluded from the numerate, is substituted.
highly structured and customized to a bor- ● A tangible-net-worth (TNW) covenant

rower’s specific condition, can limit the type requires that the borrower have a mini-
and amount of investments, new debt, liens, mum level of TNW (net worth less intangi-
asset sales, acquisitions, and guarantees. ble assets, such as goodwill, intellectual
Financial covenants enforce minimum finan- assets, excess value paid for acquired com-
cial performance measures against the bor- panies), often with a build-up provision,
rower, such as that he must maintain a higher which increases the minimum by a percent-
level of current assets than of current liabili- age of net income or equity issuance.
ties. The presence of these maintenance ● A maximum-capital-expenditures covenant

covenants—so called because the issuer must requires that the borrower limit capital
maintain quarterly compliance or suffer a expenditures (purchases of property, plant,
technical default on the loan agreement—is a and equipment) to a certain amount, which

Standard & Poor’s ● A Guide To The Loan Market September 2010 23


A Syndicated Loan Primer

may be increased by some percentage of and are unencumbered by liens, but the hold-
cash flow or equity issuance, but often ing company pledges the stock of the operat-
allowing the borrower to carry forward ing companies to the lenders. This effectively
unused amounts from one year to the next. gives lenders control of these units if the com-
pany defaults. The risk to lenders in this situ-
ation, simply put, is that a bankruptcy court
Mandatory Prepayments collapses the holding company with the oper-
Leveraged loans usually require a borrower ating companies and effectively renders the
to prepay with proceeds of excess cash flow, stock worthless. In these cases, which hap-
asset sales, debt issuance, or equity issuance. pened on a few occasions to lenders to retail
● Excess cash flow is typically defined as cash companies in the early 1990s, loan holders
flow after all cash expenses, required divi- become unsecured lenders of the company
dends, debt repayments, capital expendi- and are put back on the same level with other
tures, and changes in working capital. The senior unsecured creditors.
typical percentage required is 50% to 75%.
● Asset sales are defined as net proceeds of Springing liens/collateral release
asset sales, normally excluding receivables
Some loans have provisions that borrowers
or inventories. The typical percentage
that sit on the cusp of investment-grade and
required is 100%.
speculative-grade must either attach collateral
● Debt issuance is defined as net proceeds
or release it if the issuer’s rating changes.
from debt issuance. The typical percentage
A ‘BBB’ or ‘BBB-’ issuer may be able to
required is 100%.
convince lenders to provide unsecured financ-
● Equity issuance is defined as the net pro-
ing, but lenders may demand springing liens
ceeds of equity issuance. The typical per-
in the event the issuer’s credit quality deterio-
centage required is 25% to 50%.
rates. Often, an issuer’s rating being lowered
Often, repayments from excess cash flow
to ‘BB+’ or exceeding its predetermined lever-
and equity issuance are waived if the issuer
age level will trigger this provision. Likewise,
meets a preset financial hurdle, most often
lenders may demand collateral from a strong,
structured as a debt/EBITDA test.
speculative-grade issuer, but will offer to
release under certain circumstances, such as if
Collateral
the issuer loses its investment-grade rating.
In the leveraged market, collateral usually
includes all the tangible and intangible assets Change of control
of the borrower and, in some cases, specific
Invariably, one of the events of default in a
assets that back a loan.
credit agreement is a change of issuer control.
Virtually all leveraged loans and some of
For both investment-grade and leveraged
the more shaky investment-grade credits are
issuers, an event of default in a credit agree-
backed by pledges of collateral. In the asset-
ment will be triggered by a merger, an acqui-
based market, for instance, that typically
sition of the issuer, some substantial purchase
takes the form of inventories and receivables,
of the issuer’s equity by a third party, or a
with the amount of the loan tied to a formula
change in the majority of the board of direc-
based off of these assets. The common rule is
tors. For sponsor-backed leveraged issuers,
that an issuer can borrow against 50% of
the sponsor’s lowering its stake below a pre-
inventory and 80% of receivables. Naturally,
set amount can also trip this clause.
there are loans backed by certain equipment,
real estate, and other property.
Equity cures
In the leveraged market, there are some
loans—since the early 1990s, very few—that These provision allow issuers to fix a
are backed by capital stock of operating covenant violation—exceeding the maximum
units. In this structure, the assets of the issuer debt to EBITDA test for instance—by making
tend to be at the operating-company level an equity contribution. These provisions are

24 www.standardandpoors.com
generally found in private equity backed In addition, asset-based lending is often done
deals. The equity cure is a right, not an obli- based on specific equipment, real estate, car
gation. Therefore, a private equity firm will fleets, and an unlimited number of other assets.
want these provisions, which, if they think it’s
worth it, allows them to cure a violation with- Loan math—the art of spread calculation
out going through an amendment process, Calculating loan yields or spreads is not
through which lenders will often ask for straightforward. Unlike most bonds, which
wider spreads and/or fees in exchange for have long no-call periods and high-call premi-
waiving the violation even with an infusion of ums, most loans are prepayable at any time
new equity. Some agreements don’t limit the typically without prepayment fees. And, even
number of equity cures while others cap the in cases where prepayment fees apply, they
number to, say, one a year or two over the life are rarely more than 2% in year one and 1%
of the loan. It’s a negotiated point, however, in year two. Therefore, affixing a spread-to-
so there is no rule of thumb. Some agreements maturity or a spread-to-worst on loans is lit-
offer none, others an unlimited number. Bull tle more than a theoretical calculation.
markets tend to inspire more generous equity This is because an issuer’s behavior is
cures for obvious reasons, while in bear mar- unpredictable. It may repay a loan early
kets lenders are more parsimonious. because a more compelling financial opportu-
nity presents itself or because the issuer is
Asset-based lending acquired or because it is making an acquisi-
Most of the information above refers to tion and needs a new financing. Traders and
“cash flow” loans, loans that may be secured investors will often speak of loan spreads,
by collateral, but are repaid by cash flow. therefore, as a spread to a theoretical call.
Asset-based lending is a distinct segment of Loans, on average, between 1997 and 2004
the loan market. These loans are secured by had a 15-month average life. So, if you buy a
specific assets and usually governed by a bor- loan with a spread of 250 bps at a price of
rowing formula (or a “borrowing base”). The 101, you might assume your spread-to-
most common type of asset-based loans are expected-life as the 250 bps less the amor-
receivables and/or inventory lines. These are tized 100 bps premium or LIBOR+170.
revolving credits that have a maximum bor- Conversely, if you bought the same loan at
rowing limit, say $100 million, but also have 99, the spread-to-expect life would be
a cap based on the value of an issuer’s LIBOR+330.
pledged receivables and inventories. Usually,
the receivables are pledged and the issuer
may borrow against 80%, give or take.
Default And Restructuring
Inventories are also often pledged to secure There are two primary types of loan defaults:
borrowings. However, because they are obvi- technical defaults and the much more serious
ously less liquid than receivables, lenders are payment defaults. Technical defaults occur
less generous in their formula. Indeed, the when the issuer violates a provision of the loan
borrowing base for inventories is typically in agreement. For instance, if an issuer doesn’t
the 50% to 65% range. In addition, the bor- meet a financial covenant test or fails to pro-
rowing base may be further divided into sub- vide lenders with financial information or some
categories—for instance, 50% of other violation that doesn’t involve payments.
work-in-process inventory and 65% of fin- When this occurs, the lenders can acceler-
ished goods inventory. ate the loan and force the issuer into bank-
In many receivables-based facilities, issuers ruptcy. That’s the most extreme measure. In
are required to place receivables in a “lock most cases, the issuer and lenders can agree
box.” That means that the bank lends against on an amendment that waives the violation in
the receivable, takes possession of it, and exchange for a fee, spread increase, and/or
then collects it to pay down the loan. tighter terms.

Standard & Poor’s ● A Guide To The Loan Market September 2010 25


A Syndicated Loan Primer

A payment default is a more serious matter. The second phase is the conversion, in
As the name implies, this type of default which lenders can exchange existing loans for
occurs when a company misses either an new loans. In the end, the issuer is left with
interest or principal payment. There is often a two tranches: (1) the legacy paper at the ini-
pre-set period of time, say 30 days, during tial price and maturity and (2) the new facil-
which an issuer can cure a default (the “cure ity at a wider spread. The innovation here:
period”). After that, the lenders can choose amend-to-extend allows an issuer to term-out
to either provide a forbearance agreement loans without actually refinancing into a new
that gives the issuer some breathing room or credit (which obviously would require mark-
take appropriate action, up to and including ing the entire loan to market, entailing higher
accelerating, or calling, the loan. spreads, a new OID, and stricter covenants).
If the lenders accelerate, the company will
generally declare bankruptcy and restructure
their debt through Chapter 11. If the com-
DIP Loans
pany is not worth saving, however, because Debtor-in-possession (DIP) loans are made to
its primary business has cratered, then the bankrupt entities. These loans constitute
issuer and lenders may agree to a Chapter 7 super-priority claims in the bankruptcy distri-
liquidation, in which the assets of the busi- bution scheme, and thus sit ahead of all
ness are sold and the proceeds dispensed to prepretition claims. Many DIPs are further
the creditors. secured by priming liens on the debtor’s col-
lateral (see below).
Traditionally, prepetition lenders provided
Amend-To-Extend DIP loans as a way to keep a company viable
This technique allows an issuer to push out during the bankruptcy process. In the early
part of its loan maturities through an amend- 1990s, a broad market for third-party DIP
ment, rather than a full-out refinancing. loans emerged. These non-prepetition lenders
Amend-to-extend transactions came into were attracted to the market by the relatively
widespread use in 2009 as borrowers strug- safety of most DIPs based on their super-prior-
gled to push out maturities in the face of dif- ity status, and relatively wide margins. This was
ficult lending conditions that made the case again the early 2000s default cycle.
refinancing prohibitively expensive. In the late 2000s default cycle, however,
Amend-to-extend transactions have two the landscape shifted because of more dire
phases, as the name implies. The first is an economic conditions. As a result, liquidity
amendment in which at least 50.1% of the was in far shorter supply, constraining avail-
bank group approves the issuer’s ability to roll ability of traditional third-party DIPs.
some or all existing loans into longer-dated Likewise, with the severe economic condi-
paper. Typically, the amendment sets a range tions eating away at debtors’ collateral, not
for the amount that can be tendered via the to mention reducing enterprise values, prepe-
new facility, as well as the spread at which the tition lenders were more wary of relying
longer-dated paper will pay interest. solely on the super-priority status of DIPs,
The new debt is pari passu with the exist- and were more likely to ask for priming liens
ing loan. But because it matures later it car- to secure facilities.
ries a higher rate, and, in some cases, more The refusal of prepetition lenders to con-
attractive terms. Because issuers with big sent to such priming, combined with the
debt loads are expected to tackle debt matu- expense and uncertainty involved in a prim-
rities over time, amid varying market condi- ing fight in bankruptcy court, has greatly
tions, in some cases, accounts insist on reduced third-party participation in the DIP
most-favored-nation protection. Under such market. With liquidity in short supply, new
protection, the spread of the loan would innovations in DIP lending cropped up aimed
increase if the issuer in question prints a loan at bringing nontraditional lenders into the
at a wider margin. market. These include:

26 www.standardandpoors.com
● Junior DIPs. These facilities are typically Standard & Poor’s consider these programs
provided by bond holders or other unse- a default and, in fact, the holders are agreeing
cured debtors as part of a loan-to-own to take a principal haircut in order to allow
strategy. In these transactions, the the company to remain solvent and improve
providers receive much or all of the post- their ultimate recovery prospects.
petition equity interest as an incentive to This technique is used frequently in the bond
provide the DIP loans. market but rarely for first-lien loans. One good
● Roll-up DIPs. In some bankruptcies— example was from Harrah’s Entertainment. In
LyondellBasell and Spectrum Brands are 2009, the gaming company issued $3.6 billion
two 2009 examples—DIP providers are of new 10% second-priority senior secured
given the opportunity to roll up prepetition notes due 2018 for about $5.4 billion of bonds
claims into junior DIPs, that rank ahead of due between 2010 and 2018.
other prepetition secured lenders. This
sweetener was particularly compelling for
lenders that had bought prepetition paper
Bits And Pieces
at distressed prices and were able to realize What follows are definitions to some com-
a gain by rolling it into the junior DIPs. mon market jargon not found elsewhere in
this primer, but used constantly as short-hand
in the loan market:
Exit Loans ● Staple financing. Staple financing—or sta-

These are loans that finance an issuer’s emer- ple-on financing—is a financing agreement
gence from bankruptcy. Typically, the loans “stapled on” to an acquisition, typically by
are prenegotiated and are part of the com- the M&A advisor. So, if a private equity
pany’s reorganization plan. firm is working with an investment bank to
acquire a property, that bank, or a group
of banks, may provide a staple financing to
Sub-Par Loan Buybacks ensure that the firm has the wherewithal to
This is another technique that grew out of the complete the deal. Because the staple
bear market that began in 2007. Performing financing provides guidelines on both
paper fell to price not seen before in the loan structure and leverage, it typically forms
market—with many trading south of 70. This the basis for the eventual financing that is
created an opportunity for issuers with the negotiated by the auction winner, and the
financial wherewithal and the covenant room staple provider will usually serve as one of
to repurchase loans via a tender, or in the the arrangers of the financing, along with
open market, at prices below par. the lenders that were backing the buyer.
Sub-par buybacks have deep roots in the ● Break prices. Simply, the price at which

bond market. Loans didn’t suffer the price loans or bonds are initially traded into the
declines before 2007 to make such tenders secondary market after they close and allo-
attractive, however. In fact, most loan docu- cate. It is called the break price because
ments do not provide for a buyback. Instead, that is where the facility breaks into the
issuers typically need obtain lender approval secondary market.
via a 50.1% amendment. ● Market-clearing level. As this phrase

implies, the price or spread at which a deal


Distressed exchanges clears the primary market. (Seems to be an
Is a negotiated tender in which classholders allusion to a high-jumper clearing a hurdle.)
will swap their existing paper for a new series ● Running the books. Generally the loan

of bond that typically have a lower principal arranger is said to be “running the books,”
amount and, often, a lower yield. In exchange i.e., preparing documentation and syndicat-
the bondholders might receive stepped-up ing and administering the loan.
treatment, going from subordinated to senior, ● Disintermediation. Disintermediation refers

say, or from unsecured to second-lien. to the process where banks are replaced (or

Standard & Poor’s ● A Guide To The Loan Market September 2010 27


A Syndicated Loan Primer

disintermediated) by institutional investors. trading at a spread that is low compared


This is the process that the loan market has with other similarly rated loans in the same
been undergoing for the past 20 years. sector. Conversely, referring to something as
Another example is the mortgage market cheap means that it is trading at a spread
where the primary capital providers have that is high compared with its peer group.
evolved from banks and savings and loans That is, you can buy it on the cheap.
to conduits structured by Fannie Mae, ● Distressed loans. In the loan market, loans
Freddie Mac, and the other mortgage secu- traded at less than 80 cents on the dollar
ritization shops. Of course, the list of disin- are usually considered distressed. In the
termediated markets is long and growing. bond market, the common definition is a
In addition to leveraged loans and mort- spread of 1,000 bps or more. For loans,
gages, this list also includes auto loans and however, calculating spreads is an elusive
credit card receivables. art (see above) and therefore a more pedes-
● Loss given default. This is simply a measure trian price measure is used.
of how much creditors lose when an issuer ● Default rate. Calculated by either number
defaults. The loss will vary depending on of loans or principal amount. The formula
creditor class and the enterprise value of the is similar. For default rate by number of
business when it defaults. Naturally, all loans: the number of loans that default
things being equal, secured creditors will over a given 12-month period divided by
lose less than unsecured creditors. Likewise, the number of loans outstanding at the
senior creditors will lose less than subordi- beginning of that period. For default rate
nated creditors. Calculating loss given by principal amount: the amount of loans
default is tricky business. Some practition- that default over a 12-month period
ers express loss as a nominal percentage of divided by the total amount outstanding at
principal or a percentage of principal plus the beginning of the period. Standard &
accrued interest. Others use a present value Poor’s defines a default for the purposes of
calculation using an estimated discount calculating default rates as a loan that is
rate, typically 15% to 25%, demanded by either (1) rated ‘D’ by Standard & Poor’s,
distressed investors. (2) to an issuer that has filed for bank-
● Recovery. Recovery is the opposite of loss ruptcy, or (3) in payment default on inter-
given default—it is the amount a creditor est or principal.
recovers, rather than loses, in a given default. ● Leveraged loans. Just what is a leveraged
● Printing a deal. Refers to the price or loan is a discussion of long standing in the
spread at which the loan clears. loan market. Some participants use a
● Relative value. This can refer to the relative spread cut-off: i.e., any loan with a spread
return or spread between (1) various instru- of LIBOR+125 or LIBOR+150 or higher
ments of the same issuer, comparing for qualifies. Others use rating criteria: i.e.,
instance the loan spread with that of a any loan rated ‘BB+’ or lower qualifies. But
bond; (2) loans or bonds of issuers that are what of loans that are not rated? At
similarly rated and/or in the same sector, Standard & Poor’s LCD we have developed
comparing for instance the loan spread of a more complex definition. We include a
one ‘BB’ rated healthcare company with loan in the leveraged universe if it is rated
that of another; and (3) spreads between ‘BB+’ or lower or it is not rated or rated
markets, comparing for instance the spread ‘BBB-’ or higher but has (1) a spread of
on offer in the loan market with that of LIBOR +125 or higher and (2) is secured
high-yield or corporate bonds. Relative by a first or second lien. Under this defini-
value is a way of uncovering undervalued, tion, a loan rated ‘BB+’ that has a spread
or overvalued, assets. of LIBOR+75 would qualify, but a non-
● Rich/cheap. This is terminology imported rated loan with the same spread would not.
from the bond market to the loan market. It is hardly a perfect definition, but one
If you refer to a loan as rich, it means it is that Standard & Poor’s thinks best cap-

28 www.standardandpoors.com
tures the spirit of loan market participants potential buyers to submit for individual
when they talk about leveraged loans. names or the entire portfolio. The dealer
● Middle market. The loan market can be will then collate the bids and award each
roughly divided into two segments: large facility to the highest bidder.
corporate and middle market. There are as ● OWIC. This stands for “offers wanted in
many was to define middle market as there competition” and is effectively a BWIC in
are bankers. But, in the leveraged loan mar- reverse. Instead of seeking bids, a dealer is
ket, the standard has become an issuer with asked to buy a portfolio of paper and solic-
no more than $50 million of EBITDA. Based its potential sellers for the best offer.
on this, Standard & Poor’s uses the $50 mil- ● Cover bid. The level that a dealer agrees to
lion threshold in its reports and statistics. essentially underwrite a BWIC or an auc-
● Axe sheets. These are lists from dealers tion. The dealer, to win the business, may
with indicative secondary bids and offers give an account a cover bid, effectively put-
for loans. Axes are simply price indications. ting a floor on the auction price.
● Circled. When a loan or bond is full sub- ● Loan-to-own. A strategy in which
scribed at a given price it is said to be cir- lenders—typically hedge funds or distressed
cled. After that, the loan or bond moves to investors—provide financing to distressed
allocation and funding. companies. As part of the deal, lenders
● Forward calendar. A list of loans or bond receive either a potential ownership stake if
that has been announced but not yet closed. the company defaults, or, in the case of a
These include both instruments that are yet bankrupt company, an explicit equity stake
to come to market and those that are as part of the deal.
actively being sold but have yet to be circled. ● Most favored nation clauses. Some loans
● BWIC. An acronym for “bids wanted in will include a provision to protect lenders
competition.” Really just a fancy way of if the issuer subsequently places a new loan
describing a secondary auction of loans or at a higher spread. Under these provision,
bonds. Typically, an account will offer up a the spread of the existing paper ratchets up
portfolio of facilities via a dealer. The to the new spread (though in some cases
dealer will then put out a BWIC, asking the increase is capped). ●

Standard & Poor’s ● A Guide To The Loan Market September 2010 29


Rating Leveraged Loans: An Overview

Thomas L. Mowat n 2009, U.S. corporate defaults reached their highest level in 30
New York
(1) 212-438-1588
tom_mowat@standardandpoors.com
I years, according to Standard & Poor’s 2009 U.S. Corporate
William H. Chew Default Study published July 15, 2009. In 2009, 191 U.S. corporate
New York
(1) 212-438-7981 issuers defaulted. The speculative-grade corporate default rate in
bill_chew@standardandpoors.com
the U.S. was 11% at year-end 2009. While we are projecting a
significantly lower speculative-grade default rate for the 12
months ended June 2011, the 2009 spike in defaults and continued
unrest in the leveraged loan market highlight the importance of
fundamental credit analysis and recovery analytics. As default
rates increase, recoveries become the focus for many leveraged
investors because, with rising default rates, recoveries play a
greater role in overall credit losses.

In December 2003, Standard & Poor’s Poor’s began assigning recovery ratings to the
became the first rating agency to establish a unsecured debt of speculative-grade issuers.
separate, stand-alone rating scale to evaluate
the potential recovery investors might expect
in the event of a loan default. Before that, we
Why A Separate Recovery Scale?
used our traditional rating scale, which Investors in loans recognize that they are
focused almost exclusively on the likelihood incurring both types of risks: the risk of
of default (will the borrower pay on time?) default and the risk of loss in the event of
rather than on what the ultimate repayment default. In traditional bond markets, espe-
would be if the borrower failed to make cially bonds issued by investment-grade com-
timely payments. Since then, Standard & panies, the risk of default is relatively remote,
Poor’s has assigned recovery ratings to more and little attention is paid to covenants, col-
than 2,700 speculative-grade secured loans lateral, or other protective features that
and bonds. In March of 2008, Standard & would mitigate loss in the event of default.
Indeed, such protective features are rare in

30 www.standardandpoors.com
such markets. But in the leveraged loan mar- have fallen into the lower recovery rating cat-
ket, where the borrowers tend to be specula- egories (categories 5 and 6; see table 1), but
tive grade (i.e., rated ‘BB+’ and below), the occasionally a second lien has been so well
risk of default is significantly higher than it is protected that it has merited a higher rating.
for investment-grade borrowers. Therefore, Hence, once again, we have the need for
we have the necessity of collateral, covenants, recovery ratings to make that differentiation.
and similar features of “secured” lending.
But the challenge for investors is that not
all loans labeled “secured” are equally
Comparing Default
secured, or even protected at all. In the past, And Recovery Ratings
data has shown, for example, that the major- Standard & Poor’s recovery rating methodol-
ity of all secured loans do, in fact, repay their ogy builds upon its traditional default (corpo-
lenders 100% of principal in the event of rate credit rating) analysis. The traditional
default, with another sizable percentage pro- analysis focuses on attributes of the borrower
viding substantial, albeit less than full, recov- itself, which we tend to group under the
eries. But a significant number do not do heading of “business risk” factors (the bor-
nearly so well, and, indeed, might as well be rower’s industry, its business niche within
unsecured in terms of the actual protection that industry, and other largely qualitative
afforded investors. factors like the quality of its management,
A primary purpose of Standard & Poor’s overall strategy, etc.) and “financial risk” fac-
recovery ratings is to help investors differenti- tors (cash flow, capital structure, access to
ate between loans that are fully secured, par- liquidity, as well as financial reporting and
tially secured, and those that are “secured” in accounting issues, etc.). The company’s abil-
name only. (See chart 1.) Second-lien loans ity to meet its financial obligations on time
are a specific example of secured loans and, therefore, avoid default, is based on a
whereby recovery prospects in a bankruptcy combination of all these qualities, and it is
could vary dramatically depending on the the analyst’s job to balance them appropri-
overall makeup of the capital structure in ately in coming up with an overall rating.
question. These deals have attributes of both (See chart 2.)
secured loans and subordinated debt, and In assigning its corporate credit ratings,
determining post-default recovery prospects Standard & Poor’s is actually grouping the
requires detailed analysis of the individual rated companies into categories based on the
deal. Most second-lien loans that we rate relative likelihood of their meeting their finan-

Chart 1 Total Distribution Of Current/Outstanding Speculative-Grade


Secured Issues With Recovery Ratings

As of July 26, 2010


No. of ratings (left scale) % of ratings (right scale)

1,000 40
900 35
800
30
700
600 25
500 20
400 15
300
10
200
100 5
0 0
1+ 1 2 3 4 5 6
© Standard & Poor’s 2010.

Standard & Poor’s ● A Guide To The Loan Market September 2010 31


Rating Leveraged Loans: An Overview

cial obligations on time (i.e., avoiding ing across rating categories. For example, over
default.) The relative importance of the vari- five years, companies originally rated ‘BB’
ous attributes may vary substantially from default, as a group, greater than almost four
one credit to another, even within the same times the rate ‘BBB’ rated companies do. ‘B’
rating category. For example, a company with and ‘CCC’ rated companies default at an even
a very high business risk (e.g., intense compe- accelerated pace.
tition, minimal barriers to entry, constant This empirical data demonstrates the valid-
technology change, and risk of obsolescence) ity of Standard & Poor’s debt ratings over
would generally require a stronger financial time and validates the market’s use of them
profile to achieve the same overall rating level for classifying debt securities to price them
as a company in a more stable business. The and to help make decisions about their
companies that Standard & Poor’s rates ‘BB’, appropriateness for a given investor’s portfo-
for example, may present a wide range of lio. But saying that a given set of debt issuers
combinations of business and financial risk, in the same rating category have similar char-
but are all expected to have a similar likeli- acteristics and are equally default-prone does
hood of defaulting on the timely payment of not tell an investor which of the companies in
their financial obligations. Likewise with ‘AA’ that rating category will actually be the ones
rated credits, ‘B’ rated credits, etc. to default. No amount of analysis can tell us
Over the years, Standard & Poor’s has that, since if we knew for certain that a given
tracked the actual default rates of companies company that has the attributes of, for exam-
that it has rated (among other reasons) to val- ple, a ‘BB’, were actually going to default at
idate its rating methodology. Table 2 shows some point, it would not, in fact, be rated
the cumulative default rates for the past 29 ‘BB’, but instead would be rated much lower.
years by rating category. As we might expect, As investors move down the rating scale,
the rate of default increases substantially mov- they may not know exactly which deals will

Chart 2 Standard & Poor’s Criteria

Getting to the corporate credit rating (”CCR”)

Country Risk

Industry Characteristics
Business Risk
Company Position

Profitability / Peer Group Comparisons

Rating


Accounting


Governance, Risk Tolerance, Financial Policy

● Cash Flow Adequacy Financial Risk

● Capital Structure, Asset Protection

● Liquidity / Short-Term Factors

© Standard & Poor’s 2010.

32 www.standardandpoors.com
default, but they surely know that a larger that degree of default risk, it will generally
percentage of their deals will default; and insist on collateral security. Lenders are, in
they had better be prepared for it. In the syn- effect, willing to treat a ‘BBB’ rated credit as
dicated loan market, the market practice has though it will not likely default. But the pre-
evolved to the point that companies rated sumption is reversed for ’BB’ (and below)
‘BBB’ and which generally default at the rate credits, where the increased default risk is so
of about 2% over five years, are “allowed” severe that the market insists on treating
by the market to borrow unsecured. The every credit as though it might well default.
market is saying, in effect, that it can live Standard & Poor’s recovery ratings take a
with a default rate of that magnitude without similar approach by assigning recovery rat-
having to worry about protecting itself if a ings to speculative-grade issuers. While we
default actually occurs. But for ‘BB’ rated do not assume that a given deal will default,
credits, where the likelihood of default occur- our analysts—the industry specialists who
ring is more than four times greater, the mar- cover companies on an ongoing basis,
ket has drawn a line and decided that, for working along with the recovery specialist

Table 1 Recovery Rating Scale And Issue Rating Criteria


For issuers with a speculative-grade corporate credit rating
Issue rating notches relative
Recovery rating* Recovery description Recovery expectations¶ to corporate credit rating
1+ Highest expectation, full recovery 100%§ +3 notches
1 Very high recovery 90%–100% +2 notches
2 Substantial recovery 70%–90% +1 notch
3 Meaningful recovery 50%–70% 0 notches
4 Average recovery 30%–50% 0 notches
5 Modest recovery 10%–30% -1 notch
6 Negligible recovery 0%–10% -2 notches

*As noted above, recovery ratings in certain countries are capped to adjust for reduced creditor recovery prospects in these jurisdictions.
Furthermore, the recovery ratings on unsecured debt issued by corporate entities with corporate credit ratings of ‘BB-‘ or higher are generally
capped at ‘3’ to account for the risk that their recovery prospects are at greater risk of being impaired by the issuance of additional priority or
pari passu debt prior to default. ¶Recovery of principal plus accrued but unpaid interest at the time of default. §Very high confidence of full
recovery resulting from significant overcollateralization or strong structural features.

Table 2 Cumulative Average Default Rates By Rating Modifier 1981–2009


—Time horizon (years)—
Rating 1 2 3 4 5 10 15
AAA 0 0.03 0.14 0.26 0.39 0.82 1.14
AA 0.02 0.07 0.14 0.24 0.33 0.74 1.02
A 0.08 0.21 0.35 0.53 0.72 1.97 2.99
BBB 0.26 0.72 1.23 1.86 2.53 5.6 8.36
BB 0.97 2.94 5.27 7.49 9.51 17.45 21.57
B 4.93 10.76 15.65 19.46 22.3 30.82 35.74
CCC/C 27.98 36.95 42.4 45.57 48.05 53.41 57.28

Source: S&P Annual 2009 Global Corporate Default Study.

Standard & Poor’s ● A Guide To The Loan Market September 2010 33


Rating Leveraged Loans: An Overview

who is assigned to that industry team Another trend driving the use of ratings is
specifically to do recovery analysis—deter- the sophistication of typical loan investors—
mine together the most likely default sce- bank and nonbank. Most have risk manage-
nario that is consistent with our assessment ment or capital allocation models that require
of the company’s fundamental business and the input of two critical data points: the
financial risks. In other words, if this com- probability of default and the expected loss
pany were to default, what would be the given default. With these two inputs, an
most likely scenario? They then project investor can project the expected credit losses
what the company’s financial condition for its entire portfolio. Standard & Poor’s
would be at the time of default and, equally traditional default rating, which can be linked
important, at the conclusion of the workout to decades of empirical default studies to
process. Then they evaluate what the com- project default probability, can provide the
pany itself and/or the collateral (which may probability of default input that an investor
be the same, but not always) would be needs. Our recovery rating provides the
worth and how that value would be distrib- other—and until recently, missing—critical
uted among the various creditors. (For a data piece that loan investors need to feed
detailed description of the analytical their credit risk management models.
methodology used, see the accompanying In addition to the recovery rating itself, with
article in this book, “Criteria Guidelines its specific estimate of recovery in the event of
For Recovery Ratings On Global Industrials default, Standard & Poor’s analysts provide a
Issuers’ Speculative-Grade Debt.”) complete recovery report that explains in
detail the analysis, the default scenario, the
other assumptions, and the reasoning behind
Role Of Ratings the recovery rating. This allows investors to
In The Loan Market look behind and, if they wish, even to “reverse
The U.S. leveraged loan market is a rated engineer” our analysis, selecting what they
market, with Standard & Poor’s rating about agree or disagree with, and altering our sce-
70% of all new leveraged loans. This is not narios to reflect their own view of the com-
surprising, considering that most investors in pany, the industry, or the collateral valuation.
the U.S. leveraged loan market are now non- For further information about Standard &
bank institutional investors, rather than com- Poor’s Recovery Ratings, or to receive the
mercial banks. These institutional investors: weekly S&P Loan & Recovery Rating
● Are accustomed to having ratings on the Report by email, please contact Bill
debt instruments they buy, and Chew at 212-438-7981 or bill_chew@
● Often have ratings on their own debt standardandpoors.com, or visit our Bank
which, in turn, are dependent on the rat- Loan & Recovery Rating web site at:
ings of the underlying loans they purchase. www.bankloanrating.standardandpoors.com. ●

34 www.standardandpoors.com
Criteria Guidelines For Recovery
Ratings On Global Industrials Issuers’
Speculative-Grade Debt

Steve Wilkinson tandard & Poor’s Ratings Services has been assigning recovery
New York
(1) 212-438-5093
steve_wilkinson@
standardandpoors.com
S ratings—debt instrument-specific estimates of post-default
recovery for creditors—since December 2003. At that time, we
Anne-Charlotte Pedersen
New York began issuing recovery ratings and analyses for all new secured
(1) 212-438-6816
anne-charlotte_pedersen@
standardandpoors.com
bank loans in the U.S. Since that time, we have steadily expanded
William H. Chew our recovery ratings to cover secured debt issued in other countries
Managing Director
New York and, in March 2008, to unsecured and subordinated debt instruments.
(1) 212-438-7981
bill_chew@standardandpoors.com
This article provides an overview of Standard & Poor’s general
Emmanuel Dubois-Pelerin
Managing Director recovery analysis approach for global Industrials issuers, including
Paris
(33) 1-4420-6673 specific jurisdictional considerations for the U.S. market. This
emmanuel_dubois-pelerin@
standardandpoors.com
framework is the basis for our recovery methodology worldwide
Anthony Flintoff
Senior Director although, where appropriate, our analysis is tailored to consider
Melbourne
(61) 3-9631-2038 jurisdiction-specific features that impact the insolvency process
anthony_flintoff@
standardandpoors.com
and creditor recovery prospects.

Recovery Ratings For bankruptcy proceeding or an informal out-of-


Global Industrials— court restructuring. Lender recoveries could
Definition And Context be in the form of cash, debt or equity securi-
ties of a reorganized entity, or some combina-
Recovery ratings assess a debt instrument’s
tion thereof. We focus on nominal recovery
ultimate prospects for recovery of estimated
(versus discounted present value recovery)
principal and pre-petition interest (i.e., inter-
because we believe that discounted recovery
est accrued but unpaid at the time of default)
is better identified independently by market
given a simulated payment default. Standard &
participants that are best positioned to apply
Poor’s recovery methodology focuses on esti-
their own preferred discount rate to our nom-
mating the percentage of recovery that debt
inal recovery. However, in jurisdictions with
investors would receive at the end of a formal
creditor-unfriendly features, we will cap both

Standard & Poor’s ● A Guide To The Loan Market September 2010 35


Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

recovery ratings and issue ratings to account would be expected to impact lender recovery
for incremental uncertainty. rates—provides valuable insight into creditor
While informed by historical recovery data, recovery prospects.
our recovery ratings incorporate fundamental In this light, our recovery ratings are
deal-specific, scenario-driven, forward-looking intended to provide educated approximations
analysis. They consider the impact of key of post-default recovery rates, rather than
structural features, intercreditor dynamics, the exact forecasts. Our analysis also endeavors to
nature of insolvency regimes, multijurisdic- comment on how the specific features of a
tional issues, and potential changes in valua- company’s debt and organizational structure
tion after a simulated default. Ongoing may affect lender recovery prospects. Of
surveillance through periodic and event-spe- course, not all borrowers will default, but our
cific reviews help ensure that our recovery rat- recovery ratings, when viewed together with a
ings remain forward looking by monitoring company’s risk of default as estimated by
developments in these issues and by evaluating Standard & Poor’s corporate credit rating, can
the impact of changes to a borrower’s business help investors evaluate a debt instrument’s
risks and debt and liability profile over time. risk/reward characteristics and estimate their
We acknowledge that default modeling, expected return. Our approach is intended to
valuation, and restructuring (whether as part be transparent (within the bounds of confiden-
of a formal bankruptcy proceeding or other- tiality), so that market participants may draw
wise) are inherently dynamic and complex value from our analysis itself rather than
processes that do not lend themselves to pre- merely from the conclusion of the analysis.
cise or certain predictions. These processes
invariably involve unforeseen events and are
subject to extensive negotiations that are
Recovery Rating Scale
influenced by the subjective judgments, nego- And Issue Rating Framework
tiating positions, and agendas of the various The table summarizes our enhanced issue rat-
stakeholders. Even so, we believe that our ing framework. The issue rating we apply to
methodology of focusing on a company’s the loans and bonds of companies with spec-
unique and fundamental credit risks— ulative-grade corporate credit ratings is based
together with an informed analysis of how on the recovery rating outcome for the spe-
the composition and structure of its debt, cific instrument being rated. Issues with a
legal organization, and nondebt liabilities high recovery rating (‘1+’, ‘1’, or ‘2’) would

Recovery Rating Scale And Issue Rating Criteria


For issuers with a speculative-grade corporate credit rating
Recovery Issue rating notches relative
Recovery rating* Recovery description expectations¶ to corporate credit rating
1+ Highest expectation, full recovery 100%§ +3 notches
1 Very high recovery 90%–100% +2 notches
2 Substantial recovery 70%–90% +1 notch
3 Meaningful recovery 50%–70% 0 notches
4 Average recovery 30%–50% 0 notches
5 Modest recovery 10%–30% -1 notch
6 Negligible recovery 0%–10% -2 notches

*As noted above, recovery ratings in certain countries are capped to adjust for reduced creditor recovery prospects in these jurisdictions.
Furthermore, the recovery ratings on unsecured debt issued by corporate entities with corporate credit ratings of ‘BB-‘ or higher are generally
capped at ‘3’ to account for the risk that their recovery prospects are at greater risk of being impaired by the issuance of additional priority or
pari passu debt prior to default. ¶Recovery of principal plus accrued interest at the time of default on a nominal basis. §Very high confidence of
full recovery resulting from significant overcollateralization or strong structural features.

36 www.standardandpoors.com
lead us to rate the loan or bond above the numerical analysis, we increase the trans-
corporate credit rating, while a low recovery parency and consistency of our assessments
rating (‘5’ or ‘6’) would lead us to rate the of the impact of countries’ insolvency rules—
issue below the corporate credit rating. especially those that are less creditor friendly
when assigning recovery and issue ratings.
To review the details of our adjustments,
Jurisdiction-Specific Adjustments the grouping of various countries into groups
For Recovery And Issue Ratings with similar characteristics, and the extent of
Standard & Poor’s due diligence for extend- our issue-notching caps for each group, see
ing recovery ratings beyond the U.S. has “Jurisdiction-Specific Adjustments To
entailed an assessment of how insolvency Recovery And Issue Ratings”.
proceedings in practice in various countries
affect post-default recovery prospects. This
work has enabled us to consistently incorpo- General Recovery
rate jurisdiction-specific adjustments when we Methodology And Approach
assign recovery and issue ratings outside the For Global Industrials
U.S. With the help of local insolvency practi- Recovery analytics for Industrials issuers has
tioners, we have assessed each jurisdiction’s three basic components: (1) determining the
creditor friendliness in theory as well as how most likely path to default for a company; (2)
the law works in practice. For the latter, we valuing the company following default; and
so far lack empirical data, as outside of the (3) distributing that value to claimants based
U.S. very little reliable historical default and upon the relative priority of each claimant.
recovery data is available to verify in practice Our analytical process breaks down these
the predictability of insolvency proceedings components into the following steps:
and actual recovery rates. We will refine and ● Establishing a simulated path to default;

update our analysis and methodology over ● Forecasting the company’s profitability

time as appropriate if more actual loss data and/or cash flow at default based on our
and practical evidence becomes available. simulated default scenario;
The four main factors that shape our analy- ● Determining an appropriate valuation for

sis of the jurisdictions’ creditor friendliness are: the company following default;
● Security, ● Identifying and estimating debt and nondebt

● Creditor participation/influence, claims in our simulated default scenario;


● Distribution of value/certainty of priorities, ● Determining the distribution of value based

and on relative priorities;


● Time to resolution. ● Assigning a recovery rating (or ratings),

Based on the score reached on each of including a published “recovery report” that
these factors, we have classified the reviewed summarizes our assumptions and conclusions.
countries into three categories, according to
their creditor-friendliness. This classification Establishing a simulated path to default
has enabled us to make jurisdiction-specific This is a fundamental part of our recovery
adjustments to our recovery analysis. Namely, analysis because we must first understand the
relative to our standard assignment of recov- forces most likely to cause a default before we
ery and debt issue ratings, we cap both recov- can estimate a reasonable valuation given
ery ratings and the differential between the default. This step draws on the company and
issuer credit and debt issue ratings in coun- sector knowledge of Standard & Poor’s credit
tries if and to the extent we expect the recov- analysts to formulate and quantify the factors
ery process and actual recovery rates to be most likely to cause a company to default given
negatively affected by insolvency regimes that its unique business risks and the financial risk
favor debtors or other noncreditor con- inherent in the capital structure that we are
stituencies. We believe that by transparently evaluating in our default and recovery analysis.
overlaying analytical judgment on top of pure

Standard & Poor’s ● A Guide To The Loan Market September 2010 37


Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

At the outset of this process, we decon- ● Required cash interest payments (including
struct the borrower’s projections to under- assumed increases to LIBOR rates on float-
stand management’s general business, ing-rate debt and to the margin charged on
industry, and economic expectations. Once debt obligations that have maintenance
we understand management’s view, we make financial covenants); and
appropriate adjustments to key economic, ● Other cash payments the borrower is either

industry, and firm specific factors to simulate contractually or practically obligated to


the most likely path to a payment default. pay that are not already captured as an
expense on the borrower’s income state-
Forecasting profitability and/or ment. (Lease payments, for example, are
cash flow at default accounted for within free cash flow and,
The simulated default scenario is our assess- thus, are not considered a fixed charge.)
ment of the borrower’s most likely path to a The insolvency proxy at the point of pro-
payment default. The “insolvency proxy” is jected default may be greater than 1.0x in a
the point along that path at which we expect few special circumstances:
● For “strategic” bankruptcy filings, when
the borrower to default. In other words, the
insolvency proxy is the point at which funds a borrower may attempt to take advan-
available plus free cash flow is insufficient to tage of the insolvency process primarily
pay fixed charges: to obtain relief from legal claims or oner-
ous contracts;
● When a borrower may rationally be expected
(Funds available + Free cash flow) / Fixed
to retain a greater amount of cash (e.g., to
charges <= 1.0
prepare for a complex, protracted restructur-
ing; if it is in a very capital-intensive industry;
The terms in this equation are defined as:
or if it is in a jurisdiction that does not allow
Funds available. The sum of balance sheet
for super-priority standing for new credit in a
cash and revolving credit facility availability (in
post-petition financing); and
excess of the minimal amount a company needs
● When a borrower’s financial covenants
to operate its business at its seasonal peak).
have deteriorated beyond the level at which
Free cash flow. EBITDA in the year of
even the most patient lender could tolerate
default, less a minimal level of required
further amendments or waivers. (Lenders
maintenance capital expenditures, less cash
with no financial maintenance covenants
taxes, plus or minus changes in working cap-
have effectively surrendered this option and
ital. For default modeling and recovery esti-
have reduced their ability to influence com-
mates, our EBITDA and free cash flow
pany behavior.)
estimates ignore noncash compensation
Conversely, free cash flow may decline
expenses and do not use Standard & Poor’s
below the insolvency proxy when the bor-
adjustments for operating leases.
rower’s operating performance is expected to
Fixed charges. The sum, in the year of
continue to deteriorate due to cyclicality or
default, of:
business model contraction resulting from the
● Scheduled principal amortization (We gen-
competitive and economic conditions assumed
erally do not include “bullet” or “balloon-
in the simulated default scenario. In any
ing” maturities as fixed charges, as lenders
event, our analysis will identify the level of
typically would expect such amounts to be
cash flow used as the basis for our valuation.
refinanced and would presumably be reluc-
tant to force a company into default that
Determining valuation
can otherwise comfortably service its fixed
charges. Consequently, our default and To help us determine an appropriate valua-
recovery modeling will typically assume tion for a company (given our simulated
that additional business and cash flow dete- default scenario), we may consider a variety
rioration is necessary to trigger a default.); of valuation methodologies, including market
multiples, discounted cash flow (DCF) model-

38 www.standardandpoors.com
ing, and discrete asset analysis. The market comparable firms because these are generally
multiples and DCF methods are used to more numerous. With transaction multiples,
determine a company’s enterprise value as a we try to use forward multiples (purchase
going concern. This is generally the most price divided by projected EBITDA) rather
appropriate approach when our simulated than trailing multiples (purchase price divided
default and recovery analysis indicates that by historical EBITDA). This is because we
the borrower’s reorganization (or the outright believe that forward multiples, which are gen-
sale of the ongoing business or certain seg- erally lower because they incorporate the ben-
ments) is the most likely outcome of an insol- efit of perceived cash flow synergies used to
vency proceeding. We use discrete asset justify the purchase price, provide a more
valuation most often for industries in which appropriate reference point. In addition,
this valuation approach is typically used, or “trading” multiples for publicly traded firms
when the simulated default scenario indicates can be useful because they allow us to track
that the borrower’s liquidation is the most how multiples have changed over economic
likely outcome of insolvency. In addition, we and business cycles. This is especially relevant
may use a combination of the discrete and for cyclical industries and for sectors entering
enterprise valuation methods when we believe a different stage of development or experienc-
that a company will reorganize, but that its ing changing competitive conditions.
debt and organizational structure provides A selection of multiples helps match our
certain creditors with priority claims against valuation with the conditions assumed in our
particular assets or subsidiaries. For example, simulated default scenario. For example, a
Standard & Poor’s will consider whether a firm projected to default in a cyclical trough
company’s decision to securitize or not securi- may warrant a higher multiple than one
tize material assets impacts the value avail- expected to default at a cyclical midpoint.
able to distribute to other creditors. Furthermore, two companies in the same
Market multiples. The key to valuing a industry may merit meaningfully different
firm using a market multiples approach is to multiples if their simulated default scenarios
select appropriate comparable companies, or are very different. For example, if one is
“comps.” The analysis should include several highly levered and at risk of default from rel-
comps that are similar to the firm being val- atively normal competitive stresses while the
ued with respect to business lines, geographic other is unlikely to default unless there is a
markets, margins, revenue, capital require- large unexpected fundamental deterioration
ments, and competitive position. Of course, in the cash flow potential of the business
an ideal set of comps does not always exist, model (which could make historical sector
so analytical judgment is often required to multiples irrelevant).
adjust for differences in size, business pro- Our multiples analysis may also consider
files, and other attributes. In addition, in the alternative industry specific multiples—such as
context of a recovery analysis, our multiples subscribers, hospital beds, recurring revenue,
must consider the competitive and economic etc.—where appropriate. Alternatively, such
environments assumed in our simulated metrics may serve as a check on the soundness
default scenario, which are often very differ- of a valuation that relied on an EBITDA mul-
ent than present conditions. As a result, our tiple, DCF, or discrete asset approach.
analysis strives to consider a selection of mul- Discounted cash flow (DCF). Standard &
tiples and types of multiples. Poor’s DCF valuation analysis for recovery
Ideally, we are interested in multiples for analytics generally uses a three-stage model.
similar firms that have reorganized due to cir- The first stage is the simulated default sce-
cumstances consistent with our simulated nario; the second stage is the period during
default scenario. In practice, however, the insolvency; and the third stage represents the
existence of such “emergence” multiple comps long-term operating performance of the reor-
is rare. As a result, our analysis often turns to ganized firm. Our valuation is based on the
“transaction” or “purchase” multiples for third stage, which typically values a company

Standard & Poor’s ● A Guide To The Loan Market September 2010 39


Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

using a perpetuity growth formula, which would allow the company to fully draw the
contemplates a long-term steady-state growth facility in a simulated default scenario. For
rate deemed appropriate for the borrower’s letters of credit, especially those issued under
business. However, the third stage may also dedicated synthetic letter of credit tranches,
include specific annual cash flow forecasts for we will assess whether these contingent obli-
a period of time following reorganization gations are likely to be drawn following
before assigning a terminal value through the default. Our estimate of debt outstanding at
perpetuity growth formula. In any case, the default also includes an estimate of pre-peti-
specifics underlying our cash flow forecast tion interest, which is calculated by adding six
and valuation are outlined in Standard & months of interest (based on historical data
Poor’s recovery reports. from Standard & Poor’s LossStats® database)
Discrete asset valuation. We value the rele- to our estimated principal amount at default.
vant assets by applying industry- and asset- The inclusion of pre-petition interest makes
specific advance rates in conjunction with our recovery analysis more consistent with
third-party appraisals (when we are provided regulatory credit risk capital requirements.
with the appraisals). Our analysis focuses on the recovery
prospects for the debt instruments in a com-
Identifying and estimating the value pany’s current or pro forma debt structure,
of debt and nondebt claims and generally does not make estimates for
After valuing a company, we must then iden- other debt that may be issued prior to a
tify and quantify the debt obligations and default. We feel that this approach is prudent
other material liabilities that would be and more relevant to investors because the
expected to have a claim against the company amount and composition of any additional
following default. Potential claims fall into debt (secured, unsecured, and/or subordi-
three broad categories: nated) may materially impact lender recovery
● Principal and accrued interest on all debt
rates, and it is not possible to know these par-
outstanding at the point of default, ticulars in advance. Further, incremental debt
whether issued at the operating company, added to a company’s capital structure may
subsidiary, or holding company level; materially affect its probability of default,
● Bankruptcy-related claims, such as debtor-
which, in turn, could impact all aspects of our
in-possession (DIP) financing and adminis- recovery analysis (i.e., the most likely path to
trative expenses for professional fees and default, valuation given default, and loss given
other bankruptcy costs; default). Consequently, changes to a com-
● Other nondebt claims such as taxes
pany’s debt structure are treated as events that
payable, certain securitization programs, require a reevaluation of our default and
trade payables, deficiency claims on recovery analysis. This is a key aspect of our
rejected leases, litigation liabilities, and ongoing surveillance of our default and recov-
unfunded post-retirement obligations. ery ratings. We do, however, make some
Our analysis of these claims and their exceptions to this approach. Such exceptions
potential values strives to consider each bor- will be outlined in our recovery reports and
rower’s particular facts and circumstances, as generally fall under two categories:
● Permitted, but uncommitted, incremental
well as the expected impact on the claims as
a result of our simulated default scenario. debt may be included as part of our default
We estimate debt outstanding at the point and recovery analysis if this is consistent
of default by reducing term loans by sched- with our expectations and our underlying
uled amortization paid prior to our simulated corporate credit rating on a given issuer.
● Our default and recovery analysis may
default and by assuming that all committed
debt, such as revolving credit facilities and assume the repayment of near-term debt
delayed draw term loans, is fully funded. For maturities if the company is expected to
asset-based lending (ABL) facilities, we will retire these obligations and has the liquid-
consider whether the borrowing base formula ity to do so. Similarly, principal prepay-

40 www.standardandpoors.com
ments—whether voluntary or part of an collateral value is insufficient to fully cover a
excess cash flow sweep provision—may be secured claim, the uncovered amount or
considered for certain credits when deemed “deficiency balance” will be pari passu with
appropriate. Otherwise, we generally all other senior unsecured claims.
assume that debt that matures prior to our ● Structural issues and contractual agree-

simulated default date is rolled over on ments can also alter the priority of certain
similar terms but at current market rates. claims relative to each other or to the value
Our analytical treatment and estimates for attributable to specific assets or entities in
bankruptcy-related and other nondebt claims an organization.
in default is generally specific to the laws and As a result of these caveats, the recovery
customs of the jurisdictions involved in our prospects for different debt instruments of the
simulated default scenario. Please refer to same type (whether they be senior secured, sen-
Appendix 1 for a review of our approach and ior unsecured, senior subordinated, etc.) might
methodology for these claims in the U.S. be very different, depending on the structure of
the transactions. While the debt type of an
Determining distribution of value instrument may provide some indication as to
The distribution follows a “waterfall” its relative seniority, it is the legal structure and
approach that reflects the relative seniority of associated terms and conditions that are the
the claimants and will be specific to the laws, ultimate arbiter of priority. Consequently, a
customs, and insolvency regime practices for fundamental review of a company’s debt and
the relevant jurisdictions for a company. For legal entity structure is required to properly
example, the quantification and classification evaluate the relative priority of claimants. This
of bankruptcy-related and nondebt claims for requires an understanding of the terms and
insolvencies outside of the U.S. might be very conditions of the various debt instruments as
different from the methodology for U.S. they pertain to borrower and guarantor rela-
Industrials companies discussed in the tionships, collateral pledges and exclusions,
Appendix. Furthermore, local laws and cus- facility amounts, covenants, and debt maturi-
toms may warrant deviations from the water- ties. In addition, we must understand the
fall distribution we follow in the U.S. Where breakout of the company’s cash flow and assets
relevant, we will publish our guidelines and as it pertains to its legal organizational struc-
rationale for these differences before rolling out ture and consider the effect of key jurisdic-
our unsecured recovery ratings in these juris- tional and intercreditor issues.
dictions. In the U.S., our general assumption of Key structural issues to explore include
the relative priority of claimants is as follows: identifying:
● Higher priority liens on specific assets by
● Super-priority claims, such as DIP financing,

● Administrative expenses,
forms of secured debt such as mortgages,
● Federal and state tax claims,
industrial revenue bonds, and ABL facilities;
● Non-guarantor subsidiaries (domestic or
● Senior secured claims,

● Junior secured claims,


foreign) that do not guarantee a com-
● Senior unsecured claims,
pany’s primary debt obligations or provide
● Subordinated claims,
asset pledges to support the company’s
● Preferred stock,
secured debt;
● Claims at non-guarantor subsidiaries that
● Common stock.

However, this priority of claims is subject will have a higher priority (i.e., a “struc-
to two critical caveats: turally superior”) claim on the value
● The beneficial position of secured creditor
related to such entities;
● Material exclusions to the collateral
claims, whether first-priority or otherwise, is
valid only to the extent that the collateral pledged to secured lenders, including the
supporting such claims is equal to, or greater lack of asset pledges by foreign subsidiaries
than, the amount of the claim (including or the absence of liens on significant
higher priority and pari passu claims). If the domestic assets, including the stock of for-

Standard & Poor’s ● A Guide To The Loan Market September 2010 41


Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

eign or domestic non-guarantor sub- enterprise being evaluated, any equity value
sidiaries (whether due to concessions that remains after satisfying the structurally
demanded by and granted to the borrower, superior claims would be available to satisfy
poor transaction structuring, regulatory other creditors of the entities that own these
restrictions, or limitations imposed by subsidiaries. Well-structured debt will often
other debt indentures); and include covenants to restrict the amount of
● Whether a company’s foreign subsidiaries structurally superior debt that can be placed at
are likely to file for bankruptcy in their such subsidiaries. Furthermore, well-structured
local jurisdictions as part of the default and secured debt will take a lien on the stock of
restructuring process. such subsidiaries to ensure a priority interest
The presence of obligations with higher- in the equity value available to support other
priority liens on certain assets means that the creditors. In practice, the pledge of foreign
enterprise value available to other creditors subsidiary stock owned by U.S. entities is usu-
must be reduced to account for the distribu- ally limited to 65% of voting stock for tax
tion of value to satisfy these creditors first. In reasons. The residual value that is not cap-
most instances, asset-specific secured debt tured by secured lenders through stock pledges
claims (such as those previously listed) are would be expected to be available to all senior
structured to ensure full collateral coverage unsecured creditors on a pro rata basis.
even in a default scenario. As such, our The exclusion of other material assets (other
analysis will typically reduce the enterprise than whole subsidiaries or subsidiary stock)
value by the amount of these claims to deter- from the collateral pledged to support secured
mine the remaining enterprise value available debt must also be incorporated into our analy-
for other creditors. That said, there may be sis. The value of such assets is typically deter-
exceptions that will be considered on a case- mined using a discrete asset valuation
by-case basis if the amounts are material. approach, and our estimated value and related
Well-structured secured bank or bond debt assumptions will be disclosed in our recovery
that does not have a first lien on certain report as appropriate. We expect the value of
assets will get second-priority liens on assets excluded assets would be shared by all senior
that are significant and may have meaningful unsecured creditors on a pro rata basis.
excess collateral value. For example, this is An evaluation of whether foreign sub-
often the case when secured debt collateral- sidiaries would also be likely to file for bank-
ized by a first lien on all noncurrent assets ruptcy is also required, because this would
also takes a second-priority lien on working likely increase the cost of the bankruptcy
capital assets that are already pledged to sup- process and create potential multijurisdic-
port an asset-based revolving credit facility. tional issues that could impact lender recov-
Significant domestic or foreign non-guaran- ery rates. The involvement of foreign courts
tor entities must be identified because these in a bankruptcy process presents a myriad of
entities have not explicitly promised to repay complexities and uncertainties. For these
the debt. Thus, the portion of enterprise value same reasons, however, U.S.-domiciled bor-
derived from these subsidiaries does not rowers that file for bankruptcy seldom also
directly support the rated debt. As a result, file their foreign subsidiaries without a spe-
debt and certain nondebt claims at these sub- cific benefit or reason for doing so.
sidiaries have a structurally higher priority Consequently, we generally assume that for-
claim against the subsidiary value. eign subsidiaries of U.S. borrowers do not file
Accordingly, the portion of the company’s for bankruptcy unless there is a compelling
enterprise value stemming from these sub- reason to assume otherwise, such as a large
sidiaries must be estimated and treated sepa- amount of foreign debt that needs to be
rately in the distribution of value to creditors. restructured to enable the company to emerge
This requires an understanding of the break- from bankruptcy. When foreign subsidiaries
out of a company’s cash flow and assets. are expected to file bankruptcy, our analysis
Because these subsidiaries are still part of the

42 www.standardandpoors.com
will be tailored to incorporate the particulars such, our analysis does not evaluate the likeli-
of the relevant bankruptcy regimes. hood of substantive consolidation, though we
Intercreditor issues may affect the distribu- acknowledge that this risk could affect recover-
tion of value and result in deviations from ies in certain cases.
“absolute priority” (i.e., maintenance of the
relative priority of the claims, subject to Assigning recovery ratings
structural and contractual considerations, so We estimate recovery rates by dividing the
that a class of claims will not receive any dis- portion of enterprise or liquidation value pro-
tribution until all classes above it are fully jected to be available to cover the debt to
satisfied), which is assumed by Standard & which the recovery rating applies, by the esti-
Poor’s methodology. In practice, however, mated amount of debt (principal and pre-
Chapter 11 bankruptcies are negotiated set- petition interest) and pari passu claims
tlements and the distribution of value may outstanding at default. We then map the
vary somewhat from the ideal implied by recovery rate to our recovery rating chart to
absolute priority for a variety of intercreditor determine the issue and recovery ratings.
reasons, including, in the U.S., “accommoda- Standard & Poor’s accompanies its recovery
tions” and “substantive consolidation.” ratings with written recovery reports, which
Accommodations refer to concessions identify the simulated payment default, valua-
granted by senior creditors to junior tion assumptions, and other factors on which
claimants in negotiations to gain their coop- the recovery ratings are based. This disclosure
eration in a timely restructuring. We generally is intended to improve the utility of our
do not explicitly model for accommodations analysis by providing investors with more
because it is uncertain whether any conces- information with which to evaluate our con-
sions will be granted, if those granted will clusions and to allow them to consider differ-
ultimately have value (e.g., warrants as a con- ent assumptions as they deem appropriate.
tingent equity claim), or whether the value
will be material enough to meaningfully Surveillance of recovery ratings
affect our projected recovery rates.
After our initial analysis at debt origination,
Substantive consolidation represents a poten-
we monitor material changes affecting the
tially more meaningful deviation from the dis-
borrower and its debt and liability structure
tribution of value according to absolute
to determine if the changes might also alter
priority. In a substantive consolidation, the
creditor recovery prospects. This is essential
entities of a corporate group may be treated as
given the dynamic nature of credit in general
a single consolidated entity for the purposes of
and default and recovery modeling in particu-
a bankruptcy reorganization. This effectively
lar. Therefore, a fundamental component of
would eliminate the credit support provided by
recovery analysis is periodic and event spe-
unsecured guarantees or the pledge of inter-
cific surveillance designed to monitor devel-
company loans or subsidiary stock, and dilutes
oping risk exposures that might affect
the recovery prospects of creditors that relied
recovery. Any material changes to our default
on these features to the benefit of those that
and recovery ratings or analysis will be dis-
did not. Even the threat of substantive consoli-
closed in updates to our recovery reports.
dation may result in a negotiated settlement
Factors that could impact our default and
that could affect recovery distribution. While
recovery analysis or ratings include:
substantive consolidation can meaningfully
● Acquisitions and divestitures;
impact the recovery prospects of certain credi-
● Updated valuation assumptions;
tors, it is a discretionary judicial doctrine that
● Shifts in the profit and cash flow contribu-
is only relevant in certain situations. It is diffi-
tions of borrower, guarantor, or non-guar-
cult to predict whether any party would seek
antor entities;
to ask a bankruptcy court to apply it in a spe-
● Changes in debt or the exposure to non-
cific case, or the likelihood that party would
debt liabilities;
succeed in persuading the court to do so. As

Standard & Poor’s ● A Guide To The Loan Market September 2010 43


Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

● Intercreditor dynamics; and to consider disaggregated analyses for proba-


● Changes in bankruptcy law or case histories. bility of default and recovery given default.
We also believe our recovery analysis may
provide investors insight into how a com-
Conclusion pany’s debt and organizational structure may
We believe that our recovery ratings are bene- affect recovery rates. ●
ficial because they allow market participants

44 www.standardandpoors.com
Appendix:
U.S. Industrials Analysis Of Claims And Estimation Of Amounts

This appendix covers Standard & Poor’s ana- prospects by allowing companies to restruc-
lytical considerations regarding the treatment ture their operations and preserve the value
of bankruptcy-specific and other nondebt of their business. As a result of these uncer-
claims in our default and recovery analysis of tainties, estimating the impact of a DIP facil-
U.S.-domiciled Industrials borrowers. Our ity is generally beyond the scope of our
approach endeavors to consider the bor- analysis, even though we recognize that DIP
rower’s particular facts and circumstances, as facilities may materially impact recovery
well as the expected impact on the claims as prospects in certain cases.
a result of the simulated default scenario. Administrative expenses. Administrative
Still, the potential amount of many of these expenses relate to professional fees and other
claims is highly variable and difficult to pre- costs associated with bankruptcy that are
dict. In addition, these claims are likely to required to preserve the value of the estate
disproportionately affect the recovery and complete the bankruptcy process. These
prospects of unsecured creditors because costs must be paid prior to exiting bank-
most of these claims would be expected to be ruptcy, making them effectively senior to
classified as general unsecured claims in those of all other creditors. The dollar
bankruptcy. This contributes to the histori- amount and materiality of administrative
cally higher standard deviation of recovery claims usually correspond to the company’s
rates for unsecured lenders (relative to size and the complexity of its capital struc-
secured lenders). ture. We expect that these costs will be less
While these issues make projecting recov- for simple capital structures that can usually
ery rates for unsecured debt challenging, we negotiate an end to a bankruptcy quickly and
believe that an understanding of the analytical may even use a pre-packaged bankruptcy
considerations related to these claims can help plan. Conversely, these costs are expected to
investors make better decisions regarding an be greater for large borrowers with complex
investment’s risks and recovery prospects. Our capital structures where the insolvency
recovery reports endeavor to comment on our process is often characterized by protracted
assumptions regarding the types and amounts multiple party disputes that drive up bank-
of the claims as appropriate. ruptcy costs and diminish lender recoveries.
When using an enterprise value approach,
Bankruptcy-specific priority claims our methodology estimates the value of these
Debtor in possession financing. DIP facilities claims as a percentage of the borrower’s
are usually super-priority claims that enjoy emergence enterprise value as follows:
● Three percent for capital structures with
repayment precedence over unsecured debt
and, often, secured debt. However, it is one primary class of debt;
● Five percent for two primary classes of
exceedingly difficult to accurately quantify
the size or likelihood of DIP financing or to debt (first- and second-lien creditors may
forecast how DIP financing may affect the be adversaries in a bankruptcy proceeding
recovery prospects for different creditors. and are treated as separate classes by
This is because the size or existence of a theo- Standard & Poor’s);
● Seven percent for three primary classes of
retical DIP commitment is unpredictable, DIP
borrowings at emergence may be substan- debt; and
● Ten percent for certain complex capital
tially less than the DIP commitment, and
such facilities may be used to fully or par- structures.
tially repay some pre-petition secured debt. When using a discrete asset valuation
Furthermore, the presence of DIP financing approach, these costs may be implicitly
might actually help creditor recovery accounted for in the orderly liquidation value
discounts used to value a company’s assets.

Standard & Poor’s ● A Guide To The Loan Market September 2010 45


Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

Other nondebt claims estimates for these claims will be disclosed in


Taxes. Various U.S. government authorities our recovery reports.
successfully assert tax claims as either admin- Regulatory and litigation claims. These
istrative, priority, or secured claims. However, claims are fact- and borrower-specific and are
it is very difficult to project the level and sta- expected to be immaterial for the vast major-
tus of such claims at origination (e.g., tax dis- ity of issuers. For others, however, they may
putes en route to default are extremely hard play a significant role in our simulated
to predict). We also expect that, while such default scenario and represent a sizable liabil-
claims will normally be paid before senior ity that impairs the recovery prospects of
secured claims, their overall amount is sel- other creditors. Borrowers that fall into this
dom material enough to impact lender recov- category may be in the tobacco, chemical,
eries. Therefore, we acknowledge that tax building materials, environmental services,
claims may indeed be priority claims, but we mining, or pharmaceutical industries. Even
generally do not, at origination, reduce our within these sectors, however, we are most
expectation for lenders’ recovery by estimat- likely to factor these issues into our analysis
ing the amount of potential tax claims. in a meaningful way when a borrower is
Swap termination costs. The Bankruptcy either already facing significant exposure to
Code accords special treatment for counter- these liabilities or is unlikely to default with-
parties to financial contracts, such as swaps, out a shock of this type to its business (such
repurchase agreements, securities contracts, as a high speculative-grade-rated company
and forward contracts, to ensure continuity with low to moderate leverage and relatively
in the financial markets and to avoid systemic stable cash flow).
risk (so long as both the type of contract and After determining whether it is reasonable
the type of counterparty fall within certain to include such claims in our default and
statutory provisions). In addition to not being recovery analysis, we are left with the chal-
subject to the automatic stay that generally lenge of sizing the claims and determining
precludes creditors from exercising their how they might impact creditor recovery
remedies against the debtor, financial contract prospects. Unfortunately, the case history is
counterparties have the right to liquidate, ter- very limited in this area and does not offer
minate, or accelerate the contract in a bank- clear guidelines on how to best handle these
ruptcy. Most currency and interest rate swaps inherent uncertainties. As such, we tailor our
related to secured debt are secured on a pari approach on a case-by-case basis to the bor-
passu basis with the respective loans. Other rower’s specific circumstances to help us reach
swaps are likely to be unsecured. While we an appropriate solution. When significant, our
acknowledge the potential for such claims, approach and assumptions will be outlined in
quantifying such claims will usually be our recovery report so that investors can eval-
impractical and beyond the scope of our uate our treatment, and consider alternative
analysis at origination. That said, making assumptions if desired, as part of their invest-
estimates for these claims may be more prac- ment decision. We note that claims in this cat-
tical in surveillance as a company approaches egory would typically be expected to have
bankruptcy and the potential impact of these general unsecured status in a bankruptcy,
types of claims becomes clearer. although they may remain ongoing costs of a
Cash management obligations. Obligations reorganized entity and thus reduce the value
under automated clearing house programs available to other creditors.
and other cash management services provided Securitizations. Standard accounts receiv-
by a borrower’s banks may be incremental to able securitization programs involve the sale
its exposure to its bank lenders under its of certain receivables to a bankruptcy-remote
credit facilities. In some cases, these obliga- special purpose entity in an arms length
tions may be material and may be secured on transaction under commercially reasonable
a pari passu basis by the bank collateral. terms. The assets sold are not legally part of
When we are aware of these situations, our the debtor’s estate (although in some circum-

46 www.standardandpoors.com
stances they may continue to be reported on the company’s normal working capital cycle
the company’s balance sheet for accounting (and, thus, are already accounted for in our
purposes), and the securitization investors are valuations using market multiples or DCF).
completely reliant on the value of the assets For firms expected to liquidate, an estimate
they purchased to generate their return. As a of accounts payable will be made, with the
result, the securitization investors do not have amount treated as an unsecured claim.
any recourse against the estate, although the Leases. U.S. bankruptcy law provides com-
sale of the assets may affect the value avail- panies the opportunity to accept or reject
able to other creditors. When a discrete asset leases during the bankruptcy process (for
valuation approach is used and the sold commercial real property leases, the review
receivables continue to be reported on the period is limited to 210 days, including a
company’s balance sheet, we will consider the one-time 90-day extension, unless the lessor
securitized debt from such programs to be a agrees to an extension). If a lease is accepted,
secured claim with priority on the value from the company is required to keep rent pay-
the receivables within the securitization. ments on the lease current, meaning that
Securitizations may also be in the form of a there will be no claim against the estate. This
future flow-type structure, which securitizes also allows the lessee to continue to use the
all or a portion of the borrower’s future rev- leased asset, with the cash flow (i.e., value)
enue and cash flow (typically related to par- derived from the asset available to support
ticular contracts, patents, trademarks, or other creditors.
other intangible assets), would have a claim If a lease is rejected, the company must dis-
against our estimated valuation. Such transac- continue using the asset, and the lessor may
tions effectively securitize all or a part of the file a general unsecured claim against the
borrower’s future earnings, and the related estate. As a result, we must estimate a reason-
claims would have priority claim to the value able lease rejection rate for the firm given the
stemming from the securitized assets. This types of assets leased, the industry, and our
claim would diminish the enterprise value simulated default scenario. Leases are typi-
available to other corporate creditors. Such cally rejected for one of three reasons:
transactions are typically highly individual- ● The lease is priced above market rates;

ized, and the amount of the claims and the ● The leased asset is generating negative or

value of the assets in our simulated default insufficient returns; or


analysis are evaluated on a case-by-case basis. ● The leased asset is highly vulnerable to

Trade creditor claims. Typically, trade cred- obsolescence during the term of the lease.
itor claims are unsecured claims that would Our evaluation may ballpark the rejection
rank pari passu with a borrower’s other unse- rate by assuming it matches the percentage
cured obligations. However, because a bor- decline in revenue in our simulated default
rower’s viability as a going concern hinges scenario or, if applicable, by looking at com-
upon continued access to goods and services, mon industry lease rejection rates. If leases are
many pre-petition claims are either paid in material, we may further evaluate whether
the ordinary course or treated as priority our knowledge of a company’s portfolio of
administrative claims. This concession to crit- leased assets is likely to result in a higher or
ical trade vendors ensures that they remain lower level of unattractive leases (and rejec-
willing to carry on their relationships with tions) in a default scenario. For example, if a
the borrower during the insolvency proceed- company’s leased assets are unusually old,
ings, which preserves the value of the estate underutilized, or priced above current market
and enhances the recovery prospects for all rates, then a higher rejection rate may be war-
creditors. Consequently, our analysis does not ranted. In practice, this level of refinement in
make an explicit estimate for trade creditor our analysis will be most relevant when a
claims in bankruptcy for companies that are company has a substantial amount of lease
expected to reorganize, but rather, it assumes obligations and a significant risk of near-term
that these costs continue to be paid as part of default. Uneconomical leases that are

Standard & Poor’s ● A Guide To The Loan Market September 2010 47


Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

amended through renegotiation in bankruptcy cation of retiree benefits. Because these types
are considered to be rejected. of employee arrangements are not common in
In bankruptcy, the amount of unsecured many industries, these liabilities would only
claims from rejected leases is determined by be relevant for certain companies. Where rel-
taking the amount of lost rental income and evant, the key issue is whether these obliga-
subtracting the net value available to the lessor tions are likely to be renounced or changed
by selling or re-leasing the asset in its next best after default, since no claim results if they are
use. However, the deficiency claims of com- unaltered. Of course, employment-related
mercial real estate lessors is further restricted claims are more likely to arise when a com-
to the greater of one year’s rent or 15% of the pany is at a competitive disadvantage because
remaining rental payments not to exceed three of the costs of maintaining these commit-
years’ rent. Lessors of assets other than com- ments. Even then, some past bankruptcies
mercial real property do not have their poten- suggest that some companies may not use the
tial deficiency claims capped, but such leases bankruptcy process to fully address these
are generally not material and are usually for problems. What is clear, however, is that
relatively short periods of time. With these employment-related claims may significantly
issues in mind, Standard & Poor’s quantifies dilute recoveries for the unsecured creditors
lease deficiency claims for most companies by of certain companies and that these risks are
multiplying their estimated lease rejection rate most acute for companies that are grappling
by three times their annual rent. with burdensome labor costs. To reflect this
However, there are a few exceptions to our risk, we are likely to include some level of
general approach. Deficiency claims for leases employment-related claims for companies
of major transportation equipment (e.g., air- where uncompetitive labor or benefits costs
craft, railcars, and ships) are estimated on a are a factor in our simulated default scenario.
case-by-case basis, with our assumptions dis- Collective bargaining agreement rejection
closed in our recovery reports. This is neces- claims. A borrower that has collective bargain-
sary because these lease obligations do not ing agreements (CBA), including above-market
have their claims capped, may be longer wages, benefits, or work rules, is likely to seek
term, and are typically for substantial to reject these contracts in a bankruptcy. In
amounts. In addition, we use a lower-rent order to reject a CBA, the borrower must
multiple for cases in which a company relies establish, and the bankruptcy court must find
primarily on very short-term leases (three that the borrower has proposed, modifications
years or less). Furthermore, we do not to the CBA that are necessary for its successful
include any deficiency claim for leases held reorganization. In addition, the court must
by individual asset-specific subsidiaries that find that all creditors and affected parties are
do not have credit support from other entities treated fairly and equitably, that the borrower
(by virtue of guarantees or co-lessee relation- has bargained fairly with the relevant union,
ships) due to the lack of recourse against that the union rejected the proposal without
other entities and the likelihood that these good cause, and that equity considerations
subsidiaries are likely to be worthless if the clearly favor rejection. Proceedings to reject a
leases are rejected. This situation was relevant CBA typically result in a consensual reduction
in many of the movie exhibitor bankruptcies in wages and benefits, and modified work
in the early 2000 time period. rules under a replacement or modified agree-
Employment-related claims. Material unse- ment prior to the bankruptcy court’s decision
cured claims may arise when a debtor rejects, on the motion to reject.
terminates, or modifies the terms of employ- If a CBA were rejected, the affected
ment or benefits for its current or retired employees would have unsecured claims for
employees. Principally, these claims would damages that would be limited to one year’s
arise from the rejection of labor contracts, compensation plus any unpaid compensation
the voluntary or involuntary termination of due under the CBA. However, if a CBA were
defined benefit pension plans, or the modifi- modified through negotiation without rejec-

48 www.standardandpoors.com
tion, the damages for lost wages and benefits covered under a union contract during bank-
and modified work rules may not be limited ruptcy are similar to the requirements for the
to this amount. rejection of a CBA, but they may be modified
Pension plan termination claims. The abil- by order of the bankruptcy court without
ity to terminate a defined benefit pension rejecting the plan or program under which the
plan is provided under the U.S. Employee benefits are provided in its entirety. However,
Retirement Income Security Act (ERISA). these obligations are often amended prior to
Under ERISA, these plans may be terminated bankruptcy for companies that are placed at a
voluntarily by the debtor as the plan sponsor, competitive disadvantage because of these
or involuntarily by the Pension Benefit costs. As such, we must consider whether the
Guaranty Corp. (PBGC) as the agency that borrower has modified, or is likely to modify,
insures plan benefits. Typically, any termina- the benefits prior to bankruptcy.
tion during bankruptcy will be a “distress ter- In the case of benefits provided to employ-
mination,” in which the plan assets are, or ees that were not represented by unions, the
would be, insufficient to pay benefits under borrower may be able to revise the benefits
the plan. However, the bankruptcy of the prior to bankruptcy with little or no negotia-
plan sponsor does not automatically result in tion with the retirees. For union retirees, ben-
the termination of its pension plans, and even efit modifications prior to bankruptcy likely
underfunded plans may not necessarily be ter- would occur in the context of concessions in
minated. For example, a borrower may elect negotiations with the relevant union. In either
to maintain underfunded plans, or may not case, modifications prior to bankruptcy
succeed in terminating a plan, if it fails to would not result in claims in bankruptcy that
demonstrate that it would not be able to pay could dilute recoveries. If the borrower
its debts and successfully reorganize unless reduces its retiree benefits liability prior to
the plan is terminated. bankruptcy, further modifications in bank-
In a distress termination, the PBGC ruptcy may result in a smaller unsecured
assumes the liabilities of the pension plan up claim than if it had entered the proceeding
to the limits prescribed under ERISA and gets with a greater liability. If we conclude that
an unsecured claim in bankruptcy against the the borrower will modify its retiree benefits
debtor for the unfunded benefits. The calcula- prior to bankruptcy, our recovery analysis
tion of this liability is based on different will consider the likely effect of that modifi-
assumptions than the borrower’s reported lia- cation on the borrower’s reduced benefit lia-
bility in its financial statements. This, in addi- bility in bankruptcy. Conversely, if we
tion to the difficulty of predicting the funded conclude that these plans will be modified in
status of a plan at some point in the future, bankruptcy, but not before, then the potential
complicates our ability to accurately assess liability will be more significant.
the value of these claims. To see other articles discussing Standard &
Retiree benefits modification claims. Non- Poor’s expanded recovery ratings scale and
pension retiree benefits are payments to issuer ratings framework, see our special
retirees for medical, surgical, or hospital care report published June 12, 2007, on
benefits, or benefits in the event of sickness, RatingsDirect, titled, “Expanded Recovery
accident, disability, or death. The require- Ratings Scale And Issue Ratings
ments for modifying these benefits for plans Framework.” ●

Standard & Poor’s ● A Guide To The Loan Market September 2010 49


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52 www.standardandpoors.com
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