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A wave of downgrades tied to loan buybacks is igniting debate in the leveraged loan and CLO markets, highlighting the growing tension between CLO managers and rating agencies.

CLO managers are already facing mark-to-market losses resulting from the growing number of loans rated below triple-C in their portfolios. The proportion of CLO portfolios with 15-20% of assets rated CCC+ or below went from about 13% last month to about 37% this month, according to a May 8 research report from Morgan Stanley, which based its calculations on a sample of 527 transactions (Fig. 1).

CLO managers are now dealing with an additional problem arising from rating actions that place issuers that buy back their loans below par in technical default. These technical defaults, managers say, artificially inflate the number of distressed loans in their portfolio, increasing the likelihood that many CLOs will go static.

Loan buybacks - which occur when an issuer buys back its loans in the secondary market - have gained in popularity as issuers look to retire debt in a sub-par market and reduce interest costs.

The buybacks, typically completed via an amendment process, are not coercive in nature, giving investors the flexibility to decide whether or not they would like to tender their paper at the price being offered by the issuer. In some cases, companies use cash on hand or increased equity contributions from private equity sponsors to de-lever.

In many cases, loan buybacks are being executed significantly below par, and, as such, are being viewed as distressed transactions by both Moody’s Investors Service and Standard & Poor’s, which, in turn, have been classifying the buybacks as limited default (LD) and selective default (SD), respectively.

“Given our rating methodology of rating to the original promise to pay, economic losses to investors caused by exchange offerings and similar restructurings are by our rating definition a default,” Mimi Barker, director of communications at S&P, said in an e-mailed statement.

To be sure, both agencies recognize that not all buybacks are distressed. In criteria reports released earlier this year, the agencies said they assess an issuer’s creditworthiness to determine if its buyback is distressed or merely opportunistic.

In Moody’s case, if an issuer rated Caa1 or lower implements a buyback that is at a significant discount to par, the transaction is highly likely to be considered a distressed exchange. When this rating is B1 or higher, the transaction is likely to be considered an opportunistic exchange.

S&P’s rating benchmark for identifying a distressed buyback is an issuer credit rating of B- or lower.

Distressed loan buybacks: A win-win for all?
Broadly speaking, both agencies contend that when a distressed buyback is classified as LD or SD, the agencies make assessments that there is a realistic possibility that the issuer would have filed for bankruptcy or fallen into payment default had the buyback not occurred.

For instance, in April, Moody’s downgraded Emmis Communications‘ corporate family rating to Caa2 from Caa1 and changed its probability of default rating to Caa3/LD from Caa2, while S&P lowered the company’s corporate credit rating to SD from CCC+.

The downgrades came on the heels of the company announcing that it would purchase its term loans at a 45% discount and that it had hired Blackstone Advisory Services LP to explore a possible amendment to its credit facility or a possible restructuring of some of its liabilities.

Subsequently, on May 4, S&P raised the company’s corporate credit rating back to CCC+ from SD after Emmis completed four sub-par Dutch tender offers, ultimately buying back its loans at an average discount of 43%.

The rating agencies’ underlying argument is that a distressed buyback is akin to an out-of-court restructuring and that by buying back its loan at a deep discount to par, a distressed issuer is likely avoiding default and not fulfilling the promise to repay its debt at its original terms.

“Bankruptcy is one way of restructuring your debt and reducing the promise you had made to creditors. A distressed buyback is another,” said Kenneth Emery, senior vice president in the Credit Policy division at Moody’s.

These distressed buybacks “can be beneficial for the company by reducing unsustainable debt levels and can be good for those creditors looking to crystallize losses. But the fact remains that the original promise to pay on this debt was not met,” he added.

But critics say investors themselves could stand to gain from a buyback transaction that is voluntary, especially when an issuer offers to buy back its loans above current market prices but below par. In fact, S&P, in its report, acknowledged that “holders may be very pleased with an offer that is above market prices, especially if they account for the investment on a mark-to-market basis.”

“Pre-offer, sellers have always had the alternative of selling the (loan) in the secondary market for less than the original promise,” wrote Chris Taggert, senior loan strategist at independent research firm CreditSights, in an April 22 report. “Why getting more for the (loan) from the seller’s perspective, and improving the capital structure to boot, is tantamount to a default is highly speculative.”

Old rules for a new market
The rating agencies’ argument has the institutional loan world up in arms because the feasibility of issuers repaying their debt on original terms has changed in light of the deterioration in the credit markets.

For one, today’s market, where the average bid on the 100 most widely held loans was sitting at 78.6 as recently as the end of April, is vastly different from the market that existed two years ago when the average leveraged loan was trading at or near par (Fig. 2).

“If you take a B2 or B3 rated company with a performing loan and you suddenly give it a selective default rating because it bought back its loans at a sizeable discount, you do severe, life-threatening damage to CLO investors,” said a CLO manager.

CLO managers dub the rating agencies’ technical default policies as crime and punishment that are disproportionate, stating that the agencies are exacerbating an already serious problem.

“With buybacks, you get de-leveraging, so why is the punishment so harsh,” said another CLO manager, adding that the rating agencies are using rules that were written for a different market and are applying them too literally now.

“The agencies are trying to prove that they’re purer than pure and a lot of people think it’s self-serving,” said a third manager.

Worsening an already serious problem?
The downgrade problem appears to begin early on in the buyback process. For instance, S&P, in its report, said that it generally lowers the facility and issuer credit rating to CC at the mere announcement or anticipation of a distressed buyback.

An example of this is Cinram International Inc., which announced at the end of the first quarter that it was seeking bank permission to amend its credit agreement to buy back up to $150 million of its term loan at a discount to par using an auction.

Like many other borrowers that have been engaging in buybacks, Cinram’s incentive came from its loan trading at a significant discount to par in the secondary market (Fig. 3).

Following the announcement, S&P said the company’s long-term corporate credit rating would be lowered to CCC+ from B for the duration of the buyback process, which could take up to a year, and that the corporate credit rating would be lowered to SD upon completion of the offer.

“Our downgrade today does not reflect a perceived increase in Cinram’s bankruptcy risk,” S&P said in its March 25 ratings release. “Rather, our downgrade is based on the financial pressure we feel Cinram is under to reduce its debt burden by retiring debt for less than originally contracted,”

Once the buyback is completed, the untendered portion of Cinram’s loan is likely to be upgraded, owing to the company’s de-leveraged capital structure.

The impact this fluctuation in ratings has on the loan market is by no means negligible.

At a time of rising defaults and severe liquidity constraints, downgrades or defaults resulting from buybacks add enormous pressure to ratings - and timing-sensitive investors such as CLOs (Fig. 4).

Due to falling prices on underlying loan assets, CLOs are already being forced to mark them to market and, in many cases, move them into their triple-C or default baskets. That, in turn, is reducing CLOs’ overcollateralization cushion (Fig. 5).

So, downgrades to triple-C or an assignment of SD or LD resulting from a loan buyback inflict even greater pain by triggering overcollateralization (OC) tests for those CLOs that choose to hold onto the loan in question instead of tendering it.

These CLOs are required to mark to market the price of the defaulted or downgraded asset based on its price in the secondary market.

The lesser of two evils
CLOs are having “to choose between two undesirable outcomes,” said one CLO manager. “Should a CLO crystallize a loss by selling back its paper to the issuer for a low price or should it take the hit on its OC test by keeping the paper?”

Market players estimate that over 50% of CLOs have breached their OC tests and that buyback-related defaults are a major contributor to that.

Another problem has to do with the time at which a downgrade or default rating is assigned. CLOs have reporting dates in which they do their OC tests. If the test falls on a day when the loan being bought back is assigned a SD/LD rating, then it has to be marked to market and that impacts the OC cushion.

If a CLO fails its OC test, it must redirect cash flows to its senior note holders, reducing what it can pay its equity investors. This affects CLO managers who either own the CLO equity piece or rely on subordinated fees that are contingent on passing OC tests.

CLO managers also say that by moving issuers to default, the rating agencies are, essentially, trying to measure an unobservable event. In other words, it isn’t always apparent that had it not done a buyback, an issuer that was downgraded to SD would have definitively defaulted on its debt.

“It’s a self-fulfilling prophecy because if companies cannot live to fight another day, it really does increase their chances to default,” said a CLO manager.

The future of buybacks
When asked if the rating agencies are putting additional pressure on the market at a time when the market can ill afford it, Emery from Moody’s said that “Moody’s needs to accurately capture default events and our definition of default has always included distressed exchanges. At the same time, it’s worth noting that Moody’s largely rates through these distressed buyback transactions and understands that the transaction can be beneficial to the capital structure of the company.”

A poll conducted by the Loan Syndications & Trading Association (LSTA) in mid-April asked what the likely outcome from the SD situation would be. Thirty-nine percent said the downgrades would cause more CLOs to trigger their OC tests and go static (Fig. 6).

Twenty-eight percent said borrowers would continue to do economically rational buybacks, while another 28% said CLOs would be forced to vote against buyback amendments, thus ending buybacks. The remaining 5% predicted other outcomes for the situation.

As the wider credit markets treat wounds suffered from the current financial crisis, signs of life have emerged in the healthcare industry. Healthcare is typically considered a defensive sector. Many companies have strong balance sheets, predictable cash flows and, most importantly, the ability to repay debtors. So for certain healthcare names, capital has begun to flow again. Some lenders even see the industry as a true growth engine for banks in this time of restrictive lending practices.

Despite not being completely inoculated against the crisis, $38 billion of healthcare transactions have been completed thus far in 2009, according to Thomson Reuters LPC data, accounting for almost one-quarter of total U.S. loan issuance. More impressively, 41% ($36 billion) of all investment grade lending to date comes from the healthcare sector (Fig. 1).

In fact, while most industries saw declining volumes year over year, 1Q09 healthcare syndicated loan volume outpaced 1Q08 issuance by 150%. M&A was at the forefront of activity with volume up a staggering 7.5 times compared to 1Q08 and already 57% greater than 2008’s total healthcare M&A issuance (Fig. 2). Of course, it should be noted that much of this volume is concentrated in one deal: Pfizer’s $22.5 billion loan, which is the largest U.S. syndicated loan to clear the market since 2007.

Positive sentiment in the healthcare sector has also been observed in the secondary loan market. Following signs of a limited recovery in the secondary, healthcare investors have regained some of the losses suffered in 2008. However, healthcare showed more significant signs of an uptick, well ahead of any comparable gains across the broader market. While the overall market has ticked up about 9 points since January to the 70 vicinity, the average bid on healthcare names has gained almost 13 points to the 85 context (Fig. 3).

Healthcare’s defensive status in the current recession was an important driver of a speedier recovery in the secondary, as several companies reported solid 1Q09 earnings. Community Health’s $6 billion term loan ticked up about 25 bps after the company reported a 7.6% increase in revenues, in line with market expectations (Fig. 4). The loan is currently bid near 92, up from 78 at year end. And DaVita’s TLB is now trading in the 94 context after jumping about 50 bps when the company posted almost an 8% increase in revenue in the first quarter - creeping closer to par from year-end bids of 86.

Secondary trades for HCA Inc. were greatly affected when the largest for-profit hospital chain closed on a $1.5 billion high yield bond issue, the largest deal of its kind so far this year. The company sold the 10-year notes with a yield of 9% and used proceeds to repay a portion of its LBO debt. HCA’s TLA and TLB rose 75 bps ahead of the partial repayment, but after the loans were paid down on April 24, bids settled. The TLB, which began the year at 78, is presently trading in the 91 context.

Healthcare’s blockbuster M&A deals
Contrary to other sectors where limited loan activity has been focused on refinancings and deleveraging, healthcare has seen significant event-driven financings - specifically in the M&A arena. Although most of healthcare’s primary loan issuance to date comes from Pfizer’s M&A deal, more issuers are expected to make their way to the table this year.

Pharmaceutical companies are facing increased pressure to enhance product pipelines in the face of patent expiration, which exposes their products to generic competition. To deal with this issue, larger companies, flush with cash, are looking to acquire small and mid-sized drug companies to increase product lines while reducing overlapping costs.

It is estimated that Pfizer, the world’s largest drug maker, could lose approximately $12 billion in annual revenue from the patent expiration of best-selling Lipitor in 2011. To hedge the revenue gap, the company sought out Wyeth. Thanks to the takeover, Pfizer will be able to diversify into vaccines and injectable biologic medicines. Meanwhile, Wyeth also will benefit as its anti-depressant, Effexor XR, loses patent protection in 2010.

The takeover, expected to close later this year, was contingent upon Pfizer securing loan financing - not an easy feat in a tumultuous market. But in mid-March, the company secured $22.5 billion of financing for the takeover. The loan was welcomed by lenders due to the lack of high-quality credits with attractive pricing. But capital constraints in the bank market were still evident and the company funded the majority of the $68 billion transaction with $22.5 billion in cash on hand, and $23 billion in stock (Fig. 5).

In an effort to entice lenders, highly rated companies such as Pfizer have seen their Libor spreads spike tremendously relative to credits structured prior to the credit crunch (Fig. 6). The company’s $22.5 billion, unsecured 364-day bridge loan was structured much like Verizon’s successful transaction from December 2008 - with a tight ratings grid and duration fees for amounts outstanding.

Per the grid, Pfizer’s Aa1/AAA rating set pricing initially at LIB+250 with a 50 bps step-up every quarter, a far cry from prior backstop facilities’ all-in spread of LIB+15. This, in turn, set the benchmark for other investment grade issuers. In conjunction with the new bridge loan, Pfizer also refinanced a $4 billion loan from March 2008, replacing it with a $5 billion, 364-day facility structured with the same pricing grid.

Merck & Co. also opted for less funding via the loan market, but nevertheless faced high spreads as an investment grade issuer. Merck’s $41 billion bid for Schering-Plough included only $8.5 billion in loan financing. The remainder was funded by $9.8 billion in existing cash balances, and the rest in stock.

The loan portion of the deal is split into a new $3 billion, 364-day bridge term loan, and $5.5 billion in new and amended facilities. Like Pfizer, pricing is based on issuer ratings and includes duration fees and hearty upfront fees. At the current corporate rating of Aa3/AA-, initial pricing is LIB+275. The loan is expected to be paid down by bond offerings and asset sale proceeds in the short term.

Schering-Plough was an ideal target for Merck since it has few drugs facing patent expirations, several in the mid- to late stages of development, and the company gains 100% rights to these products post-purchase.

On the other hand, pharmaceutical retailer Express Scripts is financing the majority of its acquisition of health insurer WellPoint NextRX’s subsidiaries in the loan market. But at $4.7 billion, it is a comparatively smaller transaction. Express Scripts is currently in market with a $2.5 billion, 364-day bridge loan. Pricing also has been structured similar to Pfizer’s; the initial spread for the BBB rated issuer is LIB+400, stepping up 50 bps every three months until reaching LIB+600. The deal also offers hefty upfront fees of up to 175 bps.

Once the loan is completed, the company will finance the remainder of the transaction via cash on hand and up to $1.4 billion in stock. The bridge will likely be refinanced in the bond market and is not expected to be drawn.

Bonds back biotech takeover
While the aforementioned deals tapped the loan market to various degrees, Swiss drug maker Roche Holding AG primarily financed its hostile takeover of U.S. biotech firm, Genentech Inc., using a combination of bonds, short-term notes, cash and U.S. commercial paper.

The investment grade bond market was open for business in 2009, and Roche recognized that the more it could sell there, the less it needed to raise through wary bank lenders. Ultimately, Roche, both an infrequent issuer and a high-quality name with steady cash flows, raised $39 billion in the bond markets, thereby avoiding the loan market altogether.

A $16 billion, six-part bond issue sold in the U.S., the largest corporate bond issue ever. And only a week after the U.S. bond offering, a $14 billion, four-part issue in euros and pounds sterling drew $33 billion in commitments, leaving the issue massively oversubscribed.

The offering presented generous spreads for a highly rated issuer and even included a coupon step-up clause in pricing, protecting lenders against a downgrade below single-A. After the takeover, Roche’s ratings were cut one notch by Fitch to AA-, and Moody’s Investors Service cut the long-term rating to A2 from Aa1, neither of which triggered the step-up provisions.

Roche acquired the 44% of Genentech it did not already own for the winning bid of $95 per share ($46.8 billion total) after a battle that began last summer.

Genentech is the world’s largest biotech company by market value with a portfolio of cancer drugs and other medicines. Purchasing the company gives Roche control of all revenues for big-selling cancer drugs Avastin and Herceptin, as well as absorbing an attractive portfolio of new biotech drugs, in turn, helping to round out Roche’s product portfolio.

Going forward in 2009, more M&A deals of this kind are expected. Continual breakthroughs in biologic diagnostics and drug therapies have helped create opportunity for small biotech firms, while at the same time posing new financial challenges. Small companies, regardless of their industry, have few financing options due to the credit crunch. And since the economic downturn began, the valuation of biotech companies has declined, possibly sparking further M&A activity in the healthcare sector.

Not completely recession proof
While these few jumbo healthcare deals were successful due to their investment grade profiles and rich spreads, the sector did struggle in the context of overall market trends. Relationship lending remains a priority and smaller deals are still more likely to clear market.

According to Thomson Reuters LPC data, over $1.3 billion of middle market healthcare deals have been completed this year, representing 9% of total middle market issuance to date (Fig. 7). Excluding Pfizer, the average deal size diminished to $111 million in 1Q09 from $270 million in 4Q08, highlighting the market’s sweet spot for smaller credits.

Thanks to GE Capital’s relationship-based financial support, Vesta Inc. was able to close an $89 million credit facility backing the purchase of ExtruMed LLC in late March. Pharmaceutical retailer Drug Fair Group secured a $40 million debtor-in-possession (DIP) facility provided by Bank of America after filing for Chapter 11 bankruptcy protection.

And even a middle market LBO may find success. PharmaNet is in the process of closing a $95 million LBO by JLL Partners, but the bulk of the financing burden has fallen on the sponsor, its equity contribution being over 60%.

Putting on some bandages
Through its new money assets, healthcare has provided some relief to an otherwise ailing loan market. Still, amendment activity was likewise robust. To date, the industry has amended over $42 billion of loans to extend tenors or modify financial covenants to prevent potential events of default. And in a few cases, such as Pfizer and Merck, credit agreements have been modified to allow for acquisitions.

In today’s lending environment, refinancing a loan in its entirety is not always an option, even for healthcare issuers. With tightened lending standards and banks short of cash, a new loan puts the existing bank group at risk. But as companies struggle and risk tripping financial covenants, it is in the lenders’ best interest to amend deals by pushing out maturities or loosening covenants. In return, lenders receive hefty amendment fees and much higher spreads.

Case in point: Cardinal Health recently loosened covenants on its $1.5 billion revolver from January 2007 in exchange for increased pricing. The grid jumped from a LIB+10-35 range to a much higher LIB +115-275. And in connection with an M&A transaction, Advanced Medical Optics Inc. amended its $300 million revolver to increase the total leverage ratio covenant, while the tender offer by Abbott Laboratories is pending.

With a refinancing epidemic set to hit the market in coming years, issuers are unsure where the capital will come from to support that. Thomson Reuters LPC estimates there will be $21.3 billion of healthcare loans maturing for the remainder of 2009, and another $171 billion due in the next three years, peaking at $66.2 billion in 2012 (Fig. 8).

Amendments to extend tenor should help maintain some measure of issuer liquidity in the near term. But the bond market may be a more viable long-term substitute to loans given the record-breaking issuance thus far in 2009.

The investment grade bond market has natural buyers with a higher risk tolerance, in addition to providing longer tenors on issues. 1Q09 total corporate bond issuance (exclusive of government guaranteed debt) stood at $197.6 billion, up 16% compared to 1Q08. Already, there has been talk of this year’s $25.5 billion in healthcare investment grade bridge loans being refinanced via the bond market (Fig. 9).

The prognosis
It remains uncertain whether healthcare can sustain its rally through 2009 since political reform legislation could revamp the industry. Since the recession began, prescription drug prices continue to rise and many unemployed workers cannot afford health insurance. In the near future, roughly 78 million baby boomers in the U.S. will turn 65 beginning in 2011 and will require Medicare coverage. Efforts by the government to extend insurance may negatively impact margins for pharmaceutical manufacturers, but for-profit hospitals are expected to see a decrease in bad debts.

Incentives to develop information technology (IT) will improve the overall quality of healthcare while reducing pharmaceutical costs, and healthcare-related technology companies such as Cardinal Health can benefit. But proposals to extend medical coverage into a public plan would shrink the market for private healthcare insurers.

In the debt markets, healthcare companies may have access, but with different terms than in the past. All issuers regardless of sector are facing increased pricing and fees, while banks nurse their wounds from the credit crunch.

Inverness Medical Innovations Inc. just issued $400 million in high yield bonds, doubling from the expected $200 million. And looking forward, Beckman Coulter intends to finance its acquisition of Tokyo-based Olympus Diagnostics with roughly $500 million in newly issued debt and $300 million in newly issued common stock.

As long as lenders see opportunity in healthcare, companies will continue to tap the market.

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