Secondary Loan Markets On a Tear – Is M&A Rebirth Far Behind?

Posted by John Slater on April 23, 2009

Since the collapse of the syndicated loan markets in August 2007, the private equity M&A market has gone from red hot to stone cold at the high end and luke warm in the middle market. The primary cause of this collapse is not lack of equity; at the beginning of the year PE firms had close to $200 Billion of dry powder. The issue holding back the M&A market worldwide has been the lack of leverage for new deals.

The M&A bubble of 2005-2007 was driven in great part by an explosion of new funding sources that entered the leveraged lending market, leading to an unprecedented narrowing of lending spreads. At the peak, leveraged loans were being written at spreads as much as 300 basis points narrower than historical norms. Funding sources included hedge funds, special purpose entities created by the banks, collateralized loan obligations (CLOs), institutional investors and various international purchasers.

From the market crack in August 2007 through August 2008, this market traded at a discount of up to 10% of principal, reflecting a partial return to normality in terms of risk based loan spreads. During this period it became increasingly difficult for lenders to syndicate new deals. In September 2008, coinciding with the collapse of Lehman Brothers, this market went into freefall with a basket of the largest leveraged loans trading below 65% of principal by late 2008. The market for new syndications, particularly the multibillion dollar deals that had been so prevalent, ground to a virtual halt.


Source Churchill Financial – On the Left; S&P LCD Index

At the beginning of this year, the leveraged loan market priced in not only a correction of the previous mispricing of risk, but the assumption that battle horns were blowing in the Valley of Armageddon. After rising from 63.5 to 80.6 in the last four months, the LCD Index now reflects normalization of spreads plus a fifty year flood, a substantial improvement, but far from Nirvana. The market collapse in fall 2008 had far more to do with the deleveraging of the hedge funds and special purpose entities than it did with a considered pricing of risk. A cry of “give me a bid, any bid” could be heard across the land. As the deleveraging has run its course, inventories have declined and prices have recovered.

In a thoughtful piece in Tuesday’s Wall Street Journal, Michael Milken described past manic swings in the leverage levels of America’s corporate balance sheets. He pointed out that every cycle of overleveraging has been followed by a period of recapitalization, through debt for equity exchanges, repurchases of discounted debt and new equity offerings, which restores corporate balance sheets and provides the foundation for a renewal of new investment and growth. The current rebound in leveraged loan pricing may indicate that this process is now underway in the current cycle.

So long as existing senior debt was trading to yield potential returns approaching 20% per annum, those lenders with capital remaining had little incentive to provide new debt at acceptable spreads. With that competition for investment dollars winding down, new loans will become increasingly available, though still at spreads far in excess of those available at the peak of the boom. While we are a long way from a return to the frothy M&A market of mid-decade, it’s reasonable to expect a return of the financial buyers to the marketplace and a far more active M&A market for the balance of the year than we have seen over the past six months.

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