||The examples and perspective in this article may not represent a worldwide view of the subject. (April 2010)|
The syndicated loan market is the dominant way for corporations in the U.S. and Europe to tap banks and other institutional financial capital providers for loans. The Indian market originated with the large leveraged buyout loans of the mid-1980s, and Europe's market blossomed with the launch of the euro in 1999.
At the most basic level, arrangers serve the investment-banking role of raising investor funding for an issuer in need of capital. The issuer pays the arranger a fee for this service, and this fee increases with the complexity and risk factors of the loan. As a result, the most profitable loans are those to leveraged borrowers—issuers whose credit ratings are speculative grade and who are paying spreads (premiums or margins above the relevant LIBOR in the U.S. and UK, Euribor in Europe or another base rate) sufficient to attract the interest of non-bank term loan investors. Though, this threshold moves up and down depending on market conditions.
In the U.S., corporate borrowers and private equity sponsors fairly even-handedly drive debt issuance. Europe, however, has far less corporate activity and its issuance is dominated by private equity sponsors, who, in turn, determine many of the standards and practices of loan syndication.
Loan Market Overview
The retail market for a syndicated loan consists of banks and, in the case of leveraged transactions, finance companies and institutional investors. The balance of power among these different investor groups is different in the U.S. than in Europe. The U.S. has a capital market where pricing is linked to credit quality and institutional investor appetite. In Europe, although institutional investors have increased their market presence over the past decade, banks remain a key part of the market. Consequently, pricing is not fully driven by capital market forces.
In the U.S., market flex language drives initial pricing levels. Before formally launching a loan to these retail accounts, arrangers will often get a market read by informally polling select investors to gauge their appetite for the credit. After this market read, the arrangers will launch the deal at a spread and fee that it thinks will clear the market. Until 1998, this would have been it. Once the pricing, or the initial spread over a base rate which is usually LIBOR, was set, it was set, except in the most extreme cases. If the loans were undersubscribed, the arrangers could very well be left above their desired hold level. Since the 1998 Russian financial crisis roiled the market, however, arrangers have adopted market-flex language, which allows them to change the pricing of the loan based on investor demand—in some cases within a predetermined range—and to shift amounts between various tranches of a loan, as a standard feature of loan commitment letters.
As a result of market flex, loan syndication functions as a book-building exercise, in bond-market parlance. A loan is originally launched to market at a target spread or, as was increasingly common by 2008 with a range of spreads referred to as price talk (i.e., a target spread of, say, LIBOR+250 to LIBOR+275). Investors then will make commitments that in many cases are tiered by the spread. For example, an account may put in for $25 million at LIBOR+275 or $15 million at LIBOR+250. At the end of the process, the arranger will total up the commitments and then make a call on where to price the paper. Following the example above, if the paper is vastly oversubscribed at LIBOR+250, the arranger may slice the spread further. Conversely, if it is undersubscribed even at LIBOR+275, then the arranger will be forced to raise the spread to bring more money to the table.
In Europe, banks have historically dominated the debt markets because of the intrinsically regional nature of the arena. Regional banks have traditionally funded local and regional enterprises because they are familiar with regional issuers and can fund the local currency. Since the Eurozone was formed in 1998, the growth of the European leveraged loan market has been fuelled by the efficiency provided by this single currency as well as an overall growth in merger & acquisition (M&A) activity, particularly leveraged buyouts due to private equity activity. Regional barriers (and sensitivities toward consolidation across borders) have fallen, economies have grown and the euro has helped to bridge currency gaps.
As a result, in Europe, more and more leveraged buyouts have occurred over the past decade and, more significantly, they have grown in size as arrangers have been able to raise bigger pools of capital to support larger, multi-national transactions. To fuel this growing market, a broader array of banks from multiple regions now fund these deals, along with European institutional investors and U.S. institutional investors, resulting in the creation of a loan market that crosses the Atlantic.
The European market has taken advantage of many of the lessons from the U.S. market, while maintaining its regional diversity. In Europe, the regional diversity allows banks to maintain a significant lending influence and fosters private equity’s dominance in the market.
Types of Syndications
Globally, there are three types of underwriting for syndications: an underwritten deal, best-efforts syndication, and a club deal. The European leveraged syndicated loan market almost exclusively consists of underwritten deals, whereas the U.S. market contains mostly best-efforts.
An underwritten deal is one for which the arrangers guarantee the entire commitment, then syndicate the loan. If the arrangers cannot fully subscribe the loan, they are forced to absorb the difference, which they may later try to sell to investors. This is easy, of course, if market conditions, or the credit’s fundamentals, improve. If not, the arranger may be forced to sell at a discount and, potentially, even take a loss on the paper. Or the arranger may just be left above its desired hold level of the credit.
Arrangers underwrite loans for several reasons. First, offering an underwritten loan can be a competitive tool to win mandates. Second, underwritten loans usually require more lucrative fees because the agent is on the hook if potential lenders balk. Of course, with flex-language now common, underwriting a deal does not carry the same risk it once did when the pricing was set in stone prior to syndication.
A best-efforts syndication is one for which the arranger group commits to underwrite less than or equal to the entire amount of the loan, leaving the credit to the vicissitudes of the market. If the loan is undersubscribed, the credit may not close—or may need significant adjustments to its interest rate or credit rating to clear the market. Traditionally, best-efforts syndications were used for risky borrowers or for complex transactions. Since the late 1990s, however, the rapid acceptance of market-flex language has made best-efforts loans the rule even for investment-grade transactions.
A club deal is a smaller loan—usually $25–100 million, but as high as $150 million—that is premarketed to a group of relationship lenders. The arranger is generally a first among equals, and each lender gets a full cut, or nearly a full cut, of the fees.
The Syndications Process
Leveraged transactions fund a number of purposes. They provide support for general corporate purposes, including capital expenditures, working capital, and expansion. They refinance the existing capital structure or support a full recapitalization including, not infrequently, the payment of a dividend to the equity holders. They provide funding to corporations undergoing restructurings, including bankruptcy, in the form of super senior loans also known as debtor in possession (DIP) loans. Their primary purpose, however, is to fund M&A activity, specifically leveraged buyouts, where the buyer uses the debt markets to acquire the acquisition target’s equity.
In the U.S., the core of leveraged lending comes from buyouts resulting from corporate activity, while, in Europe, private equity funds drive buyouts. In the U.S., all private equity related activities, including refinancings and recapitalizations, are called sponsored transactions; in Europe, they are referred to as LBOs.
A buyout transaction originates well before lenders see the transaction’s terms. In a buyout, the company is first put up for auction. With sponsored transactions, a company that is for the first time up for sale to private equity sponsors is a primary LBO; a secondary LBO is one that is going from one sponsor to another sponsor, and a tertiary is one that is going for the second time from sponsor to sponsor. A public-to-private transaction (P2P) occurs when a company is going from the public domain to a private equity sponsor.
As prospective acquirers are evaluating target companies, they are also lining up debt financing. A staple financing package may be on offer as part of the sale process. By the time the auction winner is announced, that acquirer usually has funds linked up via a financing package funded by its designated arranger, or, in Europe, mandated lead arranger (MLA).
Before awarding a mandate, an issuer might solicit bids from arrangers. The banks will outline their syndication strategy and qualifications, as well as their view on the way the loan will price in market. Once the mandate is awarded, the syndication process starts.
In Europe, where mezzanine capital funding is a market standard, issuers may choose to pursue a dual track approach to syndication whereby the MLAs handle the senior debt and a specialist mezzanine fund oversees placement of the subordinated mezzanine position.
The arranger will prepare an information memo (IM) describing the terms of the transactions. The IM typically will include an executive summary, investment considerations, a list of terms and conditions, an industry overview, and a financial model. Because loans are unregistered securities, this will be a confidential offering made only to qualified banks and accredited investors. If the issuer is speculative grade and seeking capital from nonbank investors, the arranger will often prepare a “public” version of the IM. This version will be stripped of all confidential material such as management financial projections so that it can be viewed by accounts that operate on the public side of the wall or that want to preserve their ability to buy bonds or stock or other public securities of the particular issuer (see the Public Versus Private section below). Naturally, investors that view materially nonpublic information of a company are disqualified from buying the company’s public securities for some period of time. As the IM (or “bank book,” in traditional market lingo) is being prepared, the syndicate desk will solicit informal feedback from potential investors on what their appetite for the deal will be and at what price they are willing to invest. Once this intelligence has been gathered, the agent will formally market the deal to potential investors.
The executive summary will include a description of the issuer, an overview of the transaction and rationale, sources and uses, and key statistics on the financials. Investment considerations will be, basically, management’s sales “pitch” for the deal.
The list of terms and conditions will be a preliminary term sheet describing the pricing, structure, collateral, covenants, and other terms of the credit (covenants are usually negotiated in detail after the arranger receives investor feedback).
The industry overview will be a description of the company’s industry and competitive position relative to its industry peers.
Most new acquisition-related loans are kicked off at a bank meeting at which potential lenders hear management and the sponsor group (if there is one) describe what the terms of the loan are and what transaction it backs. Management will provide its vision for the transaction and, most importantly, tell why and how the lenders will be repaid on or ahead of schedule. In addition, investors will be briefed regarding the multiple exit strategies, including second ways out via asset sales. (If it is a small deal or a refinancing instead of a formal meeting, there may be a series of calls or one-on-one meetings with potential investors.)
In Europe, the syndication process has multiple steps reflecting the complexities of selling down through regional banks and investors. The roles of each of the players in each of the phases are based on their relationships in the market and access to paper. On the arrangers’ side, the players are determined by how well they can access capital in the market and bring in lenders. On the lenders’ side, it is about getting access to as many deals as possible.
There are three primary phases of syndication in Europe. During the underwriting phase, the sponsor or corporate borrowers designate the MLA (or the group of MLAs) and the deal is initially underwritten. During the sub-underwriting phases, other arrangers are brought into the deal. In general syndication, the transaction is opened up to the institutional investor market, along with other banks that are interested in participating.
In the U.S. and in Europe, once the loan is closed, the final terms are then documented in detailed credit and security agreements. Subsequently, liens are perfected and collateral is attached.
Loans, by their nature, are flexible documents that can be revised and amended from time to time after they have closed. These amendments require different levels of approval. Amendments can range from something as simple as a covenant waiver to something as complex as a change in the collateral package or allowing the issuer to stretch out its payments or make an acquisition.
Loan Market Participants
There are three primary-investor constituencies: banks, finance companies, and institutional investors; in Europe, only the banks and institutional investors are active.
In Europe, the banking segment is almost exclusively made up of commercial banks, while in the U.S. it is much more diverse and can involve a commercial bank, a savings and loan institution, or a securities firm that usually provides investment-grade loans. These are typically large revolving credits that back commercial paper or are used for general corporate purposes or, in some cases, acquisitions.
For leveraged loans, U.S. banks typically provide unfunded revolving credits, letters of credit (L/C's), and—although they are becoming increasingly less common—amortizing term loans, under a syndicated loan agreement. European banks fund and hold all tranches within the credit structure.
Finance companies have consistently represented less than 10% of the leveraged loan market, and tend to play in smaller deals—$25–200 million. These investors often seek asset-based loans that carry wide spreads and that often feature time-intensive collateral monitoring.
Institutional investors in the loan market are principally structured vehicles known as collateralized loan obligations (CLO) and loan participation mutual funds (known as “prime funds” because they were originally pitched to investors as a money-market-like fund that would approximate the prime rate) also play a large role. Although U.S. prime funds do make allocations to the European loan market, there is no European version of prime funds because European regulatory bodies, such as the Financial Services Authority (FSA) in the U.K., have not approved loans for retail investors.
In addition, hedge funds, high-yield bond funds, pension funds, insurance companies, and other proprietary investors do participate opportunistically in loans. Typically, however, they invest principally in wide-margin loans (referred to by some players as “high-octane” loans), with spreads of 500 basis points or higher over the base rate.
CLOs are special-purpose vehicles set up to hold and manage pools of leveraged loans. The special-purpose vehicle is financed with several tranches of debt (typically a ‘AAA’ rated tranche, a ‘AA’ tranche, a ‘BBB’ tranche, and a mezzanine tranche) that have rights to the collateral and payment stream in descending order. In addition, there is an equity tranche, but the equity tranche is usually not rated. CLOs are created as arbitrage vehicles that generate equity returns through leverage, by issuing debt 10 to 11 times their equity contribution. There are also market-value CLOs that are less leveraged—typically three to five times—and allow managers more flexibility than more tightly structured arbitrage deals. CLOs are usually rated by two of the three major ratings agencies and impose a series of covenant tests on collateral managers, including minimum rating, industry diversification, and maximum default basket.
In U.S., CLOs had become the dominant form of institutional investment in the leveraged loan market by 2007, taking a commanding 60% of primary activity by institutional investors. But when the structured finance market cratered in late 2007, CLO issuance tumbled and by mid-2008, the CLO share had fallen to 40%.
In Europe, over the past few years, other vehicles such as credit funds have begun to appear on the market. Credit funds are open-ended pools of debt investments. Unlike CLOs, however, they are not subject to ratings oversight or restrictions regarding industry or ratings diversification. They are generally lightly levered (two or three times), allow managers significant freedom in picking and choosing investments, and are subject to being marked to market.
In addition, in Europe, mezzanine funds play a significant role in the loan market. Mezzanine funds are also investment pools, which traditionally focused on the mezzanine market only. However, when second lien entered the market, it eroded the mezzanine market; consequently, mezzanine funds expanded their investment universe and began to commit to second lien as well as payment-in-kind (PIK) portions of transaction. As with credit funds, these pools are not subject to ratings oversight or diversification requirements, and allow managers significant freedom in picking and choosing investments. Mezzanine funds are, however, riskier than credit funds in that they carry both debt and equity characteristics.
Retail investors can access the loan market through prime funds. Prime funds were first introduced in the late 1980s. Most of the original prime funds were continuously offered funds with quarterly tender periods. Managers then rolled true closed-end, exchange-traded funds in the early 1990s. It was not until the early 2000s that fund complexes introduced open-ended funds that were redeemable each day. While quarterly redemption funds and closed-end funds remained the standard because the secondary loan market does not offer the rich liquidity that is supportive of open-end funds, the open-end funds had sufficiently raised their profile that by mid-2008 they accounted for 15-20% of the loan assets held by mutual funds.
As the ranks of institutional investors have grown over the years, the loan markets have changed to support their growth. Institutional term loans have become commonplace in a credit structure. Secondary trading is a routine activity and mark-to-market pricing as well as leveraged loan indexes have become portfolio management standards.
Syndicated loans facilities (Credit Facilities) are basically financial assistance programs that are designed to help financial institutions and other institutional investors to draw notional amount as per the requirement.
There are four main types of syndicated loan facilities: a revolving credit; a term loan; an L/C; and an acquisition or equipment line (a delayed-draw term loan).
A revolving credit line allows borrowers to draw down, repay and reborrow as often as necessary. The facility acts much like a corporate credit card, except that borrowers are charged an annual commitment fee on unused amounts, which drives up the overall cost of borrowing (the facility fee). In the U.S., many revolvers to speculative-grade issuers are asset-based and thus tied to borrowing-base lending formulas that limit borrowers to a certain percentage of collateral, most often receivables and inventory. In Europe, revolvers are primarily designated to fund working capital or capital expenditures (capex).
A term loan is simply an installment loan, such as a loan one would use to buy a car. The borrower may draw on the loan during a short commitment period and repay it based on either a scheduled series of repayments or a one-time lump-sum payment at maturity (bullet payment). There are two principal types of term loans: an amortizing term loan and an institutional term loan.
An amortizing term loan (A-term loan or TLA) is a term loan with a progressive repayment schedule that typically runs six years or less. These loans are normally syndicated to banks along with revolving credits as part of a larger syndication. In the U.S., A-term loans have become increasingly rare over the years as issuers bypassed the bank market and tapped institutional investors for all or most of their funded loans.
An institutional term loan (B-term, C-term or D-term loan) is a term-loan facility with a portion carved out for nonbank, institutional investors. These loans became more common as the institutional loan investor base grew in the U.S. and Europe. These loans are priced higher than amortizing term loans because they have longer maturities and bullet repayment schedules. This institutional category also includes second-lien loans and covenant-lite loans.
The Shared National Credit Program was established in 1977 by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency to provide an efficient and consistent review and classification of any large syndicated loan. Today, the program covers any loan or loan commitment of at least $20 million that is shared by three or more supervised institutions. The agencies' review is conducted annually, usually in May and June.
See Shared National Credit Program Shared_National_Credit_Program
- Taylor, Alison; Sansone, Alicia (2007). The Handbook of Loan Syndications & Trading. New York: McGraw-Hill. p. 23. ISBN 0-07-146898-6.
- Taylor, Alison; Sansone, Alicia (2007). The Handbook of Loan Syndications & Trading. New York: McGraw-Hill. p. 36. ISBN 0-07-146898-6.
- Caouette, John B.; Altman, Edward I. (1998). Managing Credit Risk. New York: Wiley. p. 19. ISBN 0-471-11189-9.
- Taylor, Alison; Sansone, Alicia (2007). The Handbook of Loan Syndications & Trading. New York: McGraw-Hill. p. 68. ISBN 0-07-146898-6.
- Fabozzi, Frank (1999). High-Yield Bonds. New York: McGraw-Hill. p. 43. ISBN 0-07-006786-4.
6. Signoriello, Vincent J. (1991), Commercial Loan Practices and Operations, Chapter 6 Loan Syndication Agreements, ISBN 978-1-55520-134-0.