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Is the easy credit party over? From euphoria and record deal levels just a few months ago, the corporate loan and bond markets are suffering something like a whopping hangover. The days of "covenant-lite" have ended as investors are shunning riskier loans and demanding tougher terms.

Call it "back to the future" for the corporate debt market. After a year in which borrowers were typically accorded the red-carpet treatment when they came to market, the investment community--which includes hedge funds, mutual funds and bank syndicates--has turned downright surly.

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These investors, who had formerly acquiesced to an array of debt-financing schemes and structures that "all go in the bucket of borrower-friendly terms," says Bob Filek, transaction services partner at Price water house Coopers, are now playing hard to get. They are insisting on higher interest rates and coupons for both investment-grade notes and junk bonds, shunning bond structures known as "covenant-lite" for their easy terms and turning up their noses at all manner of gimmicky loans geared to make life easier for issuers.

"The market has turned dramatically in the just the last few weeks," says Peter Foley, managing director of the media, communications and entertainment business at GE Capital Corp., who was Interviewed in late July. "It's become an unsettled and uncertain place, and it's difficult to commit to issuers."

Steve Smith, joint global head of leveraged finance at UBS, agrees. "The biggest and most dramatic change is the disappearance of the CLO [collateralized loan obligation] market," he says. "The huge, mega-LBOs [leveraged buyouts] have clogged up the marketplace, and the CLO market is closed for repair."

Commencing in late June, the markets had grown so recalcitrant that in a scorecard listing compiled by The Wall Street Journal, among other things, 29 stalled or jilted bond financings were dubbed "debt dilemmas." Included was the notorious collapse on June 5 of two Bear, Stearns & Co. hedge funds, which required a $1.6 billion bailout by the Wall Street investment bank. Both funds, which were heavily invested in subprime-mortgage debt, are essentially worthless, and Bear Stearns has since ousted co-president Warren Spector.

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Meanwhile, leveraged buyouts predominated among the troubled financing situations cited by The Journal. These included:

* U.S. Foodservice Inc. pulled its $3.6 billion bond-and-loan deal on June 26 that would have seen the company taken private by buyout firms Kohlberg Kravis Roberts & Co. and Clayton Dubilier & Rice. It was "the first jumbo LBO postponed in a long time," Reuters Loan Pricing Corp., a New York-based research group and database, declared in its second-quarter report.

* Chrysler Group's $20 billion leveraged buyout, which is being engineered by Cerberus Capital Management, nearly drove off the cliff on July 20. The private equity firm's bankers postponed a sale of $12 billion in debt for the auto company, which is being hived off from Daimler Chrysler. And while issuers have been successful in raising $8 billion in loans for Chrysler's moneymaking finance unit, they were forced to raise interest rates.

* Alliance Boots, the U.K. drugstore chain, announced on July 20 it would postpone senior note financing indefinitely in the $18.4 billion LBO being engineered by Basis Capital Funds Management. Junior debt is being offered to investors--but at higher interest rates. The appearance of a European deal like Alliance Boots on the list confirms that "this is absolutely a global phenomenon," notes UBS's Smith.

What was so stunning about the debt markets' decline was not just their unexpected suddenness but the precipitousness of the fall. The tumble was from a very high perch. "For the last three years," says Jeffrey Manning, managing director of special situations at Trenwith Securities, "it's as if the market had gone on steroids."

Smith says: "Conditions were so good for so long that this comes as a real shock. Talk about a window that people thought was stuck open: you have to go back to the 2001 dot-com and telecom bust for any parallel."

The second quarter of this year was the most robust ever, reports Loan Pricing Corp. Total U.S. syndicated loan issuance topped $560 billion, making it "the biggest quarterly volume on record," reported LPC. Driving the loan market was paper for debt-hungry leveraged buyouts, "an unprecedented $65 billion," LPC reported; it added that the quarterly figure "was equivalent to the fifth-largest year on record" for LBO loans.

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Not only were those loans reaching stratospheric dollar levels, but they were getting done at cut-rate prices for borrowers, often with exceptionally easy terms, a formula known as "covenant-lite." In some cases, notes PwC's Filek, loans were made in which covenants didn't "kick in" for nine months. In other cases, borrowers no longer had to meet maintenance requirements that limited the amount of debt an issuer can carry on its balance sheet.

Says Foley of GE Capital: "In traditional covenants, you had to be within a certain leverage ratio, say six-to-one debt to cash flow. And if you dropped below that, you'd have to renegotiate." But under covenant-lite, he notes, there is no immediate recourse for the lender until the issuer wanted to borrow money.

"The maintenance test went out the window," he adds, and once the ink was dry on the contract, the only chance for renegotiating terms of the loan came when the borrower came up for renewal.

Leverage Ratios Skyrocketed

As many as one in three bond financings over the last year could be categorized as covenant-lite, reports Loan Pricing Corp. The upshot, Foley adds, was that "leverage ratios began shooting through the roof."

Filek of PwC notes that bonds used to finance LBOs in the late 1980s and early 1990s typically had seven to eight financial covenants, compared with few or none today. In addition, he says, as recently as 2001, fixed-income instruments insisted on a ratio of 2 1/2 times debt-to-EBIT-DA (earnings before interest, taxes, depreciation and amortization--a common measure of cash flow). But by this year, Filek says, lenders were accepting as much eight to nine times cash flow.

But that's not all. The frothy market had also embraced a passel of innovative debt financings, the features of which were designed to be investor-friendly. These included: "payment-in-kind toggle" (or PIK toggle) loans, "extendibles" and even--to borrow from the golfing term for a do-over--"mulligans."

A PIK toggle feature means that, instead of making twice-yearly cash payments on interest, as is customary, the borrower has the option--hence the computer term "toggle," or switch--to roll over the interest. Thus, the interest and principal could be deferred for the half-life of the loan.

The PIK toggle feature originated in the May 2005 Neiman Marcus LBO deal, in which the high-end, Dallas-based retailer was taken private by private equity firms Texas Pacific Group and Warburg Pincus, notes Jay Kim, a partner at the New York law firm Ropes & Gray.

"What it was originally intended to do was help out cyclical businesses, like those in the retail sector," Kim says of PIK toggle. "But it morphed into a standard feature of financing packages."

Another borrower-friendly structure that entered into debt financing over the last year was the "extendible" bond, where the notes carry flexible maturities. Here, borrowers are allowed to miss payments and extend the loan's maturity but, in return, consent to paying a higher interest rate. Says PwC's Filek: "This was designed to give start-up companies the flexibility to weather some initial trouble without breaking a covenant."

And then there's the mulligan, which simply meant that the borrower could miss one of its semi-annual payments without a penalty. "It's a freebie," is how GE Capital's Foley puts it. Manning at Trenwith Securities cites the mulligan as just another sign of the hegemony enjoyed by borrowers. "The power of the buy side was so strong that [it] could dictate terms to hapless lenders, or else they couldn't get the deal."

In many instances, a covenant-lite bond would also entail additional investor-friendly features. Consider, for example, LBO financing for Asurion Corp., an insurance underwriter specializing in covering lost, stolen or damaged cellphones. As recently as June 7, Asurion's LBO, in which Merrill Lynch was the lead financial arranger, was being financed by a $580 million second-lien tranche that was both covenant-lite and included a PIK toggle option, notes Neslyn D'Souza, an analyst at Standard & Poors' Leveraged Commentary and Data newsletter.

The bull market for bonds and CLO financings had begun to exhibit what former Federal Reserve Chairman Alan Greenspan once described as "irrational exuberance." One longtime investment banker at a white-shoe Wall Street firm, who asked not to be named, marveled with near-incredulity at some of the terms and loan structures, many of which allowed LBO specialists to substitute bondholders' debt for their equity. "It's allowed for people at the private equity firms to pay ever-higher prices for properties," he notes.

"But it really isn't debt," this veteran financier adds. "If you just roll your payments over and you don't have any covenants, it's more like equity. But [the lender is] only getting a 7 percent return on the investment--not the 15-to-20 percent you'd expect from an equity investment. Why on earth would you make that loan?"

Not Your Father's Bank Loan

One of the underlying reasons for the easy credit, notes Trenwith Securities' Manning, has been the emergence of the market for CLOs and syndicated bank loans. The ability to pass along the loans to a third party, he says, makes for a very different dynamic than a traditional bank loan.

"If I'm making a loan and holding it to maturity," Manning says, "I have a different standard for underwriting than if I have to make the loan and get the money back. With securitizing and syndication of loans," he adds, "the lender's attitude becomes one of, 'I don't have to stay around to see how the play ends.'"

But now, in the wake of the widespread loan defaults of the subprime mortgage lending industry, which led to the collapse of two Bear Stearns hedge funds, the fear seems to be spreading. Even though the subprime loan market is separate from the corporate loan market, "subprime contagion spilled over to other areas of the market," notes UBS's Smith.

Adds Trenwith's Manning: "It's a parallel universe. And the fact is that Bear Stearns suffered a glitch in the mortgage market and people looked at that and said it was caused by cheesy underwriting. Now, nobody wants to be stuck with a big loan they can't unload into the marketplace."

Those fears were further heightened when American Home Mortgage--the 10th-largest home lender in the U.S. and a company that made almost no subprime loans--veered on the edge of bankruptcy in late July and then actually filed for Chapter 11 in early August. Several big banks--including Bank of America, Barclays and JPMorgan Chase--had lending agreements with American Home, which blamed "extraordinary disruptions" in the credit markets.

Such close connections, plus the fact that that many of the big banks are heavily involved in LBO deals--Bank of America, Citigroup and JPMorgan Chase, in particular--have added to concerns about just how well these financial institutions will weather the current storm. During July, stock prices tumbled on investor fears sparked by economic risks from a meltdown in subprime mortgage loans and the shrunken appetite that investors were displaying for LBO paper peddled by banks and securities firms.

And, with the market for securitized commercial bank loans virtually at a standstill, there was speculation that financial institutions now on the hook with bridge loans could get slammed if the deals go south. The veteran Wall Street banker warns that it's not unthinkable that a major financial institution could suffer severe losses and face bankruptcy from bad bets in the LBO market. He cites what happened to investment bank First Boston Corp.

Saved by Credit Suisse

In 1989, First Boston loaned hundreds of millions of dollars to finance the takeover of Ohio Mattress Co., the maker of Sealy mattresses. But when the junk bond market imploded, First Boston was left holding the bag. Credit Suisse bailed the firm out and, while First Boston staved off bankruptcy, it came under control of the Swiss bank.

Through early August, at least, such dire events hadn't occurred. Market participants are quick to note that inflation is under control and corporate profits have remained strong. "The good news is that there haven't been a lot of defaults," says GE's Foley.

Given the good-new, bad-news scenario so far, the double-barreled question being asked, says Trenwith's Manning, is: "Are the corporate debt markets undergoing a sea change, or is this just a case of summer doldrums?"

If it's a permanent condition, it could spell the end of the bombshell LBO era, in which $50 billion takeovers by private equity firms were getting done and $100 billion deals seemed to be just around the corner, all on impossibly forgiving terms.

Bob Nolan, a founding partner at Halyard Capital, a private equity firm in New York, says that the middle-market deals are feeling the markets' sting as well. Where lenders would have given borrowers debt financing amounting to six times EBITDA, he says they are "throttling back the leverage a full turn," meaning that companies taken private cannot be leveraged more than five times cash flow.

He sees two outcomes in the current environment, neither of which is especially inviting. "Bidders who had been relying on more generous leverage levels will have to reassess the price they'll pay. Or they'll have to accept the notion of less leverage and make up the difference with more equity," he says.

Scott Perricelli, a principal at LLR Partners, a private equity firm in Philadelphia, counts himself lucky not to have any deals in the market just now. He sees this as a time of great uncertainty. "We're in a transition period," he says, "and if I knew what would happen, I'd be taking positions on bonds and making a boatload of money."

If the market deteriorates further and many LBOs eventually collapse, not everyone will go broke. "For every hedge fund that gets beaten up," says the Wall Street banker, "there's a guy on the other side of that trade doing very well."

And Trenwith's Manning, who specializes in investing in distressed situations, expects that he's going to have a busy season in bankruptcy and restructuring work. "People like me make money after the correction," he says. "The herd gets culled."

PAUL SWEENEY (easysween@aol.com) is a freelance writer in Austin, Texas, and a frequent contributor to Financial Executive.

RELATED ARTICLE: TAKE AWAYS

** In the space of a few months, the credit markets turned from euphoric to bearish, with many deals made on easy terms coming under sharp scrutiny.

** Huge problems in the subprime mortgage market have washed into the bond market, with investors shunning riskier transactions and demanding less leverage.

** Some observers think that the ongoing woes could end the boom in leveraged buyouts and possibly threaten the independence of a major bank or investment bank exposed to troubled deals.
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Author:Sweeney, Paul
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Date:Sep 1, 2007
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