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Slide 1: Credit Market Update December 2008 INVESTMENT BANKING SERVICES SINCE 1987 200 Wheeler Road, 4th Floor (South) Burlington, MA 01803 http://www.merger.com
Slide 2: How Tight is the Credit Market Today? Advertisement in BusinessWeek 11/17/08 Presentation for: General Electric, which relies on low-cost Commercial Paper to lend through GE Capital, has found that the contraction in CP has driven up the cost of capital to a point where it is cheaper to offer debt instruments direct to consumers Pg. 2
Slide 3: How Tight is the Credit Market Today? ABL pricing is LIBOR + 500 to +600 (inclusive of points paid at closing) Cash flow loans are pricing at LIBOR + 800 to +1500. Most middle-market borrowers closing on cash flow loans since mid-September are paying north of 15% all-in Covenant-lite deals went away in 1H 2007 and have given way to an average of three maintenance covenants on new issues LIBOR, taking a beating from Central Bankers world wide, is losing its luster as a benchmark - as such, nearly half of all loans in 1H 2008 included a LIBOR floor. Presentation for: Recent loans are being priced with an absolute rate floor of 5.0% to 5.5% Pg. 3
Slide 4: How Tight is the Credit Market Today? There is virtually no mezzanine lending going on today. Sub-debt providers, tasked with getting unlevered returns of 15%, can do better in the secondary market, buying senior secured paper at a discount There is virtually no DIP lending going on today, other than from participants already in the capital structure Exit financing for companies in bankruptcy is nearly impossible to find Major players like GE Capital, Madison, Wachovia, GMAC, Textron, and CIT are essentially out of the market Presentation for: Pg. 4
Slide 5: How Tight is the Credit Market Today? Net percentage of U.S. banks that indicate tightening credit standards on corporate loans 100 80 Shading indicates period of recession 60 Large and Mid-Size Borrowers Small Borrowers 40 20 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 -20 -40 Source: Federal Reserve (published in the Wall Street Journal, November 4, 2008) Recent tightening is more significant and widespread than at any time in the past 20 years. Presentation for: Current bias among lenders is to tighten in anticipation of recession, falling corporate earnings, and rising default rates. Pg. 5
Slide 6: Cost & Availability of Capital Commercial Paper: Costs have doubled, and maturities have shortened to days, not weeks. CLO Market: Major finance companies, unable to raise capital in the CLO market, are having to draw down warehouse lines with ever-widening spreads. De-Levering: Major lenders are looking to de-lever their balance sheets, and are selling off loan participations and distressed assets. Competition from the Secondary Market: The glut of secondary market debt has driven up the implied interest rates on BB corporate bonds to 15% and higher. Staggering hedge fund redemptions, seizures (such as Highland Credit Strategies’ $672 million fund), and bankruptcy filings have generated liquidations of debt. Fortress said 11/13 that it received $2.6 billion in withdrawal requests for its funds, which manage $9.1 billion. Presentation for: Pg. 6
Slide 7: Cost & Availability of Capital Potential Liquidations of Debt Securities (by Investor Type) Investor Type Collateralized Loan Obligations (CLOs) Hedge Funds, High Yield Funds Prime Rate Funds Insurance Companies Finance Companies Banks Source: UBS, Standard & Poor’s Note: Debt Maturing Between October 23, 2008 and January 23, 2009 ( Mkt Value of Holdings X Assumed Liquidation )= Forced Liquidations - Near-Term Maturities = Net Liquidations $ 179.3 136.8 23.6 14.2 28.3 89.6 5% 50% 9.0 68.4 0.0 0.0 0.0 0.0 11.7 9.0 1.6 0.9 1.9 5.9 -2.7 59.5 -1.6 -0.9 -1.9 -5.9 As much as $46.6 Billion of debt securities, including traditional loans, syndications, and corporate bonds may trade before year-end Presentation for: Until the selling pressure subsides, the secondary market will continue to compete with new borrowers for scarce capital Pg. 7
Slide 8: Cost & Availability of Capital Who owns the “Leveraged Loans”? Everybody. Purchasers of Leveraged Loans Q1-Q3 2008: “Leveraged Loans” are cash flow loans made at 4x – 6x EBITDA, many of which were used to finance LBOs and dividend recaps Presentation for: It’s not just the hedge funds that provided the debt. It was BofA, Wachovia, GE Capital, Madison, Allied, CapitalSource and others. Pg. 8
Slide 9: Cost & Availability of Capital Sample of Benchmark Loans offering Yields upwards of 28% Presentation for: The glut of corporate debt trading in the secondary market makes it possible to buy existing secured debt in large cap companies with strong earnings at yields that are significantly “above market” relative to current loan underwriting. Pg. 9
Slide 10: What are the Experts Saying? The great sucking sound of the secondary market: Bank Loans “Performing bank loans with no near term probability of default, are trading at 71 cents on the dollar. It used to be that anything under 80 was ‘distressed’… when a bank can buy that loan at LIBOR +900, why lend at LIBOR+ 400 bp?” Bank of America “We have bought out several positions from [Large National Bank] in club deals where we already had an interest, generally at a discount that gave us returns better than what we are getting in primary lending [which is currently L+600]” Wells Fargo “We didn’t do syndications on the origination side, but we have several relationships at [Large Regional Banks] which have given us the opportunity to buy participations [in recent months] at a discount” Danversbank Presentation for: “There are more non-bank lenders than banks, and the delevering of the non-bank lenders is driving the market, rather than the bank work-out officers.” Spring Street Capital Pg. 10
Slide 11: What are the Experts Saying? About default rates “There is an expectation that default rates across all industry sectors will rise from current historic lows” RBS Citizens “Default rates don’t really matter, because everything is trading like it will default. If I had to guess, I’d say defaults will be 15% next year” Monarch Alternative Capital LP “I have been involved in several situations where lenders have refused to deliver even routine ammendments, and are instead putting companies in default.” Choate “Lenders got into bad habits, and for years their work-out strategy was ‘go borrow from someone else’, but that is no longer the case” Turnaround Professional “High yield default rates will go to 10%. We will get a couple of 10% years like we had in 1991 and 1992” King Street Capital Presentation for: Pg. 11
Slide 12: What are the Experts Paying? Implied default rates and loss given default Loan Index Loss Given Spread (S) (% over LIBOR) Default Rate (D) Default (L) WHERE IS THE MARKET TODAY? Current Market for Bank Loans Current Market for Leveraged Loans WHAT IS "NORMAL"? Long-Term Average Historical Worst-Case 3.3% 8.0% 3.8% 8.0% 30.0% 30.0% 1.1% 2.4% 2.2% 5.6% 6.0% 14.0% 3.0% 3.0% 30.0% 30.0% 0.9% 0.9% 5.1% 13.1% (D) x (L) = (A) Anticipated Risk Spread (S) - (A) = Excess Spread MARKET PRICING RELATIVE TO LONG-TERM AVERAGE EXCESS SPREAD Current Market for Bank Loans Current Market for Leveraged Loans 6.0% 14.0% 7.6% 23.6% 50.0% 50.0% 3.8% 11.8% 2.2% 2.2% Buying secured bank loans at a discount of 39%*, generates an implied LIBOR spread of 1400bp. 1400bp suggests that either defaults will reach 23.6% with loss given default of 50%, or some similar scenario. If we experience 18% defaults (10% greater than the worst ever for loans), lenders would have to recover just 53% (25% less than historic average) to match historical MAX excess spread. *Lyondell Chemical Company, $16 billion in assets, Bank Debt/EBITDA = 2x. TLB traded at 61 as of October 23rd, a 17.5% YTM Presentation for: Pg. 12
Slide 13: What are the Experts Saying? Default rates on Corporate Debt Since 1990 Looking back over the last 40* years, the highest default rate was less than 15%! Source: Standard & Poor’s LCD, FRM * Data back to 1990 shown. Presentation for: Given the history of loan defaults over the past 40* years, the “worst case” scenario would seem to be <15% default rate. The average loss on default is 30%. Therefore the likelihood of a loss, on average would warrant an excess spread of ~450bp. Yet ABL is now pricing at +600bp, and cash flow loans at +800bp. Pg. 13
Slide 14: Current M&A Climate Debt Multiples are down relative to 2007 Debt Multiples for Large LBOs (EBITDA >$50M) 7 6 5 4 3 Subordinated Debt/EBITDA Second Lien & Other Sr. Debt/EBITDA 2 1 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08 Senior (First Lien) Debt/EBITDA Source: Standard & Poor’s LCD Debt financing, which drove up LBO valuations through 2007, has dropped off significantly Presentation for: Second Lien, which pumped up LBO debt in 2006 and 2007, has effectively gone away Pg. 14
Slide 15: Current M&A Climate Lower-Middle Market Debt Multiples are at 2002 Levels Debt Multiples for Lower Middle-Market LBOs (EBITDA <$10M) 6 5 4 3 Subordinated Debt/EBITDA Second Lien & Other Sr. Debt/EBITDA 2 1 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08 4Q08 Senior (First Lien) Debt/EBITDA Source: Mirus Survey Data Tightening credit standards and higher interest rates have reduced debt available for LBOs, driving down valuations for LBOs (and M&A overall) Presentation for: Senior leverage on lower middle-market deals is down to approximately 2x EBITDA, from an average multiple of more than 4x in Spring 2007 Pg. 15
Slide 16: Current M&A Climate 50 45 40 35 30 25 20 15 10 5 0 1998 1999 2000 Equity Contribution (%) to LBOs 32.4% 30.2% 43.7% 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08 M&A VolumeStandard & Poor’s LCD Source: ($B) 120 100 80 60 60 40 20 0 51 40 34 33 51 46 32 21 26 Leveraged M&A Volume ($ Billions) 89 68 52 41 30 17 11 17 10 4 10 10 6 11 12 10 9 21 15 18 29 35 32 34 61 106 95 67 64 32 27 98 98 99 99 00 01 00 01 02 02 03 03 04 04 05 05 06 4Q 2Q 2Q 4Q 2Q 4Q 2Q 2Q 4Q 4Q 2Q 2Q 4Q 4Q 2Q 4Q 2Q 4Q 06 07 07 4Q Source: Standard & Poor’s LCD Presentation for: With continued market uncertainty and a higher equity requirement in LBOs, leveraged M&A volume fell off in 2008, dropping to only $27.1 billion in Q2, 74% lower than the Q2’07 all-time high of $105.6 billion 2Q Pg. 16 2Q 08
Slide 17: What are the Experts Saying? About the current LBO market “The market (for LBO debt) is broken and will need to be reconstituted in some fashion.” Bank of America “ABL is now pricing at L+500 or 600. Senior leverage, if you can get it, is at 2x (EBITDA). Nobody with a healthy and growing business is a seller right now, to the chagrin of the Private Equity guys.” HIG Capital “DIP lending really isn’t available right now” Sun Capital Partners “Right now we are looking at micro cap and smaller public companies that have 4x and 5x levereage that can't get liquidity, and doing PIPEs” HIG Capital “I fear that banks are going to take this opportunity to put pressure on disfavored borrowers to exit [the facility].” Choate Presentation for: Pg. 17
Slide 18: Current M&A Climate Large LBOs held up through Q3, driven by equity, not debt Breakdown of Valuations in Large LBOs (target EBITDA >$50M) 12 10 9.8x 7.9x 8 6.1x 6 5.7x SENIOR 4.5x 3.6x Subordinated Debt & Other/EBITDA Senior Secured Debt/EBITDA 4 2 Equity/EBITDA 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08 Sources: Standard & Poors LCD Presentation for: Despite tightening credit that brought senior debt multiples from 5.7x in 2007 to 3.6x in Q3, buyers continued paying high multiples through August of 2008, filling the void with more equity and mezz Pg. 18
Slide 19: Current M&A Climate Middle-Market LBO prices are back to 2003-2004 levels Breakdown of Debt and Equity in LBOs (target EBITDA <$10M) 8.0 7.0 6.0 5.0 4.0 3.0 Seller-financed subordinated debt 3.7x SENIOR 2x 2.1x Subordinated Debt/EBITDA Senior "Stretch" /EBITDA Senior Secured Debt/EBITDA 2.0 1.0 0.0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08 4Q 08 Sources: Based on Mirus Survey (middle-market debt multiples) and Standard & Poors LCD (equity contribution) Equity/EBITDA Presentation for: Lower Middle-Market Valuations held up through early September close to 6x EBITDA. However, senior secured is now at 2.1x and there is no “stretch” or mezzanine debt available. Pg. 19
Slide 20: Fall-Out Q4 2008 Borrowers are drawing down revolvers to “test” their availability (or horde cash) Lenders, trying to protect their balance sheets, are finding creative reasons (technical defaults) to not fund Asset-Based Lenders are being directed by credit managers to get new appraisals Appraisers, worried about a flood of distressed assets coming into the market, are issuing very conservative appraisals on equipment, inventory, real estate and other assets ABL formulas will require many borrowers to contract their revolving credit facilities in Q1 2009 Weakness in retail, automotive, building products and consumer discretionary will result in significant defaults in Q4. Pg. 20 Presentation for:
Slide 21: Expectations for 2009 Banks are looking to de-lever, reducing their loans outstanding by 10%-20%, meaning significantly less capital available to borrowers. Leveraged lenders, such as GE Capital, Textron, Newstar, etc. may need to de-lever by as much as 30%, depending on what happens with CP and TARP. CLOs and Hedge Fund assets will mature and create new demand, without supply to match Refinancings will be more difficult, especially for overleveraged borrowers Default rates may reach 10% as soon as late Q1 2009, as borrowers run into issues with collateral appraisals, declining revenues, shrinking margins, severance costs, restructuring charges, etc. Presentation for: Pg. 21
Slide 22: Expectations for 2009 With DIP financing scarce, borrowers will be forced to work out more loans with their lenders to avoid uncertainty of Chapter 11 Inter-creditor agreements and complex capital structures, as has been seen with the home mortgage market, will create systemic challenges to effective work-outs Presentation for: Pg. 22