Where the wall went

When you look at the marketplace as a whole, it’s awash with liquidity,” says John Fraser of 3i Debt Management, speaking in a conference room in midtown Manhattan. “Investors and managers seem willing to finance just about anything.”

Fraser’s relative calm transforms into something slightly more unsettling when he follows that benign observation with a deeply pessimistic musing. 

It will have long term implications for investors who don’t consider the quality of the companies in which they invest,” he says. “We’re going to see defaults increase. There’s no doubt in my mind that we’re setting ourselves up for another default crisis.”


The Wall

Let’s wind the clock back a few years.

In 2010, analysts were sounding the alarm on the volume of loans scheduled to mature in 2013 and 2014. At the time, they believed the volume of loans reaching maturity would create insurmountable hurdles to companies and their sponsors. With fresh memories of the 2008-2009 credit crunch in mind, the thought of roughly $800 billion in outstanding LBO loans reaching term in a tight liquidity environment was cause for legitimate concern.

For good reason, the financial crisis triggered something of an apocalypse in the credit market. The disruption of traditional lending prompted a spike in corporate default rates. More than 100 Moody’s-rated corporate issuers defaulted on $281.2 billion of debt in 2008, compared to just 18 defaults on $6.7 billion the previous year, according to one report from the ratings agency. 

From 2008 to 2009, or really about the middle of 2010, you could not actually get a loan,” says John Harris of Harbert Mezzanine. “The whole system kind of froze. When General Electric can’t sell commercial paper, it’s frozen.”

As the world emerged from that morass, speculation abounded as to how financial sponsors would manage the mountain of debt their companies had assumed in the years leading up to the crisis, particularly the mid-market shops whose assets lacked the blue chip pedigree possessed by certain large-cap transactions. 

Mid-market sponsors are feeling increasingly uncomfortable with the assumption that banking market liquidity will return any time soon. With sovereign and corporate debt refinances set to peak ahead of the leveraged refinancing peak in 2013-14, there is growing realisation that liquidity may, if anything, become tighter,” Marlborough Partners Jonathan Guise told sister publication Private Equity International back in 2011. “There is, therefore, significant risk for all but the strongest credits in waiting too long before refinancing.”

Fortunately, liquidity did not become tighter. If anything, it became more readily available than ever. Low interest rates and investor demand for yield fueled the leveraged loan and high yield volumes for much of 2012 and 2013, which in turn eased the refinancing process for many companies that would have faced challenges in a different market environment. 

Last year, US leveraged loan issuance topped its pre-crash peak of $535 billion thanks largely to the refinances. Roughly half of all issuance for the year came in the form of refinances, compared to just 14 percent for leveraged buyouts.

The sheer volume of refinancing deals has had a stunning effect on the leveraged loan maturity wall:  only $11 billion is still set to mature this year, based on estimates made back in September. That is still a substantial sum, yet it represents only a fraction of the $174 billion had been scheduled to mature in 2014 when estimates were made back in December 2010, according to a Hamilton Lane report that cites S&P/LCD data.

The Hamilton Lane report attributes the improvement to the implementation of deleveraging and extension strategies. Indeed, since 2010, 94 percent of the 2014-maturity US loans have been eliminated.

The year end 2013 data suggests the maturity wall for 2014 and 2015 has been reduced down to almost zero. Only $17 billion is set to mature before 2016, and that only represents 2.5 in outstanding [volume],” The Carlyle Group’s director of research Jason Thomas tells Private Debt Investor. “I think it’s safe to assume that the 2.5 percent of outstanding loans that remain have something wrong with them.”


The strength in what remains

Despite the relative ease with which many companies and sponsors were able to push back their maturities, there have been – somewhat inevitably – a few stragglers as well. 

What’s been unique is the volume of refinancing, the volume of re-pricing and the overall change in the interest rate paid,” Thomas says. “When you had companies that did not avail themselves of the significant improvement in borrowing terms, that is suggestive that there’s something wrong for these companies.”

For his part, Fraser views the unwillingness of lenders to support such companies’ refinancing bids as a sign of encouragement, largely because of his concerns regarding the industry-wide decline in lending standards.

In his conversation with Private Debt Investor, he describes one such case involving a trucking company that had been renegotiating a contract with its employees’ union. The company’s refinancing package was contingent on the union approving a company-friendly deal, similar to the one it had through the crisis. When the union rejected that deal, the company’s backers spiked the refinancing package. 

They had a deal to restructure some of their debt as equity, bring in new equity and bring in a new credit facility,” Fraser says. “Even though the markets look awash with liquidity, investors are still paying attention to what’s happening to companies in the real world … Credit standards have not fallen by the wayside.”

It’s a strong example of lenders showing some spine, to be sure. Even so, lenders have become increasingly borrower- friendly over the last several years because of the volume of capital being put to work and the level of competition they face in locking down deals. The current environment will pose challenges in the long run should companies hit a tougher refinancing market, and higher interest rates, once they reach maturities scheduled for 2016 and beyond.

One of the striking things about it, from my perspective, is that default seems to be more of a liquidity phenomenon than an economic phenomenon,” says Thomas. “If CCC-rated borrowers can rollover their paper, there aren’t going to be many defaults.”

It’s a trend distressed managers are keeping an eye on as well.

In terms of the weaker credits, if you haven’t been able to make something happen in this market, things are going to get increasingly tougher,” says Maria Boyazny of MB Global Partners. “A spike in lower quality issuance is always followed by a spike in defaults.”


So what happens next?

Although the long-term outlook for both the economy and capital markets has improved, many sources indicated that they believe that companies operating at the lower end of the market will face biggest challenges as they face debt maturities over the next few years. Investment staff at The Massachusetts Pension Reserves Investment Management Board is in the process of implementing a strategy within its private debt allocation to target these smaller distressed opportunities.

I think it’s a bifurcated market,” says Boyazny. “[Smaller businesses have] been increasingly shut out because their lenders were historically the GE Capitals and regional/smaller banks. And some of those institutions have shut down their small business lending programmes.”

Smaller companies certainly operate with a less of a cushion should refinancing terms or the cost of capital increase over the next few years. And with many non-traditional lenders focusing their efforts towards the upper reaches of the market, any declines in community or regional bank lending will certainly have an effect on their ability to rollover their debt loads.

It would suggest the economy has improved enough that the government can slow stimulus, which likely would increase risk among middle market corporate credits,” Highland Capital Management chief executive officer James Dondero tells Private Debt Investor, adding that the most important ramifications for such an environment would be felt in the real estate market, where institutional investors such as the San Diego City Employees’ Retirement System have said they will target managers who are positioning themselves to exploit the lack of traditional financing.

A modest rise in interest rates to 3 to 5 percent and a normalisation of the yield curve would slow the construction boom defining multi-family and retail real estate. It would also slow the mortgage refinancing boom that is driving earnings at regional banks and home improvement centers.”

Although concerns about the market facing yet another wall of refinancing remain valid, lenders and borrowers can take solace in the fact that the situation has improved dramatically over the last few years. Overall, US leveraged loan volumes set to mature in the next five years total $488 billion. Unlike previous eras, however, that total is spread across a fairly wide range – just $51 billion scheduled for 2016, $124 billion for 2017, $136 billion for 2018 and $152 billion for 2019 as of September, according to the Hamilton Lane report.

Furthermore, the US Federal Reserve Board of Governors’ willingness to taper its quantitative easing strategy is indicative of a growing confidence in the underlying factors that ultimately dictate the overall health of the economy. Even if costs of capital should rise, and borrowing terms constrict, the potential of a rising economy lifts all boats, so to speak.

If you have a loan, bond, credit facility, and it’s maturing, and [you] don’t have the ability to pay it off. You have two options, you can raise equity, which is very expensive, or you can refinance,” says Harrison. “You can’t just say ‘I’m not going to refinance’, because you don’t really have a choice.”

As for the possibility of another “wall of refinancing” in three years, Harrison does not appear phased. “This [cycle’s] been going for the last fifty years. It’s always been there.”

The refinancing cycle is just that, a cycle. While the possibility of another distressed crisis remains on the horizon, the market should be able to confront that possibility with a better understanding of what may occur. There are lessons to be learned in the high leverage multiples and loose borrowing standards that contributed to the 2008-2009 crisis, and those should be acknowledged and remembered going forward.

The possibility for another disaster will only present itself when those lessons are forgotten.

“The only thing that scares me is when I hear statements from people saying, essentially, that the chance of something like what happened in 2008 is essentially zero,” says Thomas, adding that the level of confidence demonstrated by some financial leaders could lull lenders into a false sense of comfort with looser lending standards. “Complacency causes people to put their guards down.”