How to Increase Loan Returns: LIBOR Floors and OID

High Credit Spreads Match High Credit Risk

Since the credit crisis began in the summer of 2007, and especially since the credit markets fell of the cliff in the fall of 2008, we have seen credit spreads in the loan and bond markets increase dramatically. Some investment grade companies today are paying spreads that were reserved for high yield companies just 3 years ago. Of course, the higher spreads correspond with increasing credit risk brought on by the recession and by investors' declining appetite for risk.

Lower LIBOR is Good News for Borrowers ...

One piece of good news for borrowers is the dramatic decrease in LIBOR, the basis over which most corporate loans are priced. Although there have been some disruptions in the LIBOR market (like the fall of 2008), this rate generally tracks the Fed Funds rate. As a result, LIBOR has come down from over 5% before the crisis to well under 1% today.

US$ LIBOR

Source: Bloomberg

... But Loan Investors Still Get Paid

Loan investors, especially institutional investors, feel the pain when LIBOR goes down. So in addition to higher spreads, loan arrangers are using these two structures to increase the returns on term loans (especially Term Loan B's) and jump-start the market:

• LIBOR Floor: Borrower and lender agree that the basis for the loan will be THE GREATER OF actual LIBOR (currently under 0.50%) or the agreed upon floor. Floors in the market today range between 2% and 3%.
• Original Issue Discount (OID): The loan is sold to investors below par and repaid at par. The difference is the OID, which in todays market is anywhere between 1% and 10%. You can think of the OID as another form of an upfront fee for investors.

MBAs Need Credit Training

The job market for recent MBA graduates has changed dramatically. A recent article in Business Week (MBA Jobs: For Some, a Waiting Game) described how some firms are delaying start dates for MBA hires. Job offers, and even interviews, are hard to get.

Shifting Job Prospects for Finance Majors

One of the hardest hit MBA majors has been finance. Business schools are good at teaching traditional corporate finance skills, mostly focused on valuation - cost of capital, discounted cash flow, optimal capital structure, etc. However, with the recession and pull back in capital market activity, not only has the number of finance jobs come down, but the skills needed for the remaining jobs have shifted. While traditional investment banking functions (think mergers and acquisitions, initial public offerings) have pulled back, the focus has shifted to the debt markets - analyzing, structuring, trading and investing in corporate bonds and loans.

Bringing the Credit Training Program to Campus

Most large commercial and investment banks have multi-week entry level training programs for their new MBA hires. These programs include credit training - how to analyze and quantify credit risk, and how to structure debt products that satisfy a borrower's financing needs. Some business schools are now bringing portions of this training to their finance students to help them prepare for the debt-focussed jobs in today's economy. For example, Financial Training Partners (www.fintrain.com) recently delivered a four-day "boot camp" on credit analysis, products and structuring at a top rated business school. Students were able to develop and hone their credit skills, and learned to speak the language of debt arrangers, issuers and investors - just what they need for interview season.

How Xerox Fell

In How the Mighty Fall and Why Some Companies Never Give In, Jim Collins lists five stages of corporate decline. We used them to analyze Xerox in our last post. Collins uses behavioral terms to describe how companies falter, not financial measures.

We have a framework for analyzing troubled companies that complements Collins’ approach. It focuses more on financial measures than management behaviors. Ours is a tool for evaluating the symptoms, while Collins’ explains the cause of the disease.

Our Five Stages of Decline
Our financial framework for analyzing a company in decline has five stages.

• Stage 1: Prosperity. A company in this stage is thriving. Sales growth, profitability, and cash flows are all very strong. Liquidity is very high, and leverage is below average for the industry.
• Stage 2: Stability. In this stage, sales growth, profitability, and cash flows are strong. Liquidity is high, and leverage is about average for the industry.
• Stage 3: Difficulty. Sales growth, profitability, and cash flows are decreasing. Liquidity is low, and leverage is above average for the industry and increasing.
• Stage 4: Distress. Sales growth, profitability, and cash flows are negative. Liquidity is very low, and leverage is very high for the industry and increasing.
• Stage 5: Default. Companies in this stage have the same characteristics as Distress. But because they have missed a debt payment, they are in some form of financial reorganization or liquidation.

Xerox in Decline
Xerox is a good example of a company going through most of these stages. Let’s take a look at some key measures as Xerox goes from stability in 1999, to difficulty in 2000, and to distress in 2001.













Xerox’s operating profitability varies some through 1999, but it’s basically stable. In 2000, the trend is much worse, and margins contract in every quarter, ending in a loss – a clear case of difficulty. In 2001, profitability improves on the strength of radical cost cuts. But it remains low, and Xerox remains in difficulty.













Xerox’s debt is stable in 1999. But it increases sharply in 2000 to fund the decline in profits – a sign of difficulty. Although debt decreases in 2001, it shifts from 30% short-term at the beginning of 1999 to 60% by the end of 2001. That is a strong indicator of distress.














Liquidity shows a fall from adequate levels in 1999 (stability) to inadequate levels in 2000 (difficulty). By the end of 2001, it’s reached a dangerously low level (distress). Here we define liquidity position as cash and available committed credit lines less short-term debt and the current portion of long-term debt.

The Company Risk Cycle
We call these five stages the Company Risk Cycle. Comparing the trends in a company’s performance and finances to the Company Risk Cycle gives you a way to anticipate what could happen next. It gives you the early warning signs of credit problems.

Of course, decline is not every company’s destiny. Economic and industry cycles come and go, and companies get worse and better as they do. And companies in trouble on their own often solve their problems and turn around the way Xerox did.

What Makes Companies Fail?

How the Mighty Fall
Jim Collins is among the best researchers and writers on management effectiveness working today. He’s turned his attention from how companies succeed to how they fail. In his new book How the Mighty Fall and Why Some Companies Never Give In, Collins describes five stages of decline.

• Stage 1: Hubris born of success. Success seems automatic, practically an entitlement, and management blinds itself to threats in the market and weaknesses in the company.
• Stage 2: Undisciplined pursuit of more. Without the right resources, leaders chase after more scale, more growth, more acclaim, more of whatever they see as "success."
• Stage 3: Denial of risk and peril. Leaders dismiss the negative, exaggerate the positive, and put a positive spin on the uncertain. They blame external factors for setbacks instead of accepting responsibility.
• Stage 4: Grasping for salvation. When the company goes into a sharp decline, it looks for simplistic solutions -- like a visionary leader, a bold new strategy, a blockbuster product, or a big acquisition -- instead of getting back to basics.
• Stage 5: Capitulation to irrelevance or death. Successive setbacks sap competitive strength, the most capable people leave, and costly false starts sap financial strength.
  

Collins cites Anne Mulcahy’s turnaround at Xerox starting in 2001 as the counter-example to decline. She saw the company’s problems with unflinching clarity, shut down weak businesses to focus on strong ones, and cut costs in spite of the pain. She also restructured the company’s finances, narrowly avoiding bankruptcy.

Xerox's Brush with Death
Xerox may be a case in point for never giving in, but it is also a good example of how a company gets into trouble. In fact, it follows Collins’ stages of decline quite closely.

• Stage 1: Hubris born of success. Xerox created the copier industry, and thanks to its vaunted technological prowess and its famous sales force remained the leader through the mid-1990s. But the large-corporate market became saturated, Xerox was the high-cost producer, and more efficient rivals began eating into its market share.
• Stage 2: Undisciplined pursuit of more. Rather than overhaul its cost structure and cut prices, Xerox tried to grow its way out of trouble by introducing digital copiers and expanding into printers and small copiers for the small-office and home-office markets.
• Stage 3: Denial of risk and peril. Sales growth and profit margins began to shrink. Pricing for digital copiers proved to be much weaker than Xerox expected, and competition in printers and small copiers was ferocious. Xerox blamed economic problems in Russia, Brazil, and parts of Asia instead.
• Stage 4: Grasping for salvation. When growth and profitability fell even more, Xerox’s solution was to bring in Rick Thoman from IBM as CEO. His new strategy was to change from selling copiers to consulting on document processing, and he reorganized the entire sales force to that end. To meet earnings targets, senior managers began manipulating the revenue and expense accounts.
• Stage 5: Capitulation to irrelevance or death. Thoman also tried to cut costs, but at first the cuts created more inefficiencies than they corrected. Inventories shot out of control, and problems consolidating billing centers caused receivables to balloon. Because of the company’s bad accounting, the Securities and Exchange Commission refused to allow Xerox to issue any securities. As its funding dried up, Xerox ran out of liquidity and had to sell assets and renegotiate its bank lines in order to survive.
  

More to Come on Stages 4 and 5 and Risk
Collins looks at decline from a management perspective, but his framework is useful in risk analysis as well. The management mistakes that lead a company to Stage 5 can have dire financial consequences, as they did at Xerox. In our next blog entry, we’ll take a look at a framework for anticipating and evaluating the financial aspects of a company in decline.

Wrangling Term Loan B Investors

According to Bloomberg.com, American Airlines is asking its lenders for a covenant waiver. A conference call was held on June 22 and responses are due by June 25. Why the rush? The covenant would be waived for the quarter ending June 30, so the company wants the amendment done before the end of the quarter.

As we have discussed in earlier entries, many companies are amending their credit agreements to reflect lower than expected operating performance driven by the recession. Airlines have been especially hard hit by the downturn, so the pressure on American's covenants is no surprise. The interesting element of this amendment is the lending group - institutional investors.

Term Loan B

A Term Loan B ("TLB") is a term loan structured for sale to institutional investors, such as collateralized debt obligations (CDOs) and prime rate mutual funds. Traditional term loans, called Term Loan A's, are typically originated by and sold to banks. Here are the main differences between the two:

Negotiating Amendments with Institutional Investors

Amendments to corporate loan agreements happen all the time. When the lenders are banks (as is typical for revolvers and TLAs), the relationship between borrower and lender often goes back many years and may include other business, such as cash management or bond underwriting. As a result, banks are often willing to work with borrowers towards a long-term solution (i.e. banks are more willing to grant waivers). TLA banks are often referred to as "relationship lenders."

Institutional investors are "transaction lenders" - their relationship with the borrower often goes no further than the individual loan. As a result, they are often less inclined than banks to grant waivers or agree to amendments.

American Airlines "Pays Up" for its Amendment

American's proposal to its TLB lenders is to waive the fixed charge covenant this quarter and cut it through the loan's maturity in 18 months. In exchange, the spread on the loan would go from 200bp over LIBOR to 400bp, and there would be a new LIBOR floor of 2.5%. This would immediately increase the interest rate on the $435 million loan by about 3.9%, increasing interest expense by over $16 million per year. In addition, the lenders would get a 75 basis point amendment fee, costing American over $3 million. These terms are not unusual in today's market for "B" rated companies like American.

What Happens After a Default?

With the weak economy, we are seeing more companies breach covenants in their loan agreements. Such a default typically gives lenders these right:

1. Acceleration (i.e. "call the loan") - declare the principal of the loan to be immediately due and payable. This typically would result in the bankruptcy of the borrower since they do not have the cash on hand to repay the loan.
2. Foreclose on collateral - As with acceleration, this would result in the bankruptcy of the borrower.
3. Stop funding unused revolver commitments. Banks will typically continue to allow some revolver borrowings because cutting off the revolver would often result in a bankruptcy.

After a covenant default, banks typically do not exercise their rights - they do not call the loan or foreclose on collateral, and they often allow the borrower to continue to borrower under the revolver. Banks know that these actions would result in bankruptcy, and it is in everyone's interest to avoid bankruptcy.

So what really happens?

Most covenant defaults result in an amendment (or waiver) to the loan agreement. The financial covenants that were breached are loosened in order to get the borrower out of default. Ideally, the company and banks should see the covenant breach coming and work out an amendment before the default happens.

A good example of this is the recent amendment done by Actuant Corporation (ticker ATU), a diversified industrial company headquartered in Wisconsin. The company was forecasting deteriorating financial performance which could have breached covenants. Before the defaults happened, the company negotiated an amendment which increased its leverage covenant from 3.5x to 4.5x (with future step-downs) and reduced its fixed charge covenant covenant from 1.75x to 1.65x.

What do banks get in exchange?

In exchange for giving a borrower more room under its covenants, banks typically get one or more of the following:

1. Increased pricing and/or a one-time fee - to compensate them for the increased risk,
2. Additional collateral - to improve their loss in the event of a bankruptcy,
3. Reduced exposure - if the company is able to reduce unused amounts on the revolver or repay a portion of the term loan,
4. Additional covenants - to ensure that cash is used to repay debt (e.g. dividend and/or capex limitations) and to better monitor the company's performance.

In the Actuant example, the banks received:

• An amendment fee and increased pricing (spread went from L+250 to L+375; commitment fee went from 40 to 50bp),
• Faster term loan amortization (from $1.5 million per quarter to $10 million), and
• Additional collateral.

Bondholders Agree to Let Bio-Rad Repay Loans First

Bio-Rad Laboratories Inc. is a life sciences company with sales of over $1.7 billion. In May of 2009, it issued $300 million of 7-year notes in a 144A offering through Credit Suisse. The company refers to the new debt as Senior Subordinated Notes. Does this mean the debt is senior or subordinated? How do we know the intercreditor priority of the notes?

Contractual Subordination

The notes are governed by an indenture, a contract signed by the borrower and by a trustee (in this case, Wells Fargo) who represents the noteholders. In addition to describing the notes and listing various covenants and defaults, the indenture includes a section on subordination. In that section, the noteholders agree that in the event of the borrower's bankruptcy or a payment default on the borrower's senior debt (or certain other events), the borrower will not make any payments on the notes until the default is cured or the senior debt is repaid in full. This arrangement is referred to as contractual subordination (see also our entries on structural subordination and effective subordination).

The Details Matter

The document creating contractual subordination can be a subordination agreement or indenture (as with Bio-Rad, and commonly used for public bonds and 144A issues), or an intercreditor agreement, which is more common with mezzanine finance and other privately placed subordinated debt. The terms of subordination vary from agreement to agreement. For example, the ability of subordinated debtholders to receive payments after a covenant breach in the senior debt can vary, as can the amount and type of allowable senior debt. Finally, the term senior subordinated debt (which is common for high yield bonds) means that the bonds are subordinated to all senior debt (typically bank loans) but it is senior to any junior subordinated debt (typically, mezzanine finance).

Who Issues Subordinated Debt, and Why?

Subordinated debt is more expensive than senior debt, so why would a company issue it? The big issuers of subordinated debt are:

1. Non-investment grade companies, who often need more debt or longer-term debt than the senior market will provide, and
2. Regulated entities, such as banks, insurance companies and electric utilities, who issue subordinated debt instead of equity in order to satisfy their regulatory capital requirements.

Microsoft's leverage nearly triples!!!

Microsoft borrowed $3.8 billion in the US corporate bond market on May 11, driving its total debt up to $5.8 billion. But there's no need for panic. The company had $36.9 billion worth of cash and investments at the end of March, was producing annualized EBITDA of $23.4 billion, and enjoys triple-A ratings from Moody's and Standard & Poor's.

Cash flow problems?
The question for Microsoft is, why borrow at all? Companies borrow for lots of reasons. One is to make up for weak or erratic cash flows. That doesn't seem to be Microsoft's problem. It's been generating strong free cash flows and stable free cash flow margins.

* Last 12 months as of March 31, 2009

(Free cash flow margin is a concept developed by the Georgia Tech Financial Analysis Lab, a leader in cash flow analytics. For more information go to http://www.mgt.gatech.edu/finlab. We calculate free cash flow somewhat differently from them in this analysis.)

Liquidity Reserves?
Another reason is to build liquidity reserves by borrowing long-term money and keeping the proceeds on hand to meet future needs. But that's typical of lower-grade companies with erratic cash flows or unpredictable cash needs, not a highly rated company with strong cash flow and few financial contingencies, like Microsoft.

War chest?
Another reason to take on more debt is to build a war chest for acquisitions. The likely target for Microsoft is Yahoo, which has a market capitalization of about $21 billion. It might cost Microsoft $25 - $30 billion to acquire Yahoo, but Microsoft doesn't need to borrow money for that. It has $37 billion in cash and investments in reserve.

WACC?
Cost of capital might be the reason. Following the precepts of modern finance, companies like to blend debt with equity in their capital structures to reduce the weighted average cost of capital. Debt is cheaper than equity up to a point, but that point is somewhere around 45% debt capitalization. At only 13.6% debt to capital, Microsoft is a long way from its optimal capital structure.

Market Access?
The last reason for using debt is market access. Companies often borrow to establish themselves in the debt markets. That helps the company's financial managers get familiar with market underwriting standards and practices and gives lenders and investors a chance to become familiar with the company's management, operations, and finances. With this bond issue, Microsoft is now active in the syndicated bank loan, commercial paper, and bond markets.

Microsoft's Motives?
So which reason is it for Microsoft? It's probably a combination of reasons. The prospectus for the bonds says the funds are for "general corporate purposes." We think its most likely for debt market access in anticipation of a major acquisition which might affect liquidity needs.

Risk and Structure
Why does all this matter from a credit risk perspective? Understanding the purpose of the loan is one of the fundamental tenets of credit analysis. For large, investment grade companies the purpose can be very vague ("general corporate purposes"), but for smaller, weaker companies it should be more precise ("working capital financing" or "new equipment purchases").

From a credit structuring perspective, the basic rule is to match the form of the credit to the nature of the need. For a general purpose loan, a revolving credit or a long-term bond would be the best fit (Microsoft's bonds were for 5, 10, and 30 years). For specific needs, the rule of thumb is to match the maturity of the credit to the life of the assets, with short-term lines of credit for working capital and medium-to-long-term loans for fixed assets.

Marchionne Madness? Can Fiat Really Help Chrysler?

When someone asked Sergio Marchionne what he would do if someone asked him to start a car company from scratch, he replied, "Lie down until the feeling passes." Anyone counting on him to do for Chrysler what he did at Fiat has to be hoping he won't be tempted to lie down soon.

Marchionne is the man behind the nearly miraculous turnaround at Fiat. Before he took over in 2004, Fiat's car company had been losing money at a bankruptcy-inducing rate. In less than two years it was profitable and growing.


The Turnaround at Fiat
How did he do it? He overhauled management, replacing twenty senior managers with energetic talent from the company's middle ranks. He tackled the sales problems at Fiat by revamping one faltering product line, the Fiat Bravo, and introducing a new one, the Fiat 500.

He cut costs, not by closing plants or laying off workers, but by making key processes more efficient. For example, he cut the time to market on the Fiat Bravo from 36 months to 18 months.

He raised €1.5 billion by getting General Motors buy itself out of a joint venture with Fiat. He reduced capital spending needs through joint ventures, like sharing an assembly plant in Poland with Ford. He also worked tirelessly to convince Fiat's managers, workers, and lenders to back his plan.

Successful Turnarounds
Anxious lenders and bondholders are wondering if he can do the same at Chrysler. But with problem credits on the rise and more companies facing turnarounds, the broader question is, what can we learn from all this? What are the hallmarks of a successful turnaround plan?

A good turnaround works in three dimensions: operations, finance, and management.

• Operations
  The focus in operations is on sales, operating costs, and working capital. The goal is to improve cash flow not just in the short-term but for the long-run as well. New products and better processes were key to Fiat's success.

• Finance
  Here the focus is on liquidity and financial flexibility. The goal is to increase readily available reserves and extend debt maturities -- boost sources of liquidity now and reduce uses in the future. The GM buyback and the Ford joint venture were ways for Fiat to raise capital and enhance liquidity at the same time.

• Management
  Management's strategy, ability, and credibility are crucial. Top leaders have to come up with a strategy that addresses the problem(s) and balances operating and financial needs as well as short-term and long-term needs. They have to be able to execute, to make the strategy happen. And they have to convince junior managers, workers, suppliers, lenders, and customers that the plan will work. Marchionne's new management team saw Fiat's problems clearly and worked hard to achieve their new goals. Marchionne constantly promoted his plans to workers, creditors, and shareholders, earning vital support during the crucial transition period in 2004 and 2005.

Michael Foods Term Loans Avoid Effective Subordination

When Thomas H. Lee Partners purchased Michael Foods in 2003, it financed the deal with a combination of term loans and bonds.  All parties agreed that if there was ever a problem, the term loans would be repaid before the bonds.  In exchange for agreeing to take this higher risk, the bondholders receive a higher return than the term loans.

Contractual Subordination

To ensure the term loans are repaid first, the bond documents include a subordination agreement.  This contract between the bondholders and the borrower says that if the company ever defaults on its debt, it must repay the loans in full before it pays anything to the bondholders.  This arrangement is referred to as contractual subordination: the bonds are called subordinated and the loans are called senior (see also our discussion of structural subordination).  Contractual subordination can also be accomplished via a contract between lenders called an intercreditor agreement.

What's the Problem?

The loans had an original maturity of 6 and 7 years, so they are due in 2009 and 2010.  The company is now looking to refinance these loans with new loans with maturities in 2014 and beyond.  These new loans will still be contractually senior to the original bonds, which don't mature until 2013.  The problem is that the new (senior) loans mature after the (subordinated) bonds.  If all goes as planned, the bonds will now be paid before the loans, defeating the purpose of the subordination agreement.  This situation, where subordinated debt is repaid before senior debt because it matures first,  is referred to as effective subordination (a banker friend of ours calls this "first in time is first in line").

What's the Solution?

Michael Foods will need to refinance the original bonds before they mature in 2013.  The new term loans include an "acceleration feature" that will bring the maturity date of the loans forward if the company can't refinance the bonds.  Thus, the loans will always come due before the bonds, avoiding effective subordination.