credit markets: tumultuous and opportunistic— navigating the shifting terrain of debt markets

Private equity, venture capital, hedge funds, and investment and commercial banks have each been significantly impacted as deal flow, profits, and jobs

have greatly diminished. Access to capital has been re-stricted, and demand for goods and services has shrunk.

Many investment pools have dropped more than 25% over the last 12 months.

Against this backdrop, the following article pro-vides a framework for analyzing the corporate credit markets’ significant sell-off in 2008 and the return of

519

Historic events battered both the financial markets and the real economy throughout 2008 and the

first quarter of 2009. On Wall Street, the destruction was most evident through the bankruptcy of

Lehman Brothers; the acquisitions of Bear Stearns, Merrill Lynch, and Wachovia; and the implosions

of AIG, Fannie Mae, and Freddie Mac. And Main Street wasn’t spared, as the declines in home

prices, large federal involvement in the banking and the automobile industries, a rapid rise in unem-

ployment, and the explosion of the U.S. federal budget deficit have shaped millions of lives and will

dramatically alter the country’s economic future. © 2009 Wiley Periodicals, Inc.

Credit Markets: Tumultuous and Opportunistic— Navigating the Shifting Terrain of Debt Markets

Correspondence to: Roger Wittlin, Silver Lake, Managing Director, One Market Plaza, Steuart Tower, 10th Floor, Suite 1000, San Francisco, CA 94105, 415.293.4355 (phone), 415.293.4365 (fax), [email protected].

SPeCiAL SeCTiOn On PRivATe equiTy

By

Roger Wittlin

Published online in Wiley interScience (www.interscience.wiley.com). © 2009 Wiley Periodicals, Inc. • DOI: 10.1002/tie.20295

liquidity and confidence in these markets since March 2009.

The Troubles of 2008, the Promise of 2009

Over the past 12 months, the rapid, dramatic changes in capital markets, both debt and equity, have affected nearly every consumer and business. Access to capital for individuals and companies was virtually frozen in the lat-ter part of 2008 and early part of 2009.

Private equity investing was altered, as credit became completely unavailable. Some of the largest leveraged buyout (LBO) transactions completed between 2006 and 2008 saw the market prices of their debt fall by 30 to 80% during the fourth quarter of 2008.1

These events created an extraordinary investment opportunity in the credit markets. As we entered 2009, credit spreads to Treasuries and absolute yields on non-investment-grade credit reached all-time highs, and an unprecedented rally has occurred during the first eight months of this year (see Figures 1 and 2).

The first eight months of 2009 have seen both the leverage loan index and high-yield index return +35.32% and +40.16%, respectively.2 There are a variety of factors that have worked together to create this unique environ-ment for credit investing in 2009. Market-technicals have stabilized or improved since the first quarter of 2009, in-cluding the following:

• Increase in Demand—Significant demand for corporate credit assets has been created by nontraditional credit

520 sPecial secTion on PRivaTe equiTy

Thunderbird international Business Review Vol. 51, No. 6 November/December 2009

investors coming into the credit markets. These in-vestors have included large pension plans that have shifted money out of equities as the risk-return trade-off for achieving equity-like returns became more favorable in debt. Private equity and hedge funds are allocating a greater percentage of their assets under management to credit, as risk-adjusted returns in the corporate credit space have been on par with equity re-turns, with far less capital structure risk. Retail money has also begun to flow into traditional high-yield mu-tual funds, which have seen inflows of approximately $10.7 billion as of June 3rd, 2009.3

• Reduction in Counterparty Risk—After the cataclysmic repercussions of the Lehman Brothers bankruptcy, the federal government (including the Treasury De-partment, the Federal Reserve, the Federal Deposit Insurance Corporation, and other federal agencies and institutions) has taken steps to reduce the percep-tion of counterparty risk in the financial system. The government was essentially forced into action by the credit market’s lack of confidence in the solvency of counterparties throughout the financial system, which was reflected in inflated credit spreads. The federal government proactively took unprecedented actions to provide liquidity and stabilize the financial system.

• Reduced Yield of Treasuries—Given the exodus from risk in 2008, yields on Treasuries have been significantly below their long-term historical averages. As of December 31, 2008, the yield on 90-day Treasury bills was 0.076%, and the yield on 10-year Treasuries was 2.213%.4 Investors have now begun to rotate away from Treasuries toward

figure 1 non-investment-Grade Bond yields

Source: Merrill Lynch High yield index.

Credit Markets: Tumultuous and Opportunistic—navigating the Shifting Terrain of Debt Markets 521

DOI: 10.1002/tie Thunderbird international Business Review Vol. 51, No. 6 November/December 2009

intermediary lenders help corporations, municipalities, states, the federal government, other public-sector institu-tions, and other entities raise long-term capital. They also act as financial guarantors of debt issuers. A partial list of entities that have undergone dramatic changes over the past year is shown in Table 1.

These institutions were significant providers of capital that fueled immense liquidity and growth in the economy. Each has been dramatically transformed by recent market events, which have reduced their ability to provide capital to issuers; Lehman Brothers has declared bankruptcy.

Excess liquidity, much of which was enabled by the se-curitization markets, ultimately led to the severe correction in valuations in 2008 and, quite likely, permanently changed the landscape of capital raising. The end of 2007 and the very beginning of 2008 was the apex of the “easy money” phe-nomenon that had been building up in the financial system for the past 30 years, the result of the glob alization of capital markets driven by these securitization markets. This easy money phase enabled consumers to borrow 90% of a home’s purchase price at interest rates below 6%, despite their in-ability to service the debt unless the underlying asset appreci-ated in value. The carnage in the housing market due to the explosion of subprime lending has been well publicized.

For institutions, the vast liquidity provided by capital markets allowed for corporate takeovers in which mul-tiples continuously expanded beyond their traditional parameters. For example, there was a media LBO, which was completed at 16.2x earnings before interest, taxes, depreciation, and amortization (EBITDA), and the debt component of such transactions was 11.6x EBITDA.6

other asset classes, including high-quality and non-investment-grade corporate credits.

• Reduction in Default Risk—By the close of last year, the credit markets may have overestimated default risk throughout the financial system. At the end of 2008, the market forecasted the risk of default to be 15 to 20% in 2009–2010. This estimation was excessively high given the variety of maneuvers companies can take to avoid default under their debt agreements. Recent estimates by credit managers have targeted the risk of default at 3% - 4%.

• Constrained Supply—There is a continued shortage of new issuance of primary leveraged loans, thus creating significant demand for secured loans in the secondary market from existing loan buyers as well as from new market participants attracted to 12 to 18% yield to worst on senior loans.

Credit investors are now searching for signs of im-proved economic fundamentals, which may help to sus-tain the rally in credit.

How Did the Markets Get Here?

To truly understand why 2009 and beyond may continue to present unique opportunities for credit investors, we must examine the forces at work in the 2008 downfall of the financial sector, which led directly to negative total rates of return of over 30% in both equity and credit.5

Sound financial institutions are the foundation of well-functioning capital markets. These balance-sheet and

figure 2 non-investment-Grade Bond Spreads to Treasuries




card receivables, auto loans, corporate loans, and commer-cial property loans. These assets backed over $10 trillion in borrowing between 2000 and 2008.8

In particular, special purpose entities issuing collat-eralized loan obligations (CLOs) became large holders of leveraged corporate debt. These holdings reached ap-proximately $600 billion in 2008.

In the majority of securitizations, the cash flows are tranched in priorities, so that cash flows received into the issuing entity are paid first to service interest/coupons due on the various tranches, and then excess cash flows are used to pay down principal on various tranches by order of maturity.

In January 2008, there were only 12 AAA-rated companies in the world, while the rating agencies had given AAA ratings to more than 60,000 structured debt vehicles,9 providing investors with a false sense of security. Many of these AAA-rated vehicles as of 1Q09 had debt trading at 30–90% below par. In hindsight, it is clear that AAA ratings misled investors and that investors were not compensated for the actual risk underlying these AAA-rated structures.

It is important to note that investors in AAA-rated corporate CLO debt were the same class of investors that purchased AAA-rated debt in other asset sectors, the largest of which was domestic residential single-family-based mortgages. The residential lending market in the United States had been rapidly growing due to the seem-ingly never-ending demand by investors for these assets. Underwriting standards for qualifying home buyers were abysmal compared to historical standards. In the latter part of 2007, the delinquencies in subprime mortgages rose from a traditional rate of 2–3% to 10% and have since grown to approximately 40%.10 Foreclosures in some high-growth communities began to top double dig-its, and it was clear that the investors in collateralized debt

In parallel to the mortgage market described above, equity contributions in many large LBOs steadily de-creased, falling below 20% in some instances. Even in many of these LBOs, the equity investors were able to later raise billions of dollars of additional debt to fund “dividend recapitalizations,” which diminished further the percentage of equity invested in these companies. During the first quarter of 2009, many of the large LBOs that occurred in 2005–2007 have tranches of debt trading at discounts of 50%, translating to significant potential losses for the equity investors in these transactions.

The easy money era traces its roots to the formation of the securitization market, which began in 1983 when Freddie Mac issued a nonrecourse, multitranche bond transaction that relied on payments from the underly-ing assets—consumer mortgages originated by Freddie Mac—to service the interest payments for the bonds. Before this transaction, corporate debt was largely a recourse obligation to the corporate entity issuing such debt.

The Freddie Mac 1983 collateralized bond obligation transaction was given a AAA rating and was very well re-ceived in the debt markets by pension fund investors. The maturity tranching of the cash flows into different average maturities was particularly attractive to pension funds that have short-, intermediate-, and long-term liabilities. The key to the growth of the securitization market came from the ability of issuers to receive AAA ratings on the lion’s share of nonrecourse structured debt. These ratings al-lowed a vast community of pension funds, mutual funds, banks, insurance companies, and money managers to invest in these assets, which were backed by cash flows.

The wildly successful debt securitization market crested with the issuance of $2.2 trillion of asset-backed securities in 2007.7 The structures of these nonrecourse asset-backed securities were then imported to other asset classes: credit

institution Mkt. Cap. on 5/1/08 ($ millions) Current StatusCiticorp 141,070.5 34% owned by gov’tBank of America 175,396.2 Recipient of large federal bailoutGoldman Sachs 85,113.8 Converted to bank holding co. Lehman Brothers (founded in 1850) 25,982.6 Declared bankruptcy on September 15, 2008Fannie Mae 29,104.0 Placed under ConservatorshipFreddie Mac 17,300.6 Placed under ConservatorshipAiG 121,450.5 80% owned by gov’tBear Stearns Forced sale to JP Morgan on 3/16/08

Source: Bloomberg L.P. database, as of June 5, 2009.

table 1 Changing Status of Financial institutions

holds, businesses, government, Main Street banks, and Wall Street firms—built up unprecedented amounts of debt on their respective balance sheets.

• Largecapbanks’aggregateassetsheldtobookequityrose from 25x to 43x during 2000–2007, a 72% in-crease in leverage.11

• SecuritizedCDOandCLOstructurestotalingover$1trillion employed leverage of up to 33x on residen-tial loan assets, meaning the buying power of assets dramatically increased, as low amounts of equity were needed to purchase assets.

• Total creditmarketdebt rose to350%ofU.S. grossdomestic product (GDP). The previous high, in 1930, was 255%; the level of credit market debt to U.S. GDP never came close to these levels in the intervening years (see Figure 3).12

• There was an outstanding notional value of deriva-tive positions of $525 trillion, which totaled 35x U.S. GDP. These unregulated derivative contracts were unsecured contracts developed by investment banks, commercial banks, insurance companies, and finan-cial guarantors.13

The clear conclusion from this data is that when financial markets and the real economy are fueled by cheap borrowed capital, a strong and dramatic correction is inevitable at some point, especially where the risks are

obligations (CDOs) backed by mortgages were going to face severe losses. In addition, many investors in these AAA-rated structured products used the short-term com-mercial paper market to finance these purchases. Much of this commercial paper had one-to-30 day maturities, which created a complete mismatch of short-term matur-ing liabilities with longer-term maturing assets.

The beginning of a monumental change in our finan-cial system was made possible due to the massive amount of borrowed money in our economy invested in securi-ties, which were rated inaccurately, as well as a mismatch of asset duration to liability duration.

The ensuing cataclysm resulted from the actions of nearly every player in the financial marketplace: rating agencies misrated securities; underwriters loosened their standards; asset managers outsourced their diligence to the rating agencies; regulators were well behind the curve of financial innovation; and many ordinary Americans simply lived well beyond their means, relying on cheap credit to finance their lifestyles.

Glenn Hutchins, cofounder and co–chief executive of Silver Lake, developed a comprehensive presentation titled “The Panic of ’08: What Happened? What’s Next?” In his presentation, Mr. Hutchins cites the following is-sues that contributed to the financial upheaval of 2008:

• Ledbyconsumerswhooverconsumedandundersavedfor a generation, all sectors of our society—house-



figure 3 u.S. Debt Build-up Worse Than 1929




and/or restructure their balance sheets and companies that ultimately had weak business models and overlever-aged balance sheets.

The carnage in valuations beginning in the latter half of 2008, combined with the improving technicals underpinning the market beginning in mid-March 2009, created a unique opportunity for credit investors to enter the market.

Where Do We Go From Here?

As the markets have experienced a substantial correction since the end of 2008, market participants are question-ing whether this rally is sustainable. The clearest indica-tor will be whether market fundamentals catch up with market technicals.

Although there has been plenty of discussion about small nascent signs of economic recovery, market tech-nicals may be far ahead of market fundamentals. For example, the unemployment rate is, at the time of this writing, at its highest point in 25 years at 9.4%. This rate does not factor in people who have given up looking for jobs, those who are working part-time since they can’t find full-time jobs, and the small-business entrepreneurs who have seen their businesses shrivel. For market funda-mentals to catch up with the technicals, the job market must stabilize and the private sector must become once again an engine of job growth. A weak job market has helped to push down both consumer confidence and consumer spending. If this market rally is to be sustained, these indicators will have to do more than simply stop ac-celerating downward.

There are also long-term issues that will need to be resolved for job losses in the United States to stabilize. During the years 2005–2007, the U.S. private sector is-sued a massive amount of corporate debt. This debt is scheduled to mature beginning in 2012–2016. Absent a

misunderstood and there is a dramatic mismatch in asset and liability duration (i.e., liquidity). In retrospect, it is quite apparent that when debt reaches such an extreme level that cash flows can no longer service debt payments, and when there is no additional liquidity to pay down principal obligations because capital markets are closed, the bubble fueling financial markets and the larger econ-omy will quickly burst.

The bankruptcy of Lehman Brothers, which was founded in 1850 and grew to become the fourth-largest investment bank in the United States, was an historic event. Lehman Brothers was a major underwriter of de-rivatives and, with a small handful of others, including AIG, in the center of financial counterparty lending.

The immediate reaction of financial markets was a worldwide drying up of credit. Day-to-day lending was severely limited, gravely imperiling many other financial institutions, including Citicorp, Goldman Sachs, and Morgan Stanley. At that point, the federal government proactively and forcefully began to address the threat of counterparty risk in the financial system.

The second half of 2008 through the beginning of March 2009 showed the dramatic results of wholesale selling of risky assets and a flight to quality assets. In fact, for a period of time, the financial markets were seized by such fear that only Treasuries were perceived as safe qual-ity assets, and the yields of certain Treasuries for a brief period of time actually went negative (see Table 2).

As 2009 continued through the first quarter and the U.S. economy was entrenched in a recession, the credit markets presented extraordinary opportunities. Average high-yield credit spreads versus Treasuries were over 2,000 basis points. Average BB-rated corporate debt traded north of 14%. First-secured leverage loans showed an average price of 6314 and a yield to maturity of 16%.The credit markets did not differentiate between compa-nies that were in a position to weather a cyclical downturn

June 30, 2008 March 9, 2009 % ChangeS&P 1,280.0 676.5 (47.1%)DJiA 11,350 6547 (42.3%)Crude Oil ($/barrel) 140.64 49.95 (64.5%)High yield index 583.21 424.72 (27.18%)90-Day Treasury Bill yield (%) 1.7306 0.2008 (88.4%)10-year Treasury Bill yield (%) 3.9690 2.8589 (28.0%)Gold ($/Ounce) 958.00 922.00 (3.76%)

Source: Bloomberg L.P. database, as of June 5, 2009.

table 2 Dramatic Destruction of Wealth

mechanisms will be up to the task ahead without further government intervention.

notes1. Note that non-investment-grade debt known as leveraged credit con-sists of loans at the senior part of the capital structure and bonds that can be secured behind the loan facility or unsecured. Subordinated bonds are the third priority.

2. Merrill Lynch High Yield Master II Index and Credit Suisse Leveraged Loan Index.

3. Standard & Poor’s: Leveraged Commentary & Data. Retrieved July 17, 2009, from http://www.lcdcomps.com/pg/research/us_research.html.

4. Source: Bloomberg L.P. Database. Retrieved June 8, 2009.

5. Google Finance market indexes.

6. SEC company filings.

7. “American MacroEconomic Dynamism,” http://econdynamism.blogspot.com/2008/07/securitized-debt-issuance-2006-2007.html.

8. Federal Reserve.

9. Bloomberg L.P. Database. Retrieved June 5, 2009.

10. Federal Reserve as of December 11, 2008.

11. Company filings, Capital IQ.

12. Ned Davis research and Silver Lake estimates before 1949; Morgan Stanley research after 1949.

13. Bank of International Settlements.

14. Source: Bloomberg on June 5, 2009.

robust return of global securitization, the markets are not deep and liquid enough to absorb this onslaught of scheduled maturities. As we can see, forward-thinking issuers are beginning to plan their refinancings now. Without effective refinancings or extensions of these maturing debts, many otherwise healthy companies could be forced into bankruptcy. Once in bankruptcy, these companies will need debtor-in-possession (DIP) financing to restructure under Chapter 11 and without it could be forced to liquidate under Chapter 7. If the current market for DIP financing remains constant throughout 2012–2016, then many otherwise good com-panies with overlevered balance sheets may be forced into liquidation.

The stabilization of the job market and the ability of companies to refinance or restructure their balance sheets will be paramount for the market. Many issuers have been working toward new means of restructuring outside of bankruptcy using loan extensions, debt ten-der offers, and debt swaps to reduce interest payments and push out debt maturities. Market participants are paying close attention to determine whether these



Roger Wittlin is the head of Silver Lake’s credit investment business, known as Silver Lake Financial. Silver Lake is the leader in private investment in technology, technology-enabled, and related growth industries.

Wittlin graduated from Thunderbird in 1978 and from 2002 to 2007 was the lead portfolio manager and group head of Sutter Credit Strategies, an autonomous business unit within Wells Capital Management. Sutter’s external as-sets grew from inception to $3.5 billion under Wittlin’s leadership. He has over 25 years of fixed income experience and was a vice president in the principal investment group at Goldman Sachs. He has been a guest speaker for the past two years at the Thunderbird Annual Private equity Conference.

credit markets: tumultuous and opportunistic— navigating the shifting terrain of debt markets

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