s&p a guide to the loan market - sept 2011

A Guide to the Loan Market

September 2011

I don’t like surprises—especially in my leveraged loan portfolio.

That’s why I insist on Standard & Poor’s Bank Loan & Recovery Ratings.

All loans are not created equal. And distinguishing the well secured from those thataren’t is easier with a Standard & Poor’s Bank Loan & Recovery Rating. Objective,widely recognized benchmarks developed by dedicated loan and recovery analysts,Standard & Poor’s Bank Loan & Recovery Ratings are determined throughfundamental, deal-specific analysis. The kind of analysis you want behind you whenyou’re trying to gauge your chances of capital recovery. Get the information you need.Insist on Standard & Poor’s Bank Loan & Recovery Ratings.

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Copyright © 2011 Standard & Poor’s Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.STANDARD & POOR’S is a registered trademark of Standard & Poor’s Financial Services LLC.

A Guide To The Loan MarketSeptember 2011

Copyright © 2011 by Standard & Poor’s Financial Services LLC (S&P) a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.

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Steven Miller William Chew

Standard & Poor’s ● A Guide To The Loan Market September 2011 3

To Our Clients

Standard & Poor's Ratings Services is pleased to bring you the 2011-2012 edition of ourGuide To The Loan Market, which provides a detailed primer on the syndicated loanmarket along with articles that describe the bank loan and recovery rating process as

well as our analytical approach to evaluating loss and recovery in the event of default.Standard & Poor’s Ratings is the leading provider of credit and recovery ratings for leveraged

loans. Indeed, we assign recovery ratings to all speculative-grade loans and bonds that we ratein nearly 30 countries, along with our traditional corporate credit ratings. As of press time,Standard & Poor's has recovery ratings on the debt of more than 1,200 companies. We alsoproduce detailed recovery rating reports on most of them, which are available to syndicatorsand investors. (To request a copy of a report on a specific loan and recovery rating, please referto the contact information below.)

In addition to rating loans, Standard & Poor’s Capital IQ unit offers a wide range of infor-mation, data and analytical services for loan market participants, including: ● Data and commentary: Standard & Poor's Leveraged Commentary & Data (LCD) unit is the

leading provider of real-time news, statistical reports, market commentary, and data forleveraged loan and high-yield market participants.

● Loan price evaluations: Standard & Poor's Evaluation Service provides price evaluations forleveraged loan investors.

● Recovery statistics: Standard & Poor's LossStats(tm) database is the industry standard forrecovery information for bank loans and other debt classes.

● Fundamental credit information: Standard & Poor’s Capital IQ is the premier provider of financialdata for leveraged finance issuers.If you want to learn more about our loan market services, all the appropriate contact

information is listed in the back of this publication. We welcome questions, suggestions, andfeedback on our products and services, and on this Guide, which we update annually. Wepublish Leveraged Matters, a free weekly update on the leveraged finance market, whichincludes selected Standard & Poor's recovery reports and analyses and a comprehensive listof Standard & Poor's bank loan and recovery ratings.

To be put on the subscription list, please e-mail your name and contact information [email protected] or call (1) 212-438-7638. You can also access thatreport and many other articles, including this entire Guide To The Loan Market in electronicform, on our Standard & Poor's loan and recovery rating website: www.bankloanrating.standardandpoors.com.

For information about loan-market news and data, please visit us online atwww.lcdcomps.com or contact Marc Auerbach at [email protected] or(1) 212-438-2703. You can also follow us on Twitter, Facebook, or LinkedIn.

Contents

A Syndicated Loan Primer 7

Rating Leveraged Loans: An Overview 31

Criteria Guidelines For Recovery Ratings On Global IndustrialsIssuers’ Speculative-Grade Debt 36

Key Contacts 53


At the most basic level, arrangers serve thetime-honored investment-banking role of rais-ing investor dollars for an issuer in need ofcapital. The issuer pays the arranger a fee forthis service, and, naturally, this fee increaseswith the complexity and riskiness of the loan.As a result, the most profitable loans arethose to leveraged borrowers—issuers whosecredit ratings are speculative grade and whoare paying spreads (premiums above LIBORor another base rate) sufficient to attract theinterest of nonbank term loan investors, typi-cally LIBOR+200 or higher, though thisthreshold moves up and down depending onmarket conditions.

Indeed, large, high-quality companies paylittle or no fee for a plain-vanilla loan, typi-cally an unsecured revolving credit instru-ment that is used to provide support forshort-term commercial paper borrowings orfor working capital. In many cases, moreover,

these borrowers will effectively syndicate aloan themselves, using the arranger simply tocraft documents and administer the process.For leveraged issuers, the story is a very dif-ferent one for the arranger, and, by “different,”we mean more lucrative. A new leveragedloan can carry an arranger fee of 1% to 5%of the total loan commitment, generallyspeaking, depending on (1) the complexity ofthe transaction, (2) how strong market condi-tions are at the time, and (3) whether theloan is underwritten. Merger and acquisition(M&A) and recapitalization loans will likelycarry high fees, as will exit financings andrestructuring deals. Seasoned leveragedissuers, by contrast, pay lower fees forrefinancings and add-on transactions.

Because investment-grade loans are infre-quently used and, therefore, offer drasticallylower yields, the ancillary business is asimportant a factor as the credit product in

A Syndicated Loan Primer

Asyndicated loan is one that is provided by a group of lenders

and is structured, arranged, and administered by one or

several commercial or investment banks known as arrangers.

Starting with the large leveraged buyout (LBO) loans of the mid-

1980s, the syndicated loan market has become the dominant way

for issuers to tap banks and other institutional capital providers

for loans. The reason is simple: Syndicated loans are less expen-

sive and more efficient to administer than traditional bilateral,

or individual, credit lines.

Steven C. MillerNew York(1) [email protected]


www.standardandpoors.com8

arranging such deals, especially because manyacquisition-related financings for investment-grade companies are large in relation to thepool of potential investors, which wouldconsist solely of banks.

The “retail” market for a syndicated loanconsists of banks and, in the case of leveragedtransactions, finance companies and institu-tional investors. Before formally launching aloan to these retail accounts, arrangers willoften get a market read by informally pollingselect investors to gauge their appetite for thecredit. Based on these discussions, the arrangerwill launch the credit at a spread and fee itbelieves will clear the market. Until 1998, thiswould have been it. Once the pricing was set,it was set, except in the most extreme cases. Ifthe loan were undersubscribed, the arrangerscould very well be left above their desired holdlevel. After the Russian debt crisis roiled themarket in 1998, however, arrangers haveadopted market-flex language, which allowsthem to change the pricing of the loan basedon investor demand—in some cases within apredetermined range—as well as shift amountsbetween various tranches of a loan, as a stan-dard feature of loan commitment letters.Market-flex language, in a single stroke,pushed the loan market, at least the leveragedsegment of it, across the Rubicon, to a full-fledged capital market.

Initially, arrangers invoked flex language tomake loans more attractive to investors byhiking the spread or lowering the price. Thiswas logical after the volatility introduced bythe Russian debt debacle. Over time, how-ever, market-flex became a tool either toincrease or decrease pricing of a loan, basedon investor reaction.

Because of market flex, a loan syndicationtoday functions as a “book-building” exercise,in bond-market parlance. A loan is originallylaunched to market at a target spread or, aswas increasingly common by the late 2000s,with a range of spreads referred to as price talk(i.e., a target spread of, say, LIBOR+250 toLIBOR+275). Investors then will make com-mitments that in many cases are tiered by thespread. For example, an account may put infor $25 million at LIBOR+275 or $15 millionat LIBOR+250. At the end of the process, the

arranger will total up the commitments andthen make a call on where to price the paper.Following the example above, if the paper isoversubscribed at LIBOR+250, the arrangermay slice the spread further. Conversely, if it isundersubscribed even at LIBOR+275, then thearranger will be forced to raise the spread tobring more money to the table.

Types Of SyndicationsThere are three types of syndications: anunderwritten deal, a “best-efforts” syndica-tion, and a “club deal.”

Underwritten deal

An underwritten deal is one for which thearrangers guarantee the entire commitment,and then syndicate the loan. If the arrangerscannot fully subscribe the loan, they areforced to absorb the difference, which theymay later try to sell to investors. This is easy,of course, if market conditions, or the credit’sfundamentals, improve. If not, the arrangermay be forced to sell at a discount and,potentially, even take a loss on the paper. Orthe arranger may just be left above its desiredhold level of the credit. So, why do arrangersunderwrite loans? First, offering an under-written loan can be a competitive tool to winmandates. Second, underwritten loans usuallyrequire more lucrative fees because the agentis on the hook if potential lenders balk. Ofcourse, with flex-language now common,underwriting a deal does not carry the samerisk it once did when the pricing was set instone prior to syndication.

Best-efforts syndication

A “best-efforts” syndication is one for whichthe arranger group commits to underwrite lessthan the entire amount of the loan, leaving thecredit to the vicissitudes of the market. If theloan is undersubscribed, the credit may notclose—or may need major surgery to clear themarket. Traditionally, best-efforts syndicationswere used for risky borrowers or for complextransactions. Since the late 1990s, however,the rapid acceptance of market-flex languagehas made best-efforts loans the rule even forinvestment-grade transactions.


Club deal

A “club deal” is a smaller loan (usually $25million to $100 million, but as high as $150million) that is premarketed to a group ofrelationship lenders. The arranger is generallya first among equals, and each lender gets afull cut, or nearly a full cut, of the fees.

The Syndication ProcessThe information memo, or “bank book”

Before awarding a mandate, an issuer mightsolicit bids from arrangers. The banks willoutline their syndication strategy and qualifi-cations, as well as their view on the way theloan will price in market. Once the mandateis awarded, the syndication process starts.The arranger will prepare an informationmemo (IM) describing the terms of the trans-actions. The IM typically will include anexecutive summary, investment considera-tions, a list of terms and conditions, an indus-try overview, and a financial model. Becauseloans are not securities, this will be a confi-dential offering made only to qualified banksand accredited investors.

If the issuer is speculative grade and seek-ing capital from nonbank investors, thearranger will often prepare a “public” ver-sion of the IM. This version will be strippedof all confidential material such as manage-ment financial projections so that it can beviewed by accounts that operate on the pub-lic side of the wall or that want to preservetheir ability to buy bonds or stock or otherpublic securities of the particular issuer (seethe Public Versus Private section below).Naturally, investors that view materially non-public information of a company are disqual-ified from buying the company’s publicsecurities for some period of time.

As the IM (or “bank book,” in traditionalmarket lingo) is being prepared, the syndi-cate desk will solicit informal feedback frompotential investors on what their appetite forthe deal will be and at what price they arewilling to invest. Once this intelligence hasbeen gathered, the agent will formally mar-ket the deal to potential investors. Arrangerswill distribute most IM’s—along with otherinformation related to the loan, pre- and

post-closing—to investors through digitalplatforms. Leading vendors in this space areIntralinks, Syntrak, and Debt Domain.

The IM typically contain the followingsections:

The executive summary will include adescription of the issuer, an overview of thetransaction and rationale, sources and uses,and key statistics on the financials.

Investment considerations will be, basically,management’s sales “pitch” for the deal.

The list of terms and conditions will be apreliminary term sheet describing the pricing,structure, collateral, covenants, and otherterms of the credit (covenants are usuallynegotiated in detail after the arranger receivesinvestor feedback).

The industry overview will be a descriptionof the company’s industry and competitiveposition relative to its industry peers.

The financial model will be a detailedmodel of the issuer’s historical, pro forma,and projected financials including manage-ment’s high, low, and base case for the issuer.

Most new acquisition-related loans kick offat a bank meeting at which potential lendershear management and the sponsor group (ifthere is one) describe what the terms of theloan are and what transaction it backs.Understandably, bank meetings are moreoften than not conducted via a Webex orconference call, although some issuers stillprefer old-fashioned, in-person gatherings.

At the meeting, call or Webex, manage-ment will provide its vision for the transac-tion and, most important, tell why and howthe lenders will be repaid on or ahead ofschedule. In addition, investors will bebriefed regarding the multiple exit strate-gies, including second ways out via assetsales. (If it is a small deal or a refinancinginstead of a formal meeting, there may be aseries of calls or one-on-one meetings withpotential investors.)

Once the loan is closed, the final terms arethen documented in detailed credit and secu-rity agreements. Subsequently, liens are per-fected and collateral is attached.

Loans, by their nature, are flexible docu-ments that can be revised and amendedfrom time to time. These amendments require



different levels of approval (see VotingRights section below). Amendments canrange from something as simple as acovenant waiver to something as complex asa change in the collateral package or allow-ing the issuer to stretch out its payments ormake an acquisition.

The loan investor market

There are three primary-investor consisten-cies: banks, finance companies, and institu-tional investors.

Banks, in this case, can be either a com-mercial bank, a savings and loan institution,or a securities firm that usually providesinvestment-grade loans. These are typicallylarge revolving credits that back commercialpaper or are used for general corporate pur-poses or, in some cases, acquisitions. Forleveraged loans, banks typically provideunfunded revolving credits, LOCs, and—although they are becoming increasingly lesscommon—amortizing term loans, under asyndicated loan agreement.

Finance companies have consistently repre-sented less than 10% of the leveraged loanmarket, and tend to play in smaller deals—$25 million to $200 million. These investorsoften seek asset-based loans that carry widespreads and that often feature time-intensivecollateral monitoring.

Institutional investors in the loan marketare principally structured vehicles known ascollateralized loan obligations (CLO) andloan participation mutual funds (known as“prime funds” because they were originallypitched to investors as a money-market-likefund that would approximate the prime rate).In addition, hedge funds, high-yield bondfunds, pension funds, insurance companies,and other proprietary investors do participateopportunistically in loans.

CLOs are special-purpose vehicles set up tohold and manage pools of leveraged loans.The special-purpose vehicle is financed withseveral tranches of debt (typically a ‘AAA’rated tranche, a ‘AA’ tranche, a ‘BBB’ tranche,and a mezzanine tranche) that have rights tothe collateral and payment stream in descend-ing order. In addition, there is an equitytranche, but the equity tranche is usually not

rated. CLOs are created as arbitrage vehiclesthat generate equity returns through leverage,by issuing debt 10 to 11 times their equitycontribution. There are also market-valueCLOs that are less leveraged—typically 3 to 5times—and allow managers more flexibilitythan more tightly structured arbitrage deals.CLOs are usually rated by two of the threemajor ratings agencies and impose a series ofcovenant tests on collateral managers, includ-ing minimum rating, industry diversification,and maximum default basket. By 2007, CLOshad become the dominant form of institutionalinvestment in the leveraged loan market, tak-ing a commanding 60% of primary activity byinstitutional investors. But when the structuredfinance market cratered in late 2007, CLOissuance tumbled and by mid-2010, CLO’sshare had fallen to roughly 30%.

Loan mutual funds are how retail investorscan access the loan market. They are mutualfunds that invest in leveraged loans. Thesefunds—originally known as prime fundsbecause they offered investors the chance toearn the prime interest rate that banks chargeon commercial loans—were first introducedin the late 1980s. Today there are three maincategories of funds:● Daily-access funds: These are traditional

open-end mutual fund products into whichinvestors can buy or redeem shares eachday at the fund’s net asset value.

● Continuously offered, closed-end funds:These were the first loan mutual fundproducts. Investors can buy into thesefunds each day at the fund’s net assetvalueNAV. Redemptions, however, aremade via monthly or quarterly tendersrather than each day like the open-endfunds described above. To make sure theycan meet redemptions, many of thesefunds, as well as daily access funds, set uplines of credit to cover withdrawals aboveand beyond cash reserves.

● Exchange-traded, closed-end funds: Theseare funds that trade on a stock exchange.Typically, the funds are capitalized by aninitial public offering. Thereafter, investorscan buy and sell shares, but may notredeem them. The manager can also expandthe fund via rights offerings. Usually, they


are only able to do so when the fund istrading at a premium to NAV, however—aprovision that is typical of closed-end fundsregardless of the asset class.In March 2011, Invesco introduced the

first index-based exchange traded fund,PowerShares Senior Loan Portfolio(BKLN), which is based on the S&P/LSTALoan 100 Index.

The table below lists the 20 largest loanmutual fund managers by AUM asof July 31, 2011.

Public Versus PrivateIn the old days, the line between public andprivate information in the loan market was asimple one. Loans were strictly on the privateside of the wall and any information trans-mitted between the issuer and the lendergroup remained confidential.

In the late 1980s, that line began to blur asa result of two market innovations. The firstwas more active secondary trading thatsprung up to support (1) the entry of non-bank investors in the market, such as insur-ance companies and loan mutual funds and(2) to help banks sell rapidly expanding port-folios of distressed and highly leveraged loansthat they no longer wanted to hold. Thismeant that parties that were insiders on loansmight now exchange confidential informationwith traders and potential investors who were

not (or not yet) a party to the loan. The sec-ond innovation that weakened the public-pri-vate divide was trade journalism that focuseson the loan market.

Despite these two factors, the public versusprivate line was well understood and rarelycontroversial for at least a decade. Thischanged in the early 2000s as a result of:● The proliferation of loan ratings, which, by

their nature, provide public exposure forloan deals;

● The explosive growth of nonbank investorsgroups, which included a growing numberof institutions that operated on the publicside of the wall, including a growing num-ber of mutual funds, hedge funds, and evenCLO boutiques;

● The growth of the credit default swapsmarket, in which insiders like banks oftensold or bought protection from institu-tions that were not privy to insideinformation; and

● A more aggressive effort by the press toreport on the loan market.Some background is in order. The vast

majority of loans are unambiguously privatefinancing arrangements between issuers andtheir lenders. Even for issuers with publicequity or debt that file with the SEC, thecredit agreement only becomes public when itis filed, often months after closing, as anexhibit to an annual report (10-K), a quar-terly report (10-Q), a current report (8-K), or


Assets under management (bil. $)

Eaton Vance Management 13.39

Fidelity Investments 12.12

Hartford Mutual Funds 7.25

Oppenheimer Funds 6.39

Invesco Advisers 4.44

PIMCO Funds 4.16

Lord Abbett 4.16

RidgeWorth Funds 4.13

Franklin Templeton Investment Funds 2.71

John Hancock Funds 2.61

Source: Lipper FMI.

DWS Investments 2.61

T. Rowe Price 2.00

BlackRock Advisors LLC 1.84

ING Pilgrim Funds 1.84

RS Investments 1.51

Nuveen Investments 1.37

MainStay Investments 1.34

Pioneer Investments 0.88

Highland Funds 0.74

Goldman Sachs 0.64

Largest Loan Mutual Fund Managers


some other document (proxy statement, secu-rities registration, etc.).

Beyond the credit agreement, there is a raftof ongoing correspondence between issuersand lenders that is made under confidentialityagreements, including quarterly or monthlyfinancial disclosures, covenant complianceinformation, amendment and waiver requests,and financial projections, as well as plans foracquisitions or dispositions. Much of thisinformation may be material to the financialhealth of the issuer and may be out of thepublic domain until the issuer formally putsout a press release or files an 8-K or someother document with the SEC.

In recent years, this information has leakedinto the public domain either via off-line con-versations or the press. It has also come tolight through mark-to-market pricing serv-ices, which from time to time report signifi-cant movement in a loan price without anycorresponding news. This is usually an indi-cation that the banks have received negativeor positive information that is not yet public.

In recent years, there was growing concernamong issuers, lenders, and regulators thatthis migration of once-private informationinto public hands might breach confidential-ity agreements between lenders and issuersand, more importantly, could lead to illegaltrading. How has the market contended withthese issues?● Traders. To insulate themselves from vio-

lating regulations, some dealers and buy-side firms have set up their trading deskson the public side of the wall.Consequently, traders, salespeople, andanalysts do not receive private informa-tion even if somewhere else in the institu-tion the private data are available. This isthe same technique that investment bankshave used from time immemorial to sepa-rate their private investment bankingactivities from their public trading andsales activities.

● Underwriters. As mentioned above, in mostprimary syndications, arrangers will pre-pare a public version of information mem-oranda that is scrubbed of privateinformation like projections. These IMswill be distributed to accounts that are on

the public side of the wall. As well, under-writers will ask public accounts to attend apublic version of the bank meeting and dis-tribute to these accounts only scrubbedfinancial information.

● Buy-side accounts. On the buy-side thereare firms that operate on either side ofthe public-private divide. Accounts thatoperate on the private side receive allconfidential materials and agree to nottrade in public securities of the issuers inquestion. These groups are often part ofwider investment complexes that do havepublic funds and portfolios but, viaChinese walls, are sealed from these partsof the firms. There are also accounts thatare public. These firms take only publicIMs and public materials and, therefore,retain the option to trade in the publicsecurities markets even when an issuer forwhich they own a loan is involved. Thiscan be tricky to pull off in practicebecause in the case of an amendment thelender could be called on to approve ordecline in the absence of any real infor-mation. To contend with this issue, theaccount could either designate one personwho is on the private side of the wall tosign off on amendments or empower itstrustee or the loan arranger to do so. Butit’s a complex proposition.

● Vendors. Vendors of loan data, news, andprices also face many challenges in man-aging the flow of public and private infor-mation. In generally, the vendors operateunder the freedom of the press provisionof the U.S. Constitution’s FirstAmendment and report on information ina way that anyone can simultaneouslyreceive it—for a price of course.Therefore, the information is essentiallymade public in a way that doesn’t deliber-ately disadvantage any party, whether it’sa news story discussing the progress of anamendment or an acquisition, or it’s aprice change reported by a mark-to-mar-ket service. This, of course, doesn’t dealwith the underlying issue that someonewho is a party to confidential informationis making it available via the press orprices to a broader audience.


Another way in which participants dealwith the public versus private issue is to askcounterparties to sign “big-boy” letters.These letters typically ask public-side institu-tions to acknowledge that there may beinformation they are not privy to and theyare agreeing to make the trade in any case.They are, effectively, big boys and will acceptthe risks.

Credit Risk: An OverviewPricing a loan requires arrangers to evaluatethe risk inherent in a loan and to gaugeinvestor appetite for that risk. The principalcredit risk factors that banks and institutionalinvestors contend with in buying loans aredefault risk and loss-given-default risk.Among the primary ways that accounts judgethese risks are ratings, credit statistics, indus-try sector trends, management strength, andsponsor. All of these, together, tell a storyabout the deal.

Brief descriptions of the major riskfactors follow.

Default risk

Default risk is simply the likelihood of a bor-rower’s being unable to pay interest or princi-pal on time. It is based on the issuer’sfinancial condition, industry segment, andconditions in that industry and economicvariables and intangibles, such as companymanagement. Default risk will, in most cases,be most visibly expressed by a public ratingfrom Standard & Poor’s Ratings Services oranother ratings agency. These ratings rangefrom ‘AAA’ for the most creditworthy loansto ‘CCC’ for the least. The market is divided,roughly, into two segments: investment grade(loans to issuers rated ‘BBB-’ or higher) andleveraged (borrowers rated ‘BB+’ or lower).Default risk, of course, varies widely withineach of these broad segments. Since the mid-1990s, public loan ratings have become a defacto requirement for issuers that wish to dobusiness with a wide group of institutionalinvestors. Unlike banks, which typically havelarge credit departments and adhere to inter-nal rating scales, fund managers rely onagency ratings to bracket risk and explain the

overall risk of their portfolios to their owninvestors. As of mid-2011, then, roughly80% of leveraged-loan volume carried a loanrating, up from 45% in 1998 and virtuallynone before 1995.

Loss-given-default risk

Loss-given-default risk measures how severe aloss the lender is likely to incur in the eventof default. Investors assess this risk based onthe collateral (if any) backing the loan andthe amount of other debt and equity subordi-nated to the loan. Lenders will also look tocovenants to provide a way of coming backto the table early—that is, before other credi-tors—and renegotiating the terms of a loan ifthe issuer fails to meet financial targets.Investment-grade loans are, in most cases,senior unsecured instruments with looselydrawn covenants that apply only at incur-rence, that is, only if an issuer makes anacquisition or issues debt. As a result, lossgiven default may be no different from riskincurred by other senior unsecured creditors.Leveraged loans, by contrast, are usually sen-ior secured instruments that, except forcovenant-lite loans (see below), have mainte-nance covenants that are measured at the endof each quarter whether or not the issuer is incompliance with pre-set financial tests. Loanholders, therefore, almost always are first inline among pre-petition creditors and, inmany cases, are able to renegotiate with theissuer before the loan becomes severelyimpaired. It is no surprise, then, that loaninvestors historically fare much better thanother creditors on a loss-given-default basis.

Credit statistics

Credit statistics are used by investors to helpcalibrate both default and loss-given-defaultrisk. These statistics include a broad array offinancial data, including credit ratios measur-ing leverage (debt to capitalization and debtto EBITDA) and coverage (EBITDA to inter-est, EBITDA to debt service, operating cashflow to fixed charges). Of course, the ratiosinvestors use to judge credit risk vary byindustry. In addition to looking at trailingand pro forma ratios, investors look at man-



agement’s projections and the assumptionsbehind these projections to see if the issuer’sgame plan will allow it to service its debt.There are ratios that are most geared toassessing default risk. These include leverageand coverage. Then there are ratios that aresuited for evaluating loss-given-default risk.These include collateral coverage, or thevalue of the collateral underlying the loan rel-ative to the size of the loan. They also includethe ratio of senior secured loan to junior debtin the capital structure. Logically, the likelyseverity of loss-given-default for a loanincreases with the size of the loan as a per-centage of the overall debt structure so does.After all, if an issuer defaults on $100 millionof debt, of which $10 million is in the formof senior secured loans, the loans are morelikely to be fully covered in bankruptcy thanif the loan totals $90 million.

Industry sector

Industry is a factor, because sectors, natu-rally, go in and out of favor. For that reason,having a loan in a desirable sector, like tele-com in the late 1990s or healthcare in theearly 2000s, can really help a syndicationalong. Also, loans to issuers in defensive sec-tors (like consumer products) can be moreappealing in a time of economic uncertainty,whereas cyclical borrowers (like chemicalsor autos) can be more appealing during aneconomic upswing.

Sponsorship

Sponsorship is a factor too. Needless to say,many leveraged companies are owned by oneor more private equity firms. These entities,such as Kohlberg Kravis & Roberts orCarlyle Group, invest in companies that haveleveraged capital structures. To the extentthat the sponsor group has a strong followingamong loan investors, a loan will be easier tosyndicate and, therefore, can be priced lower.In contrast, if the sponsor group does nothave a loyal set of relationship lenders, thedeal may need to be priced higher to clear themarket. Among banks, investment factorsmay include whether or not the bank is partyto the sponsor’s equity fund. Among institu-

tional investors, weight is given to an individ-ual deal sponsor’s track record in fixing itsown impaired deals by stepping up with addi-tional equity or replacing a management teamthat is failing.

Syndicating A Loan By FacilityMost loans are structured and syndicated toaccommodate the two primary syndicatedlender constituencies: banks (domestic andforeign) and institutional investors (primarilystructured finance vehicles, mutual funds, andinsurance companies). As such, leveragedloans consist of:● Pro rata debt consists of the revolving

credit and amortizing term loan (TLa),which are packaged together and, usually,syndicated to banks. In some loans, how-ever, institutional investors take pieces ofthe TLa and, less often, the revolvingcredit, as a way to secure a larger institu-tional term loan allocation. Why are thesetranches called “pro rata?” Becausearrangers historically syndicated revolvingcredit and TLas on a pro rata basis tobanks and finance companies.

● Institutional debt consists of term loansstructured specifically for institutionalinvestors, although there are also somebanks that buy institutional term loans.These tranches include first- and second-lien loans, as well as prefunded letters ofcredit. Traditionally, institutional trancheswere referred to as TLbs because they werebullet payments and lined up behind TLas.Finance companies also play in the lever-

aged loan market, and buy both pro rataand institutional tranches. With institutionalinvestors playing an ever-larger role, how-ever, by the late 2000s, many executionswere structured as simply revolvingcredit/institutional term loans, with theTLa falling by the wayside.

Pricing A Loan InThe Primary MarketPricing loans for the institutional market is astraightforward exercise based on simplerisk/return consideration and market techni-


cals. Pricing a loan for the bank market,however, is more complex. Indeed, banksoften invest in loans for more than justspread income. Rather, banks are driven bythe overall profitability of the issuer relation-ship, including noncredit revenue sources.

Pricing loans for bank investors

Since the early 1990s, almost all large com-mercial banks have adopted portfolio-man-agement techniques that measure the returnsof loans and other credit products relativeto risk. By doing so, banks have learnedthat loans are rarely compelling investmentson a stand-alone basis. Therefore, banks arereluctant to allocate capital to issuers unlessthe total relationship generates attractivereturns—whether those returns are meas-ured by risk-adjusted return on capital, byreturn on economic capital, or by someother metric.

If a bank is going to put a loan on its bal-ance sheet, then it takes a hard look notonly at the loan’s yield, but also at othersources of revenue from the relationship,including noncredit businesses—like cash-management services and pension-fund man-agement—and economics from other capitalmarkets activities, like bonds, equities, orM&A advisory work.

This process has had a breathtaking resulton the leveraged loan market—to the pointthat it is an anachronism to continue to call ita “bank” loan market. Of course, there arecertain issuers that can generate a bit morebank appetite; as of mid-2011, these includeissuers with a European or even aMidwestern U.S. angle. Naturally, issuerswith European operations are able to bettertap banks in their home markets (banks stillprovide the lion’s share of loans in Europe),and, for Midwestern issuers, the heartlandremains one of the few U.S. regions with adeep bench of local banks.

What this means is that the spread offeredto pro rata investors is important, but so,too, in most cases, is the amount of other,fee-driven business a bank can capture bytaking a piece of a loan. For this reason,issuers are careful to award pieces of bond-and equity-underwriting engagements and

other fee-generating business to banks thatare part of its loan syndicate.

Pricing loans for institutional players

For institutional investors, the investmentdecision process is far more straightforward,because, as mentioned above, they arefocused not on a basket of returns, but onlyon loan-specific revenue.

In pricing loans to institutional investors,it’s a matter of the spread of the loan rela-tive to credit quality and market-based fac-tors. This second category can be dividedinto liquidity and market technicals (i.e.,supply/demand).

Liquidity is the tricky part, but, as in allmarkets, all else being equal, more liquidinstruments command thinner spreads thanless liquid ones. In the old days—beforeinstitutional investors were the dominantinvestors and banks were less focused onportfolio management—the size of a loandidn’t much matter. Loans sat on the booksof banks and stayed there. But now thatinstitutional investors and banks put a pre-mium on the ability to package loans and sellthem, liquidity has become important. As aresult, smaller executions—generally those of$200 million or less—tend to be priced at apremium to the larger loans. Of course, oncea loan gets large enough to demandextremely broad distribution, the issuer usu-ally must pay a size premium. The thresholdsrange widely. During the go-go mid-2000s, itwas upwards of $10 billion. During moreparsimonious late-2000s $1 billion was con-sidered a stretch.

Market technicals, or supply relative todemand, is a matter of simple economics. Ifthere are a lot of dollars chasing little prod-uct, then, naturally, issuers will be able tocommand lower spreads. If, however, theopposite is true, then spreads will need toincrease for loans to clear the market.

Mark-To-Market’s EffectBeginning in 2000, the SEC directed bankloan mutual fund managers to use availablemark-to-market data (bid/ask levelsreported by secondary traders and compiled



by mark-to-market services like MarkitLoans) rather than fair value (estimatedprices), to determine the value of broadlysyndicated loans for portfolio-valuationpurposes. In broad terms, this policy hasmade the market more transparent,improved price discovery and, in doing so,made the market far more efficient anddynamic than it was in the past. In the pri-mary market, for instance, leveraged loanspreads are now determined not only by rat-ing and leverage profile, but also by tradinglevels of an issuer’s previous loans and,often, bonds. Issuers and investors can alsolook at the trading levels of comparableloans for market-clearing levels.

Types Of SyndicatedLoan FacilitiesThere are four main types of syndicatedloan facilities:● A revolving credit (within which are

options for swingline loans, multicurrency-borrowing, competitive-bid options, term-out, and evergreen extensions);

● A term loan;● An LOC; and● An acquisition or equipment line (a

delayed-draw term loan).A revolving credit line allows borrowers

to draw down, repay, and reborrow. Thefacility acts much like a corporate creditcard, except that borrowers are charged anannual commitment fee on unusedamounts, which drives up the overall costof borrowing (the facility fee). Revolvers tospeculative-grade issuers are often tied toborrowing-base lending formulas. This lim-its borrowings to a certain percentage ofcollateral, most often receivables and inven-tory. Revolving credits often run for 364days. These revolving credits—called, notsurprisingly, 364-day facilities—are gener-ally limited to the investment-grade market.The reason for what seems like an odd termis that regulatory capital guidelines man-date that, after one year of extending creditunder a revolving facility, banks must thenincrease their capital reserves to take intoaccount the unused amounts. Therefore,

banks can offer issuers 364-day facilities ata lower unused fee than a multiyear revolv-ing credit. There are a number of optionsthat can be offered within a revolvingcredit line:1. A swingline is a small, overnight borrow-

ing line, typically provided by the agent.2. A multicurrency line may allow the bor-

rower to borrow in several currencies.3. A competitive-bid option (CBO) allows

borrowers to solicit the best bids from itssyndicate group. The agent will conductwhat amounts to an auction to raisefunds for the borrower, and the bestbids are accepted. CBOs typicallyare available only to large, investment-grade borrowers.

4. A term-out will allow the borrower to con-vert borrowings into a term loan at a givenconversion date. This, again, is usually afeature of investment-grade loans. Underthe option, borrowers may take what isoutstanding under the facility and pay itoff according to a predetermined repay-ment schedule. Often the spreads ratchetup if the term-out option is exercised.

5. An evergreen is an option for the bor-rower—with consent of the syndicategroup—to extend the facility each year foran additional year.A term loan is simply an installment loan,

such as a loan one would use to buy a car.The borrower may draw on the loan during ashort commitment period and repays it basedon either a scheduled series of repayments ora one-time lump-sum payment at maturity(bullet payment). There are two principaltypes of term loans:● An amortizing term loan (A-term loans, or

TLa) is a term loan with a progressiverepayment schedule that typically runs sixyears or less. These loans are normally syn-dicated to banks along with revolving cred-its as part of a larger syndication.

● An institutional term loan (B-term, C-term,or D-term loans) is a term loan facilitycarved out for nonbank, institutionalinvestors. These loans came into broadusage during the mid-1990s as the institu-tional loan investor base grew. This institu-tional category also includes second-lien


loans and covenant-lite loans, which aredescribed below.LOCs differ, but, simply put, they are guar-

antees provided by the bank group to pay offdebt or obligations if the borrower cannot.

Acquisition/equipment lines (delayed-drawterm loans) are credits that may be drawndown for a given period to purchase speci-fied assets or equipment or to make acquisi-tions. The issuer pays a fee during thecommitment period (a ticking fee). The linesare then repaid over a specified period (theterm-out period). Repaid amounts may notbe reborrowed.

Bridge loans are loans that are intended toprovide short-term financing to provide a“bridge” to an asset sale, bond offering,stock offering, divestiture, etc. Generally,bridge loans are provided by arrangers aspart of an overall financing package.Typically, the issuer will agree to increasinginterest rates if the loan is not repaid asexpected. For example, a loan could start at aspread of L+250 and ratchet up 50 basispoints (bp) every six months the loan remainsoutstanding past one year.

Equity bridge loan is a bridge loan pro-vided by arrangers that is expected to berepaid by secondary equity commitment to aleveraged buyout. This product is used whena private equity firm wants to close on a dealthat requires, say, $1 billion of equity ofwhich it ultimately wants to hold half. Thearrangers bridge the additional $500 million,which would be then repaid when othersponsors come into the deal to take the $500million of additional equity. Needless to say,this is a hot-market product.

Second-Lien LoansAlthough they are really just another type ofsyndicated loan facility, second-lien loans aresufficiently complex to warrant a separate sec-tion in this primer. After a brief flirtation withsecond-lien loans in the mid-1990s, thesefacilities fell out of favor after the 1998Russian debt crisis caused investors to adopt amore cautious tone. But after default rates fellprecipitously in 2003, arrangers rolled outsecond-lien facilities to help finance issuers

struggling with liquidity problems. By 2007,the market had accepted second-lien loans tofinance a wide array of transactions, includingacquisitions and recapitalizations. Arrangerstap nontraditional accounts—hedge funds,distress investors, and high-yield accounts—aswell as traditional CLO and prime fundaccounts to finance second-lien loans.

As their name implies, the claims on col-lateral of second-lien loans are junior tothose of first-lien loans. Second-lien loansalso typically have less restrictive covenantpackages, in which maintenance covenantlevels are set wide of the first-lien loans.As a result, second-lien loans are priced ata premium to first-lien loans. This pre-mium typically starts at 200 bps when thecollateral coverage goes far beyond theclaims of both the first- and second-lienloans to more than 1,000 bps for lessgenerous collateral.

There are, lawyers explain, two mainways in which the collateral of second-lienloans can be documented. Either the sec-ond-lien loan can be part of a single secu-rity agreement with first-lien loans, or theycan be part of an altogether separate agree-ment. In the case of a single agreement, theagreement would apportion the collateral,with value going first, obviously, to thefirst-lien claims and next to the second-lienclaims. Alternatively, there can be twoentirely separate agreements. Here’s abrief summary:● In a single security agreement, the second-

lien lenders are in the same creditor class asthe first-lien lenders from the standpoint ofa bankruptcy, according to lawyers whospecialize in these loans. As a result, foradequate protection to be paid the collat-eral must cover both the claims of the first-and second-lien lenders. If it does not, thejudge may choose to not pay adequate pro-tection or to divide it pro rata among thefirst- and second-lien creditors. In addition,the second-lien lenders may have a vote assecured lenders equal to those of the first-lien lenders. One downside for second-lienlenders is that these facilities are oftensmaller than the first-lien loans and, there-fore, when a vote comes up, first-lien



lenders can outvote second-lien lenders topromote their own interests.

● In the case of two separate securityagreements, divided by a standstill agree-ment, the first- and second-lien lendersare likely to be divided into two separatecreditor classes. As a result, second-lienlenders do not have a voice in the first-lien creditor committees. As well, first-lien lenders can receive adequateprotection payments even if collateralcovers their claims, but does not coverthe claims of the second-lien lenders.This may not be the case if the loans aredocumented together and the first- andsecond-lien lenders are deemed a unifiedclass by the bankruptcy court.For more information, we suggest

Latham & Watkins’ terrific overview andanalysis of second-lien loans, which waspublished on April 15, 2004 in the firm’sCreditAlert publication.

Covenant-Lite LoansLike second-lien loans, covenant-lite loans area particular kind of syndicated loan facility.At the most basic level, covenant-lite loans areloans that have bond-like financial incurrencecovenants rather than traditional maintenancecovenants that are normally part and parcelof a loan agreement. What’s the difference?

Incurrence covenants generally require thatif an issuer takes an action (paying a divi-dend, making an acquisition, issuing moredebt), it would need to still be in compliance.So, for instance, an issuer that has an incur-rence test that limits its debt to 5x cash flowwould only be able to take on more debt if,on a pro forma basis, it was still within thisconstraint. If not, then it would havebreeched the covenant and be in technicaldefault on the loan. If, on the other hand, anissuer found itself above this 5x thresholdsimply because its earnings had deteriorated,it would not violate the covenant.

Maintenance covenants are far morerestrictive. This is because they require anissuer to meet certain financial tests everyquarter whether or not it takes an action. So,in the case above, had the 5x leverage maxi-

mum been a maintenance rather than incur-rence test, the issuer would need to pass iteach quarter and would be in violation ifeither its earnings eroded or its debt levelincreased. For lenders, clearly, maintenancetests are preferable because it allows them totake action earlier if an issuer experiencesfinancial distress. What’s more, the lendersmay be able to wrest some concessions froman issuer that is in violation of covenants (afee, incremental spread, or additional collat-eral) in exchange for a waiver.

Conversely, issuers prefer incurrencecovenants precisely because they are lessstringent. Covenant-lite loans, therefore,thrive when the supply/demand equation istilted persuasively in favor of issuers.

Lender TitlesIn the formative days of the syndicated loanmarket (the late 1980s), there was usuallyone agent that syndicated each loan. “Leadmanager” and “manager” titles were doledout in exchange for large commitments. Asleague tables gained influence as a marketingtool, “co-agent” titles were often used inattracting large commitments or in caseswhere these institutions truly had a role inunderwriting and syndicating the loan.

During the 1990s, the use of league tablesand, consequently, title inflation exploded.Indeed, the co-agent title has become largelyceremonial today, routinely awarded for whatamounts to no more than large retail commit-ments. In most syndications, there is one leadarranger. This institution is considered to beon the “left” (a reference to its position in anold-time tombstone ad). There are also likelyto be other banks in the arranger group,which may also have a hand in underwritingand syndicating a credit. These institutionsare said to be on the “right.”

The different titles used by significant par-ticipants in the syndications process areadministrative agent, syndication agent, docu-mentation agent, agent, co-agent or managingagent, and lead arranger or book runner:● The administrative agent is the bank that

handles all interest and principal paymentsand monitors the loan.


● The syndication agent is the bank that han-dles, in purest form, the syndication of theloan. Often, however, the syndication agenthas a less specific role.

● The documentation agent is the bank thathandles the documents and chooses thelaw firm.

● The agent title is used to indicate the leadbank when there is no other conclusivetitle available, as is often the case forsmaller loans.

● The co-agent or managing agent is largelya meaningless title used mostly as an awardfor large commitments.

● The lead arranger or book runner title is aleague table designation used to indicatethe “top dog” in a syndication.

Secondary SalesSecondary sales occur after the loan is closedand allocated, when investors are free totrade the paper. Loan sales are structured aseither assignments or participations, withinvestors usually trading through dealer desksat the large underwriting banks. Dealer-to-dealer trading is almost always conductedthrough a “street” broker.

Assignments

In an assignment, the assignee becomes adirect signatory to the loan and receives inter-est and principal payments directly from theadministrative agent.

Assignments typically require the consentof the borrower and agent, although consentmay be withheld only if a reasonable objec-tion is made. In many loan agreements, theissuer loses its right to consent in the event of default.

The loan document usually sets a mini-mum assignment amount, usually $5 mil-lion, for pro rata commitments. In the late1990s, however, administrative agentsstarted to break out specific assignment min-imums for institutional tranches. In mostcases, institutional assignment minimumswere reduced to $1 million in an effort toboost liquidity. There were also some caseswhere assignment fees were reduced or eveneliminated for institutional assignments, but

these lower assignment fees remained rareinto 2011, and the vast majority was set atthe traditional $3,500.

One market convention that became firmlyestablished in the late 1990s was assignment-fee waivers by arrangers for trades crossedthrough its secondary trading desk. This wasa way to encourage investors to trade withthe arranger rather than with another dealer.This is a significant incentive to trade witharranger—or a deterrent to not trade away,depending on your perspective—because a$3,500 fee amounts to between 7 bps to 35bps of a $1 million to $5 million trade.

Primary assignments

This term is something of an oxymoron. Itapplies to primary commitments made byoffshore accounts (principally CLOs andhedge funds). These vehicles, for a variety oftax reasons, suffer tax consequence frombuying loans in the primary. The agent willtherefore hold the loan on its books for someshort period after the loan closes and thensell it to these investors via an assignment.These are called primary assignments and areeffectively primary purchases.

Participations

A participation is an agreement between anexisting lender and a participant. As thename implies, it means the buyer is takinga participating interest in the existinglender’s commitment.

The lender remains the official holder ofthe loan, with the participant owning therights to the amount purchased. Consents,fees, or minimums are almost never required.The participant has the right to vote only onmaterial changes in the loan document (rate,term, and collateral). Nonmaterial changesdo not require approval of participants. Aparticipation can be a riskier way of pur-chasing a loan, because, in the event of alender becoming insolvent or defaulting, theparticipant does not have a direct claim onthe loan. In this case, the participant thenbecomes a creditor of the lender and oftenmust wait for claims to be sorted out to col-lect on its participation.



Loan DerivativesLoan credit default swaps

Traditionally, accounts bought and soldloans in the cash market through assign-ments and participations. Aside from that,there was little synthetic activity outsideover-the-counter total rate of return swaps.By 2008, however, the market for syntheti-cally trading loans was budding.

Loan credit default swaps (LCDS) are stan-dard derivatives that have secured loans asreference instruments. In June 2006, theInternational Settlement and DealersAssociation issued a standard trade confirma-tion for LCDS contracts.

Like all credit default swaps (CDS), anLCDS is basically an insurance contract. Theseller is paid a spread in exchange for agree-ing to buy at par, or a pre-negotiated price, aloan if that loan defaults. LCDS enables par-ticipants to synthetically buy a loan by goingshort the LCDS or sell the loan by going longthe LCDS. Theoretically, then, a loanholdercan hedge a position either directly (by buy-ing LCDS protection on that specific name)or indirectly (by buying protection on a com-parable name or basket of names).

Moreover, unlike the cash markets, whichare long-only markets for obvious reasons,the LCDS market provides a way forinvestors to short a loan. To do so, theinvestor would buy protection on a loan thatit doesn’t hold. If the loan subsequentlydefaults, the buyer of protection should beable to purchase the loan in the secondarymarket at a discount and then and deliver itat par to the counterparty from which itbought the LCDS contract. For instance, sayan account buys five-year protection for agiven loan, for which it pays 250 bps a year.Then in year 2 the loan goes into default andthe market price falls to 80% of par. Thebuyer of the protection can then buy the loanat 80 and deliver to the counterpart at 100, a20-point pickup. Or instead of physical deliv-ery, some buyers of protection may prefercash settlement in which the differencebetween the current market price and thedelivery price is determined by polling dealersor using a third-party pricing service. Cash

settlement could also be employed if there’snot enough paper to physically settle allLCDS contracts on a particular loan.

LCDX

Introduced in 2007, the LCDX is an index of100 LCDS obligations that participants cantrade. The index provides a straightforwardway for participants to take long or shortpositions on a broad basket of loans, as wellas hedge their exposure to the market.

Markit Group administers the LCDX, aproduct of CDS Index Co., a firm set up by agroup of dealers. Like LCDS, the LCDXIndex is an over-the-counter product.

The LCDX is reset every six months withparticipants able to trade each vintage of theindex that is still active. The index will be setat an initial spread based on the referenceinstruments and trade on a price basis.According to the primer posted by Markit(http://www.markit.com/information/affilia-tions/lcdx/alertParagraphs/01/document/LCDX%20Primer.pdf), “the two events thatwould trigger a payout from the buyer (pro-tection seller) of the index are bankruptcy orfailure to pay a scheduled payment on anydebt (after a grace period), for any of theconstituents of the index.”

All documentation for the index is postedat: http://www.markit.com/information/affili-ations/lcdx/alertParagraphs/01/document/LCDX%20Primer.pdf.

Total rate of return swaps (TRS)

This is the oldest way for participants to pur-chase loans synthetically. And, in reality, aTRS is little more than buying a loan on mar-gin. In simple terms, under a TRS program aparticipant buys the income stream createdby a loan from a counterparty, usually adealer. The participant puts down some per-centage as collateral, say 10%, and borrowsthe rest from the dealer. Then the participantreceives the spread of the loan less the finan-cial cost plus LIBOR on its collateralaccount. If the reference loan defaults, theparticipant is obligated to buy it at par orcash settle the loss based on a mark-to-mar-ket price or an auction price.


Here’s how the economics of a TRS work,in simple terms. A participant buys via TRS a$10 million position in a loan paying L+250.To affect the purchase, the participant puts$1 million in a collateral account and paysL+50 on the balance (meaning leverage of9:1). Thus, the participant would receive:

L+250 on the amount in the collateralaccount of $1 million, plus

200 bps (L+250 minus the borrowing cost ofL+50) on the remaining amount of $9 million.

The resulting income is L+250 * $1 millionplus 200 bps * $9 million. Based on the par-ticipants’ collateral amount—or equity contri-bution—of $1 million, the return is L+2020.If LIBOR is 5%, the return is 25.5%. Ofcourse, this is not a risk-free proposition. Ifthe issuer defaults and the value of the loangoes to 70 cents on the dollar, the participantwill lose $3 million. And if the loan does notdefault but is marked down for whatever rea-son—market spreads widen, it is down-graded, its financial conditiondeteriorates—the participant stands to losethe difference between par and the currentmarket price when the TRS expires. Or, in anextreme case, the value declines below thevalue in the collateral account and the partic-ipant is hit with a margin call.

Pricing TermsRates

Loans usually offer borrowers different inter-est-rate options. Several of these options allowborrowers to lock in a given rate for onemonth to one year. Pricing on many loans istied to performance grids, which adjust pric-ing by one or more financial criteria. Pricingis typically tied to ratings in investment-gradeloans and to financial ratios in leveragedloans. Communications loans are invariablytied to the borrower’s debt-to-cash-flow ratio.

Syndication pricing options include prime,LIBOR, CD, and other fixed-rate options:● The prime is a floating-rate option.

Borrowed funds are priced at a spread overthe reference bank’s prime lending rate.The rate is reset daily, and borroweringsmay be repaid at any time without penalty.This is typically an overnight option,

because the prime option is more costly tothe borrower than LIBOR or CDs.

● The LIBOR (or Eurodollar) option is socalled because, with this option, the inter-est on borrowings is set at a spread overLIBOR for a period of one month to oneyear. The corresponding LIBOR rate isused to set pricing. Borrowings cannot beprepaid without penalty.

● The CD option works precisely like theLIBOR option, except that the base rate iscertificates of deposit, sold by a bank toinstitutional investors.

● Other fixed-rate options are less commonbut work like the LIBOR and CD options.These include federal funds (the overnightrate charged by the Federal Reserve tomember banks) and cost of funds (thebank’s own funding rate).

LIBOR floors

As the name implies, LIBOR floors put afloor under the base rate for loans. If a loanhas a 3% LIBOR floor and three-monthLIBOR falls below this level, the base ratefor any resets default to 3%. For obviousreasons, LIBOR floors are generally seenduring periods when market conditions aredifficult and rates are falling as an incentivefor lenders.

Fees

The fees associated with syndicated loans arethe upfront fee, the commitment fee, thefacility fee, the administrative agent fee, theletter of credit (LOC) fee, and the cancella-tion or prepayment fee.● An upfront fee is a fee paid by the issuer at

close. It is often tiered, with the leadarranger receiving a larger amount in con-sideration for structuring and/or under-writing the loan. Co-underwriters willreceive a lower fee, and then the generalsyndicate will likely have fees tied to theircommitment. Most often, fees are paid ona lender’s final allocation. For example, aloan has two fee tiers: 100 bps (or 1%) for$25 million commitments and 50 bps for$15 million commitments. A lender com-mitting to the $25 million tier will be paidon its final allocation rather than on initial



commitment, which means that, in thisexample, the loan is oversubscribed andlenders committing $25 million would beallocated $20 million and the lenderswould receive a fee of $200,000 (or 1% of$20 million). Sometimes upfront fees willbe structured as a percentage of final allo-cation plus a flat fee. This happens mostoften for larger fee tiers, to encouragepotential lenders to step up for larger com-mitments. The flat fee is paid regardless ofthe lender’s final allocation. Fees are usu-ally paid to banks, mutual funds, andother non-offshore investors at close.CLOs and other offshore vehicles are typi-cally brought in after the loan closes as a“primary” assignment, and they simplybuy the loan at a discount equal to the fee offered in the primary assignment, fortax purposes.

● A commitment fee is a fee paid to lenderson undrawn amounts under a revolvingcredit or a term loan prior to draw-down.On term loans, this fee is usually referredto as a “ticking” fee.

● A facility fee, which is paid on a facility’sentire committed amount, regardless ofusage, is often charged instead of a com-mitment fee on revolving credits to invest-ment-grade borrowers, because thesefacilities typically have CBOs that allow aborrower to solicit the best bid from itssyndicate group for a given borrowing. Thelenders that do not lend under the CBO arestill paid for their commitment.

● A usage fee is a fee paid when the utiliza-tion of a revolving credit falls below a cer-tain minimum. These fees are appliedmainly to investment-grade loans and gen-erally call for fees based on the utilizationunder a revolving credit. In some cases, thefees are for high use and, in some cases, forlow use. Often, either the facility fee or thespread will be adjusted higher or lowerbased on a pre-set usage level.

● A prepayment fee is a feature generallyassociated with institutional term loans.This fee is seen mainly in weak markets asan inducement to institutional investors.Typical prepayment fees will be set on asliding scale; for instance, 2% in year one

and 1% in year two. The fee may beapplied to all repayments under a loan or“soft” repayments, those made from a refi-nancing or at the discretion of the issuer(as opposed to hard repayments made fromexcess cash flow or asset sales).

● An administrative agent fee is the annualfee typically paid to administer the loan(including to distribute interest paymentsto the syndication group, to update lenderlists, and to manage borrowings). Forsecured loans (particularly those backedby receivables and inventory), the agentoften collects a collateral monitoring fee,to ensure that the promised collateral isin place.An LOC fee can be any one of several

types. The most common—a fee for standbyor financial LOCs—guarantees that lenderswill support various corporate activities.Because these LOCs are considered “bor-rowed funds” under capital guidelines, the feeis typically the same as the LIBOR margin.Fees for commercial LOCs (those supportinginventory or trade) are usually lower, becausein these cases actual collateral is submitted).The LOC is usually issued by a fronting bank(usually the agent) and syndicated to thelender group on a pro rata basis. The groupreceives the LOC fee on their respectiveshares, while the fronting bank receives anissuing (or fronting, or facing) fee for issuingand administering the LOC. This fee isalmost always 12.5 bps to 25 bps (0.125% to0.25%) of the LOC commitment.

Original issue discounts (OID)

This is yet another term imported from thebond market. The OID, the discount frompar at loan, is offered in the new issue marketas a spread enhancement. A loan may beissued at 99 bps to pay par. The OID in thiscase is said to be 100 bps, or 1 point.

OID Versus Upfront Fees

At this point, the careful reader may be won-dering just what the difference is between anOID and an upfront fee. After all, in bothcases the lender effectively pays less than parfor a loan.


From the perspective of the lender, actually,there isn’t much of a difference. But for theissuer and arrangers, the distinction is farmore than semantics. Upfront fees are gener-ally paid from the arrangers underwriting feeas an incentive to bring lenders into the deal.An issuer may pay the arranger 2% of thedeal and the arranger, to rally investors, maythen pay a quarter of this amount, or 0.50%,to lender group.

An OID, however, is generally borne by theissuer, above and beyond the arrangementfee. So the arranger would receive its 2% feeand the issuer would only receive 99 cents forevery dollar of loan sold.

For instance, take a $100 million loanoffered at a 1% OID. The issuer wouldreceive $99 million, of which it would pay thearrangers 2%. The issuer then would be obli-gated to pay back the whole $100 million,even though it received $97 million after fees.Now, take the same $100 million loan offeredat par with an upfront fee of 1%. In this case,the issuer gets the full $100 million. In thiscase, the lenders would buy the loan not atpar, but at 99 cents on the dollar. The issuerwould receive $100 million of which it wouldpay 2% to the arranger, which would thenpay one-half of that amount to the lendinggroup. The issuer gets, after fees, $98 million.

Clearly, OID is a better deal for the arrangerand, therefore, is generally seen in more chal-lenging markets. Upfront fees, conversely, aremore issuer friendly and therefore are staplesof better market conditions. Of course, duringthe most muscular bull markets, new-issuepaper is generally sold at par and thereforerequires neither upfront fees nor OIDs.

Voting rights

Amendments or changes to a loan agreementmust be approved by a certain percentage oflenders. Most loan agreements have three lev-els of approval: required-lender level, fullvote, and supermajority:● The “required-lenders” level, usually just a

simple majority, is used for approval ofnonmaterial amendments and waivers orchanges affecting one facility within a deal.

● A full vote of all lenders, including partici-pants, is required to approve material

changes such as RATS (rate, amortization,term, and security; or collateral) rights,but, as described below, there are occasionswhen changes in amortization and collat-eral may be approved by a lower percent-age of lenders (a supermajority).

● A supermajority is typically 67% to 80%of lenders and is sometimes required forcertain material changes such as changes inamortization (in-term repayments) andrelease of collateral.

CovenantsLoan agreements have a series of restrictionsthat dictate, to varying degrees, how borrow-ers can operate and carry themselves finan-cially. For instance, one covenant may requirethe borrower to maintain its existing fiscal-year end. Another may prohibit it from tak-ing on new debt. Most agreements also havefinancial compliance covenants, for example,that a borrower must maintain a prescribedlevel of equity, which, if not maintained, givesbanks the right to terminate the agreement orpush the borrower into default. The size ofthe covenant package increases in proportionto a borrower’s financial risk. Agreements toinvestment-grade companies are usually thinand simple. Agreements to leveraged borrow-ers are often much more onerous.

The three primary types of loan covenantsare affirmative, negative, and financial.

Affirmative covenants state what actionthe borrower must take to be in compliancewith the loan, such as that it must maintaininsurance. These covenants are usually boil-erplate and require a borrower to, forexample, pay the bank interest and fees,provide audited financial statements, paytaxes, and so forth.

Negative covenants limit the borrower’sactivities in some way, such as regarding newinvestments. Negative covenants, which arehighly structured and customized to a bor-rower’s specific condition, can limit the typeand amount of acquisitions, new debtissuance, liens, asset sales, and guarantees.

Financial covenants enforce minimum finan-cial performance measures against the bor-rower, such as that he must maintain a higher



level of current assets than of current liabili-ties. The presence of these maintenancecovenants—so called because the issuer mustmaintain quarterly compliance or suffer atechnical default on the loan agreement—is acritical difference between loans and bonds.Bonds and covenant-lite loans (see above), bycontrast, usually contain incurrence covenantsthat restrict the borrower’s ability to issue newdebt, make acquisitions, or take other actionthat would breach the covenant. For instance,a bond indenture may require the issuer to notincur any new debt if that new debt wouldpush it over a specified ratio of debt toEBITDA. But, if the company’s cash flow dete-riorates to the point where its debt to EBITDAratio exceeds the same limit, a covenant viola-tion would not be triggered. This is becausethe ratio would have climbed organicallyrather than through some action by the issuer.

As a borrower’s risk increases, financialcovenants in the loan agreement becomemore tightly wound and extensive. In general,there are five types of financial covenants—coverage, leverage, current ratio, tangible networth, and maximum capital expenditures:● A coverage covenant requires the borrower

to maintain a minimum level of cash flowor earnings, relative to specified expenses,most often interest, debt service (interestand repayments), fixed charges (debt serv-ice, capital expenditures, and/or rent).

● A leverage covenant sets a maximum levelof debt, relative to either equity or cashflow, with total-debt-to-EBITDA levelbeing the most common. In some cases,though, operating cash flow is used as thedivisor. Moreover, some agreements testleverage on the basis of net debt (total lesscash and equivalents) or senior debt.

● A current-ratio covenant requires that theborrower maintain a minimum ratio ofcurrent assets (cash, marketable securities,accounts receivable, and inventories) tocurrent liabilities (accounts payable, short-term debt of less than one year), butsometimes a “quick ratio,” in whichinventories are excluded from thenumerate, is substituted.

● A tangible-net-worth (TNW) covenantrequires that the borrower have a mini-

mum level of TNW (net worth less intangi-ble assets, such as goodwill, intellectualassets, excess value paid for acquired com-panies), often with a build-up provision,which increases the minimum by a percent-age of net income or equity issuance.

● A maximum-capital-expenditures covenantrequires that the borrower limit capitalexpenditures (purchases of property, plant,and equipment) to a certain amount, whichmay be increased by some percentage ofcash flow or equity issuance, but oftenallowing the borrower to carry forwardunused amounts from one year to the next.

Mandatory PrepaymentsLeveraged loans usually require a borrowerto prepay with proceeds of excess cash flow,asset sales, debt issuance, or equity issuance.● Excess cash flow is typically defined as

cash flow after all cash expenses, requireddividends, debt repayments, capital expen-ditures, and changes in working capital.The typical percentage required is 50% to 75%.

● Asset sales are defined as net proceeds ofasset sales, normally excluding receivablesor inventories. The typical percentagerequired is 100%.

● Debt issuance is defined as net proceedsfrom debt issuance. The typical percentagerequired is 100%.

● Equity issuance is defined as the net pro-ceeds of equity issuance. The typical per-centage required is 25% to 50%.Often, repayments from excess cash flow

and equity issuance are waived if the issuermeets a preset financial hurdle, most oftenstructured as a debt/EBITDA test.

Collateral and other protective loan provisions

In the leveraged market, collateral usuallyincludes all the tangible and intangible assetsof the borrower and, in some cases, specificassets that back a loan.

Virtually all leveraged loans and some ofthe more shaky investment-grade credits arebacked by pledges of collateral. In the asset-based market, for instance, that typicallytakes the form of inventories and receivables,


with the amount of the loan tied to a formulabased off of these assets. The common rule isthat an issuer can borrow against 50% ofinventory and 80% of receivables. Naturally,there are loans backed by certain equipment,real estate, and other property.

In the leveraged market, there are someloans that are backed by capital stock of oper-ating units. In this structure, the assets of theissuer tend to be at the operating-companylevel and are unencumbered by liens, but theholding company pledges the stock of theoperating companies to the lenders. Thiseffectively gives lenders control of these unitsif the company defaults. The risk to lenders inthis situation, simply put, is that a bankruptcycourt collapses the holding company with theoperating companies and effectively rendersthe stock worthless. In these cases, which hap-pened on a few occasions to lenders to retailcompanies in the early 1990s, loan holdersbecome unsecured lenders of the companyand are put back on the same level with othersenior unsecured creditors.

Springing liens/collateral release

Some loans have provisions that borrowersthat sit on the cusp of investment-grade andspeculative-grade must either attach collateralor release it if the issuer’s rating changes.

A ‘BBB’ or ‘BBB-’ issuer may be able toconvince lenders to provide unsecured financ-ing, but lenders may demand springing liensin the event the issuer’s credit quality deterio-rates. Often, an issuer’s rating being loweredto ‘BB+’ or exceeding its predetermined lever-age level will trigger this provision. Likewise,lenders may demand collateral from a strong,speculative-grade issuer, but will offer torelease under certain circumstances, such as ifthe issuer attains an investment-grade rating.

Change of control

Invariably, one of the events of default in acredit agreement is a change of issuer control.

For both investment-grade and leveragedissuers, an event of default in a credit agree-ment will be triggered by a merger, an acqui-sition of the issuer, some substantial purchaseof the issuer’s equity by a third party, or a

change in the majority of the board of direc-tors. For sponsor-backed leveraged issuers,the sponsor’s lowering its stake below a pre-set amount can also trip this clause.

Equity cures

These provision allow issuers to fix acovenant violation—exceeding the maximumdebt to EBITDA test for instance—by makingan equity contribution. These provisions aregenerally found in private equity backeddeals. The equity cure is a right, not an obli-gation. Therefore, a private equity firm willwant these provisions, which, if they thinkit’s worth it, allows them to cure a violationwithout going through an amendmentprocess, through which lenders will often askfor wider spreads and/or fees in exchange forwaiving the violation even with an infusionof new equity. Some agreements don’t limitthe number of equity cures while others capthe number to, say, one a year or two overthe life of the loan. It’s a negotiated point,however, so there is no rule of thumb. Bullmarkets tend to inspire more generous equitycures for obvious reasons, while in bear mar-kets lenders are more parsimonious.

Asset-based lending

Most of the information above refers to“cash flow” loans, loans that may besecured by collateral, but are repaid by cashflow. Asset-based lending is a distinct seg-ment of the loan market. These loans aresecured by specific assets and usually gov-erned by a borrowing formula (or a “bor-rowing base”). The most common type ofasset-based loans are receivables and/orinventory lines. These are revolving creditsthat have a maximum borrowing limit, say$100 million, but also have a cap based onthe value of an issuer’s pledged receivablesand inventories. Usually, the receivables arepledged and the issuer may borrow against80%, give or take. Inventories are also oftenpledged to secure borrowings. However,because they are obviously less liquid thanreceivables, lenders are less generous in theirformula. Indeed, the borrowing base forinventories is typically in the 50% to 65%



range. In addition, the borrowing base maybe further divided into subcategories—forinstance, 50% of work-in-process inventoryand 65% of finished goods inventory.

In many receivables-based facilities, issuersare required to place receivables in a “lockbox.” That means that the bank lends againstthe receivable, takes possession of it, andthen collects it to pay down the loan.

In addition, asset-based lending is oftendone based on specific equipment, realestate, car fleets, and an unlimited numberof other assets.

Bifurcated collateral structures

Most often this refers to cases where theissuer divides collateral pledge betweenasset-based loans and funded term loans.The way this works, typically, is that asset-based loans are secured by current assetslike accounts receivables and inventories,while term loans are secured by fixed assetslike property, plant, and equipment. Currentassets are considered to be a superior formof collateral because they are more easilyconverted to cash.

Subsidiary guarantees

Those not collateral in the strict sense of theword, most leveraged loans are backed bythe guarantees of subsidiaries so that if anissuer goes into bankruptcy all of its unitsare on the hook to repay the loan. Thisis often the case, too, for unsecured invest-ment-grade loans.

Negative pledge

This is also not a literal form of collateral,but most issuers agree not to pledge anyassets to new lenders to ensure that the inter-est of the loanholders are protected.

Loan math—the art of spread calculation

Calculating loan yields or spreads is notstraightforward. Unlike most bonds, whichhave long no-call periods and high-call premi-ums, most loans are prepayable at any timetypically without prepayment fees. And, evenin cases where prepayment fees apply, theyare rarely more than 2% in year one and 1%

in year two. Therefore, affixing a spread-to-maturity or a spread-to-worst on loans is lit-tle more than a theoretical calculation.

This is because an issuer’s behavior isunpredictable. It may repay a loan earlybecause a more compelling financial opportu-nity presents itself or because the issuer isacquired or because it is making an acquisi-tion and needs a new financing. Traders andinvestors will often speak of loan spreads,therefore, as a spread to a theoretical call.Loans, on average, between 1997 and 2004had a 15-month average life. So, if you buy aloan with a spread of 250 bps at a price of101, you might assume your spread-to-expected-life as the 250 bps less the amor-tized 100 bps premium or LIBOR+170.Conversely, if you bought the same loan at99, the spread-to-expect life would beLIBOR+330.

Default And RestructuringThere are two primary types of loandefaults: technical defaults and the muchmore serious payment defaults. Technicaldefaults occur when the issuer violates aprovision of the loan agreement. Forinstance, if an issuer doesn’t meet a financialcovenant test or fails to provide lenders withfinancial information or some other viola-tion that doesn’t involve payments.

When this occurs, the lenders can acceler-ate the loan and force the issuer into bank-ruptcy. That’s the most extreme measure. Inmost cases, the issuer and lenders can agreeon an amendment that waives the violation inexchange for a fee, spread increase, and/ortighter terms.

A payment default is a more serious mat-ter. As the name implies, this type ofdefault occurs when a company misseseither an interest or principal payment.There is often a pre-set period of time, say30 days, during which an issuer can cure adefault (the “cure period”). After that, thelenders can choose to either provide a for-bearance agreement that gives the issuersome breathing room or take appropriateaction, up to and including accelerating, orcalling, the loan.


If the lenders accelerate, the company willgenerally declare bankruptcy and restructuretheir debt through Chapter 11. If the com-pany is not worth saving, however, becauseits primary business has cratered, then theissuer and lenders may agree to a Chapter 7liquidation, in which the assets of the busi-ness are sold and the proceeds dispensed tothe creditors.

Amend-To-ExtendThis technique allows an issuer to push outpart of its loan maturities through an amend-ment, rather than a full-out refinancing.Amend-to-extend transactions came intowidespread use in 2009 as borrowers strug-gled to push out maturities in the face of dif-ficult lending conditions that maderefinancing prohibitively expensive.

Amend-to-extend transactions have twophases, as the name implies. The first is anamendment in which at least 50.1% of thebank group approves the issuer’s ability to rollsome or all existing loans into longer-datedpaper. Typically, the amendment sets a rangefor the amount that can be tendered via thenew facility, as well as the spread at which thelonger-dated paper will pay interest.

The new debt is pari passu with the exist-ing loan. But because it matures later and,thus, is structurally subordinated, it carries ahigher rate, and, in some cases, more attrac-tive terms. Because issuers with big debtloads are expected to tackle debt maturitiesover time, amid varying market conditions, insome cases, accounts insist on most-favored-nation protection. Under such protection, thespread of the loan would increase if the issuerin question prints a loan at a wider margin.

The second phase is the conversion, inwhich lenders can exchange existing loans fornew loans. In the end, the issuer is left withtwo tranches: (1) the legacy paper at the ini-tial price and maturity and (2) the new facil-ity at a wider spread. The innovation here:amend-to-extend allows an issuer to term-outloans without actually refinancing into a newcredit (which obviously would require mark-ing the entire loan to market, entailing higherspreads, a new OID, and stricter covenants).

DIP LoansDebtor-in-possession (DIP) loans are made tobankrupt entities. These loans constitute super-priority claims in the bankruptcy distributionscheme, and thus sit ahead of all prepretitionclaims. Many DIPs are further secured by prim-ing liens on the debtor’s collateral (see below).

Traditionally, prepetition lenders providedDIP loans as a way to keep a company viableduring the bankruptcy process. In the early1990s, a broad market for third-party DIPloans emerged. These non-prepetition lenderswere attracted to the market by the relativelysafety of most DIPs based on their super-prior-ity status, and relatively wide margins. This wasthe case again the early 2000s default cycle.

In the late 2000s default cycle, however,the landscape shifted because of more direeconomic conditions. As a result, liquiditywas in far shorter supply, constrainingavailability of traditional third-party DIPs.Likewise, with the severe economic condi-tions eating away at debtors’ collateral, notto mention reducing enterprise values, prep-etition lenders were more wary of relyingsolely on the super-priority status of DIPs,and were more likely to ask for primingliens to secure facilities.

The refusal of prepetition lenders to con-sent to such priming, combined with theexpense and uncertainty involved in a prim-ing fight in bankruptcy court, has greatlyreduced third-party participation in the DIPmarket. With liquidity in short supply, newinnovations in DIP lending cropped up aimedat bringing nontraditional lenders into themarket. These include:● Junior DIPs. These facilities are typically

provided by bond holders or other unse-cured debtors as part of a loan-to-ownstrategy. In these transactions, theproviders receive much or all of the post-petition equity interest as an incentive toprovide the DIP loans.

● Roll-up DIPs. In some bankruptcies—LyondellBasell and Spectrum Brands aretwo 2009 examples—DIP providers aregiven the opportunity to roll up prepeti-tion claims into junior DIPs, that rankahead of other prepetition securedlenders. This sweetener was particularly



compelling for lenders that had boughtprepetition paper at distressed prices andwere able to realize a gain by rolling itinto the junior DIPs.

Exit LoansThese are loans that finance an issuer’s emer-gence from bankruptcy. Typically, the loansare prenegotiated and are part of the com-pany’s reorganization plan.

Sub-Par Loan BuybacksThis is another technique that grew out of thebear market that began in 2007. Performingpaper fell to price not seen before in the loanmarket—with many trading south of 70. Thiscreated an opportunity for issuers with thefinancial wherewithal and the covenant roomto repurchase loans via a tender, or in theopen market, at prices below par.

Sub-par buybacks have deep roots in thebond market. Loans didn’t suffer the pricedeclines before 2007 to make such tendersattractive, however. In fact, most loan docu-ments do not provide for a buyback. Instead,issuers typically need obtain lender approvalvia a 50.1% amendment.

Distressed exchanges

This is a negotiated tender in which classh-olders will swap their existing paper for anew series of bond that typically have a lowerprincipal amount and, often, a lower yield. Inexchange the bondholders might receivestepped-up treatment, going from subordi-nated to senior, say, or from unsecuredto second-lien.

Standard & Poor’s consider these programsa default and, in fact, the holders are agreeingto take a principal haircut in order to allowthe company to remain solvent and improvetheir ultimate recovery prospects.

This technique is used frequently in the bondmarket but rarely for first-lien loans. One goodexample was from Harrah’s Entertainment. In2009, the gaming company issued $3.6 billionof new 10% second-priority senior securednotes due 2018 for about $5.4 billion of bondsdue between 2010 and 2018.

Bits And PiecesWhat follows are definitions to some com-mon market jargon not found elsewhere inthis primer, but used constantly as short-handin the loan market:● Staple financing. Staple financing is a

financing agreement “stapled on” to anacquisition, typically by the M&A advisor.So, if a private equity firm is working withan investment bank to acquire a property,that bank, or a group of banks, may pro-vide a staple financing to ensure that thefirm has the wherewithal to complete thedeal. Because the staple financing providesguidelines on both structure and leverage,it typically forms the basis for the eventualfinancing that is negotiated by the auctionwinner, and the staple provider will usuallyserve as one of the arrangers of the financ-ing, along with the lenders that were back-ing the buyer.

● Break prices. Simply, the price at whichloans or bonds are initially traded into thesecondary market after they close and allo-cate. It is called the break price becausethat is where the facility breaks into thesecondary market.

● Market-clearing level. As this phraseimplies, the price or spread at which adeal clears the primary market. (Seems tobe an allusion to a high-jumper clearing a hurdle.)

● Running the books. Generally the loanarranger is said to be “running the books,”i.e., preparing documentation and syndicat-ing and administering the loan.

● Disintermediation. Disintermediation refersto the process where banks are replaced (ordisintermediated) by institutional investors.This is the process that the loan market hasbeen undergoing for the past 20 years.Another example is the mortgage marketwhere the primary capital providers haveevolved from banks and savings and loansto conduits structured by Fannie Mae,Freddie Mac, and the other mortgage secu-ritization shops. Of course, the list of disin-termediated markets is long and growing.In addition to leveraged loans and mort-


gages, this list also includes auto loans andcredit card receivables.

● Loss given default. This is simply a meas-ure of how much creditors lose when anissuer defaults. The loss will varydepending on creditor class and theenterprise value of the business when itdefaults. Naturally, all things beingequal, secured creditors will lose lessthan unsecured creditors. Likewise, sen-ior creditors will lose less than subordi-nated creditors. Calculating loss givendefault is tricky business. Some practi-tioners express loss as a nominal percent-age of principal or a percentage ofprincipal plus accrued interest. Othersuse a present value calculation using anestimated discount rate, typically 15% to25%, demanded by distressed investors.

● Recovery. Recovery is the opposite ofloss given default—it is the amount acreditor recovers, rather than loses, in a given default.

● Printing a deal. Refers to the price orspread at which the loan clears.

● Relative value. This can refer to the relativereturn or spread between (1) variousinstruments of the same issuer, comparingfor instance the loan spread with that of abond; (2) loans or bonds of issuers that aresimilarly rated and/or in the same sector,comparing for instance the loan spread ofone ‘BB’ rated healthcare company withthat of another; and (3) spreads betweenmarkets, comparing for instance the spreadon offer in the loan market with that ofhigh-yield or corporate bonds. Relativevalue is a way of uncovering undervalued,or overvalued, assets.

● Rich/cheap. This is terminology importedfrom the bond market to the loan market.If you refer to a loan as rich, it means it istrading at a spread that is low comparedwith other similarly rated loans in the samesector. Conversely, referring to something ascheap means that it is trading at a spreadthat is high compared with its peer group.That is, you can buy it on the cheap.

● Distressed loans. In the loan market, loanstraded at less than 80 cents on the dollarare usually considered distressed. In the

bond market, the common definition is aspread of 1,000 bps or more. For loans,however, calculating spreads is an elusiveart (see above) and therefore a more pedes-trian price measure is used.

● Default rate. Calculated by either numberof loans or principal amount. The formulais similar. For default rate by number ofloans: the number of loans that defaultover a given 12-month period divided bythe number of loans outstanding at thebeginning of that period. For default rateby principal amount: the amount of loansthat default over a 12-month perioddivided by the total amount outstanding atthe beginning of the period. Standard &Poor’s defines a default for the purposes ofcalculating default rates as a loan that iseither (1) rated ’D’ by Standard & Poor’s,(2) to an issuer that has filed for bank-ruptcy, or (3) in payment default on inter-est or principal.

● Leveraged loans. Just what is a leveragedloan is a discussion of long standing. Someparticipants use a spread cut-off: i.e., anyloan with a spread of LIBOR+125 orLIBOR+150 or higher qualifies. Others userating criteria: i.e., any loan rated ‘BB+’ orlower qualifies. But what of loans that arenot rated? At Standard & Poor’s LCD wehave developed a more complex definition.We include a loan in the leveraged universeif it is rated ‘BB+’ or lower or it is notrated or rated ‘BBB-‘ or higher but has (1)a spread of LIBOR +125 or higher and (2)is secured by a first or second lien. Underthis definition, a loan rated ‘BB+’ that hasa spread of LIBOR+75 would qualify, buta nonrated loan with the same spreadwould not. It is hardly a perfect definition,but one that Standard & Poor’s thinks bestcaptures the spirit of loan market partici-pants when they talk about leveragedloans.

● Middle market. The loan market can beroughly divided into two segments: largecorporate and middle market. There are asmany was to define middle market as thereare bankers. But, in the leveraged loan mar-ket, the standard has become an issuer withno more than $50 million of EBITDA. Based



on this, Standard & Poor’s uses the $50 mil-lion threshold in its reports and statistics.

● Axe sheets. These are lists from dealerswith indicative secondary bids and offersfor loans. Axes are simply price indications.

● Circled. When a loan or bond is full sub-scribed at a given price it is said to be cir-cled. After that, the loan or bond moves toallocation and funding.

● Forward calendar. A list of loans or bondthat has been announced but not yetclosed. These include both instrumentsthat are yet to come to market and thosethat are actively being sold but have yet tobe circled.

● BWIC. An acronym for “bids wanted incompetition.” Really just a fancy way ofdescribing a secondary auction of loans orbonds. Typically, an account will offer up aportfolio of facilities via a dealer. Thedealer will then put out a BWIC, askingpotential buyers to submit for individualnames or the entire portfolio. The dealerwill then collate the bids and award eachfacility to the highest bidder.

● OWIC. This stands for “offers wanted incompetition” and is effectively a BWIC inreverse. Instead of seeking bids, a dealer isasked to buy a portfolio of paper and solic-its potential sellers for the best offer.

● Cover bid. The level that a dealer agrees toessentially underwrite a BWIC or an auc-tion. The dealer, to win the business, maygive an account a cover bid, effectively put-ting a floor on the auction price.

● Loan-to-own. A strategy in whichlenders—typically hedge funds or distressedinvestors—provide financing to distressedcompanies. As part of the deal, lendersreceive either a potential ownership stake ifthe company defaults, or, in the case of abankrupt company, an explicit equity stakeas part of the deal.

● Most favored nation clauses. Some loanswill include a provision to protect lendersif the issuer subsequently places a new loanat a higher spread. Under these provision,the spread of the existing paper ratchets upto the new spread (though in some casesthe increase is capped). ●


Despite recent favorable rating and default trends, Standard &

Poor’s Ratings Services believes credit quality among U.S.

speculative-grade industrial issuers remains fragile. Since the fourth

quarter of 2009, we have raised more of our issuer credit ratings on

corporate industrial issuers than we’ve lowered. Default rates have

also improved. According to Standard & Poor’s Global Fixed Income

Research (GFIR), the current trailing 12-month default rate has

dropped to 2.5%; this is well below the long-term average of 4.58%

since 1982 and sharply below the peak rate of more than 11% in

2009. While these recent favorable trends reflect relative improve-

ment in the credit quality of leveraged companies, we believe these

companies remain exposed to several risks that could reverse the

recent improvement in defaults.


These risks include a weak credit mix, withabout 47% of our ratings on U.S. corporateindustrials remaining concentrated in the ‘B’and ‘CCC’ rating categories, minimal revenuegrowth, potential margin compression stem-ming from increased operating costs and thereturn of refinancing risk in 2013–2016.

These risk factors, combined with the 2009spike in defaults, highlight the importance offundamental credit analysis and recovery ana-lytics. As default rates increase, recoveriesbecome the focus for many leveraged investorsbecause, with rising default rates, recoveriesplay a greater role in overall credit losses.

In December 2003, Standard & Poor’sbecame the first rating agency to establish aseparate, stand-alone rating scale to evaluatethe potential recovery investors might expectin the event of a loan default. Before that, weused our traditional rating scale, whichfocused almost exclusively on the likelihood ofdefault (will the borrower pay on time?) ratherthan on what the ultimate repayment wouldbe if the borrower failed to make timely pay-ments. Since then, Standard & Poor’s hasassigned recovery ratings to more than 3,000speculative-grade secured loans and bonds. In March of 2008, Standard & Poor’s began

Rating Leveraged Loans: An Overview

Thomas L. MowatNew York(1) [email protected]

William H. ChewNew York(1) [email protected]


assigning recovery ratings to the unsecureddebt of speculative-grade issuers.

Why A Separate Recovery Scale?Investors in loans recognize that they areincurring both types of risks: the risk ofdefault and the risk of loss in the event ofdefault. In traditional bond markets, espe-cially bonds issued by investment-grade com-panies, the risk of default is relatively remote,and little attention is paid to covenants, col-lateral, or other protective features thatwould mitigate loss in the event of default.Indeed, such protective features are rare insuch markets. But in the leveraged loan mar-ket, where the borrowers tend to be specula-tive grade (i.e., rated ‘BB+’ and below), therisk of default is significantly higher than it isfor investment-grade borrowers. Therefore,we have the necessity of collateral, covenants,and similar features of “secured” lending.

But the challenge for investors is that notall loans labeled “secured” are equallysecured, or even protected at all. In the past,data has shown, for example, that the major-ity of all secured loans do, in fact, repay theirlenders 100% of principal in the event ofdefault, with another sizable percentage pro-viding substantial, albeit less than full, recov-eries. But a significant number do not donearly so well, and, indeed, might as well be

unsecured in terms of the actual protectionafforded investors.

A primary purpose of Standard & Poor’srecovery ratings is to help investors differenti-ate between loans that are fully secured, par-tially secured, and those that are “secured” inname only. (See chart 1.) Second-lien loansare a specific example of secured loanswhereby recovery prospects in a bankruptcycould vary dramatically depending on theoverall makeup of the capital structure inquestion. These deals have attributes of bothsecured loans and subordinated debt, anddetermining post-default recovery prospectsrequires detailed analysis of the individualdeal. Most second-lien loans that we ratehave fallen into the lower recovery rating cat-egories (categories 5 and 6; see table 1), butoccasionally a second lien has been so wellprotected that it has merited a higher rating.Hence, once again, we have the need forrecovery ratings to make that differentiation.

Comparing Issuer AndRecovery RatingsStandard & Poor’s recovery rating methodol-ogy builds upon its traditional corporatecredit issuer rating analysis. The traditionalanalysis focuses on attributes of the borroweritself, which we tend to group under theheading of “business risk” factors (the bor-


As of Aug. 25, 2011

% of ratings (right scale)No. of ratings (left scale)*

1+ 1 2 3 4 5 6

(Recovery rating)

0100200300400500600700800900

1,000

0

5

10

15

20

25

30

35

*Total number of ratings: 3,074. Average recovery rating: 2.44. Standard deviation:1.37.© Standard & Poor’s 2011.

Chart 1 Total Distribution Of Current/Outstanding Speculative Grade

Secured Issues With Recovery Ratings

rower’s industry, its business niche withinthat industry, and other largely qualitativefactors like the quality of its management,overall strategy, etc.) and “financial risk” fac-tors (cash flow, capital structure, access toliquidity, as well as financial reporting andaccounting issues, etc.). The company’s abil-ity to meet its financial obligations on timeand, therefore, avoid default, is based on acombination of all these qualities, and it isthe analyst’s job to balance them appropri-ately in coming up with an overall rating.(See chart 2.)

In assigning its corporate credit ratings,Standard & Poor’s is actually grouping therated companies into categories based on therelative likelihood of their meeting theirfinancial obligations on time (i.e., avoidingdefault.) The relative importance of the vari-ous attributes may vary substantially fromone credit to another, even within the samerating category. For example, a companywith a very high business risk (e.g., intensecompetition, minimal barriers to entry, con-stant technology change, and risk of obsoles-cence) would generally require a stronger

financial profile to achieve the same overallrating level as a company in a more stablebusiness. The companies that Standard &Poor’s rates ’BB’, for example, may present awide range of combinations of business andfinancial risk, but are all expected to have asimilar likelihood of defaulting on the timelypayment of their financial obligations.Likewise with ’AA’ rated credits, ’B’ ratedcredits, etc.

Over the years, Standard & Poor’s hastracked the actual default rates of companiesthat it has rated. Table 2 shows the cumula-tive default rates for the past 30 years by rat-ing category. As we might expect, the rate ofdefault increases substantially moving acrossrating categories. For example, over fiveyears, companies originally rated ’BB’default, as a group, almost four times therate ’BBB’ rated companies do. ’B’ and’CCC’ rated companies default at an evenaccelerated pace.

Saying that a given set of debt issuers inthe same rating category have similar charac-teristics and are equally default-prone doesnot tell an investor which of the companies in


Getting to the corporate credit rating (”CCR”)

Country Risk

Industry Characteristics

Company Position

Profitability / Peer Group Comparisons

Business Risk

Rating

Financial Risk

© Standard & Poor’s 2011.

Chart 2 Standard & Poor’s Criteria

● Accounting

Governance, Risk Tolerance,Financial Policy

Cash Flow Adequacy

Capital Structure, Asset Protection

Liquidity / Short-Term Factors

●

●

●

●


that rating category will actually be the onesto default. No amount of analysis can tell usthat, since if we knew for certain that a givencompany that has the attributes of, for exam-ple, a ’BB’, were actually going to default atsome point, it would not, in fact, be rated’BB’, but instead would be rated much lower.

As investors move down the rating scale,they may not know exactly which deals willdefault, but they surely know that a largerpercentage of their deals will default; andthey had better be prepared for it. In the syn-dicated loan market, the market practice hasevolved to the point that companies rated’BBB’ and which generally default at the rateof about 2% over five years, are “allowed”by the market to borrow unsecured. The

market is saying, in effect, that it can livewith a default rate of that magnitude withouthaving to worry about protecting itself if adefault actually occurs. But for ’BB’ ratedcredits, where the likelihood of default occur-ring is almost four times greater, the markethas drawn a line and decided that, for thatdegree of default risk, it will generally insiston collateral security. Lenders are, in effect,willing to treat a ’BBB’ rated credit as thoughit will not likely default. But the presumptionis reversed for ’BB’ (and below) credits,where the increased default risk is so severethat the market insists on treating everycredit as though it might well default.

Standard & Poor’s recovery ratings take asimilar approach by assigning recovery rat-


For issuers with a speculative-grade corporate credit rating

Recovery Issue rating notches relative Recovery rating* Recovery description expectations¶ to corporate credit rating

1+ Highest expectation, full recovery 100%§ +3 notches

1 Very high recovery 90%–100% +2 notches

2 Substantial recovery 70%–90% +1 notch

3 Meaningful recovery 50%–70% 0 notches

4 Average recovery 30%–50% 0 notches

5 Modest recovery 10%–30% -1 notch

6 Negligible recovery 0%–10% -2 notches

*As noted above, recovery ratings in certain countries are capped to adjust for reduced creditor recovery prospects in these jurisdictions.Furthermore, the recovery ratings on unsecured debt issued by corporate entities with corporate credit ratings of ‘BB-‘ or higher are generallycapped at ‘3’ to account for the risk that their recovery prospects are at greater risk of being impaired by the issuance of additional priority orpari passu debt prior to default. ¶Recovery of principal plus accrued but unpaid interest at the time of default. §Very high confidence of fullrecovery resulting from significant overcollateralization or strong structural features.

Recovery Rating Scale And Issue Rating CriteriaTable 1

—Time horizon (years)—

Rating 1 2 3 4 5 10 15

AAA 0.00 0.03 0.14 0.26 0.38 0.79 1.09

AA 0.02 0.07 0.15 0.26 0.37 0.82 1.15

A 0.08 0.19 0.33 0.50 0.68 1.84 2.77

BBB 0.25 0.70 1.19 1.80 2.43 5.22 7.71

BB 0.95 2.83 5.03 7.14 9.04 16.54 20.52

B 4.70 10.40 15.22 18.98 21.76 29.94 34.54

CCC/C 27.39 36.79 42.12 45.21 47.64 52.88 56.55

Source: Standard & Poor’s Global Fixed Income Research; Standard & Poor’s CreditPro.®

Global Corporate Average Cumulative Default Rates (1981–2010)Table 2


ings to speculative-grade issuers. While wedo not assume that a given deal will default,our analysts—the industry specialists whocover companies on an ongoing basis,working along with the recovery specialistwho is assigned to that industry teamspecifically to do recovery analysis—deter-mine together the most likely default sce-nario that is consistent with our assessmentof the company’s fundamental business andfinancial risks. In other words, if this com-pany were to default, what would be themost likely scenario? They then projectwhat the company’s financial conditionwould be at the time of default and, equallyimportant, at the conclusion of the workoutprocess. Then they evaluate what the com-pany itself and/or the collateral (which maybe the same, but not always) would beworth and how that value would be distrib-uted among the various creditors. (For adetailed description of the analyticalmethodology used, see the accompanyingarticle in this book, ”Criteria GuidelinesFor Recovery Ratings On Global IndustrialsIssuers’ Speculative-Grade Debt.”)

Role Of Ratings InThe Loan MarketThe U.S. leveraged loan market is a ratedmarket, with Standard & Poor’s rating about

70% of all new leveraged loans. This is notsurprising, considering that most investors inthe U.S. leveraged loan market are nonbankinstitutional investors, rather than commer-cial banks. These institutional investors:● Are accustomed to having ratings on the

debt instruments they buy, and● Often have ratings on their own debt

which, in turn, are dependent onthe ratings of the underlying loansthey purchase.In addition to the recovery rating itself,

with its specific estimate of recovery in theevent of default, Standard & Poor’s analystsprovide a complete recovery report thatexplains in detail the analysis, the default sce-nario, the other assumptions, and the reason-ing behind the recovery rating. This allowsinvestors to look behind and, if they wish,even to “reverse engineer” our analysis,selecting what they agree or disagree with,and altering our scenarios to reflect their ownview of the company, the industry, or the col-lateral valuation.

For further information about Standard &Poor’s Recovery Ratings, or to receive theweekly S&P Loan & Recovery RatingReport by email, please contact Bill Chewat 1-212-438-7981 or [email protected], or visit ourBank Loan & Recovery Rating web site at:www.bankloanrating.standardandpoors.com. ●

Standard & Poor’s Ratings Services has been assigning recovery

ratings—debt instrument-specific estimates of post-default

recovery for creditors—since December 2003. At that time, we

began issuing recovery ratings and analyses for all new secured

bank loans in the U.S. Since that time, we have steadily expanded

our recovery ratings to cover secured debt issued in other countries

and, in March 2008, to unsecured and subordinated debt instruments.

This article provides an overview of Standard & Poor’s general

recovery analysis approach for global Industrials issuers, including

specific jurisdictional considerations for the U.S. market. This

framework is the basis for our recovery methodology worldwide

although, where appropriate, our analysis is tailored to consider

jurisdiction-specific features that impact the insolvency process

and creditor recovery prospects.


Recovery Ratings For Global Industrials—Definition And ContextRecovery ratings assess a debt instrument’sultimate prospects for recovery of estimatedprincipal and pre-petition interest (i.e., inter-est accrued but unpaid at the time of default)given a simulated payment default. Standard &Poor’s recovery methodology focuses on esti-mating the percentage of recovery that debtinvestors would receive at the end of a formal

bankruptcy proceeding or an informal out-of-court restructuring. Lender recoveries couldbe in the form of cash, debt or equity securi-ties of a reorganized entity, or some combina-tion thereof. We focus on nominal recovery(versus discounted present value recovery)because we believe that discounted recoveryis better identified independently by marketparticipants that are best positioned to applytheir own preferred discount rate to our nom-inal recovery. However, in jurisdictions withcreditor-unfriendly features, we will cap both

Criteria Guidelines For Recovery

Ratings On Global Industrials Issuers’

Speculative-Grade Debt

Steve WilkinsonNew York(1) [email protected]

Anne-Charlotte PedersenNew York(1) [email protected]

William H. ChewManaging DirectorNew York(1) [email protected]

Anthony FlintoffSenior DirectorMelbourne(61) [email protected]


recovery ratings and issue ratings to accountfor incremental uncertainty.

While informed by historical recovery data,our recovery ratings incorporate fundamentaldeal-specific, scenario-driven, forward-lookinganalysis. They consider the impact of keystructural features, intercreditor dynamics, thenature of insolvency regimes, multijurisdic-tional issues, and potential changes in valua-tion after a simulated default. Ongoingsurveillance through periodic and event-spe-cific reviews help ensure that our recovery rat-ings remain forward looking by monitoringdevelopments in these issues and by evaluatingthe impact of changes to a borrower’s businessrisks and debt and liability profile over time.

We acknowledge that default modeling,valuation, and restructuring (whether as partof a formal bankruptcy proceeding or other-wise) are inherently dynamic and complexprocesses that do not lend themselves to pre-cise or certain predictions. These processesinvariably involve unforeseen events and aresubject to extensive negotiations that areinfluenced by the subjective judgments, nego-tiating positions, and agendas of the variousstakeholders. Even so, we believe that ourmethodology of focusing on a company’sunique and fundamental credit risks—together with an informed analysis of howthe composition and structure of its debt,legal organization, and nondebt liabilities

would be expected to impact lender recoveryrates—provides valuable insight into creditorrecovery prospects.

In this light, our recovery ratings areintended to provide educated approximationsof post-default recovery rates, rather thanexact forecasts. Our analysis also endeavors tocomment on how the specific features of acompany’s debt and organizational structuremay affect lender recovery prospects. Ofcourse, not all borrowers will default, but ourrecovery ratings, when viewed together with acompany’s risk of default as estimated byStandard & Poor’s corporate credit rating, canhelp investors evaluate a debt instrument’srisk/reward characteristics and estimate theirexpected return. Our approach is intended tobe transparent (within the bounds of confiden-tiality), so that market participants may drawvalue from our analysis itself rather thanmerely from the conclusion of the analysis.

Recovery Rating Scale And Issue Rating FrameworkThe table summarizes our enhanced issue rat-ing framework. The issue rating we apply tothe loans and bonds of companies with spec-ulative-grade corporate credit ratings is basedon the recovery rating outcome for the spe-cific instrument being rated. Issues with ahigh recovery rating (‘1+’, ‘1’, or ‘2’) would

For issuers with a speculative-grade corporate credit rating

Recovery Issue rating notches relative Recovery rating* Recovery description expectations¶ to corporate credit rating

1+ Highest expectation, full recovery 100%§ +3 notches

1 Very high recovery 90%–100% +2 notches

2 Substantial recovery 70%–90% +1 notch

3 Meaningful recovery 50%–70% 0 notches

4 Average recovery 30%–50% 0 notches

5 Modest recovery 10%–30% -1 notch

6 Negligible recovery 0%–10% -2 notches

*As noted above, recovery ratings in certain countries are capped to adjust for reduced creditor recovery prospects in these jurisdictions.Furthermore, the recovery ratings on unsecured debt issued by corporate entities with corporate credit ratings of ‘BB-‘ or higher are generallycapped at ‘3’ to account for the risk that their recovery prospects are at greater risk of being impaired by the issuance of additional priority orpari passu debt prior to default. ¶Recovery of principal plus accrued interest at the time of default on a nominal basis. §Very high confidence offull recovery resulting from significant overcollateralization or strong structural features.

Recovery Rating Scale And Issue Rating Criteria


Criteria Guidelines For Recovery Ratings On Global Industrials Issuers’ Speculative-Grade Debt

lead us to rate the loan or bond above thecorporate credit rating, while a low recoveryrating (‘5’ or ‘6’) would lead us to rate theissue below the corporate credit rating.

Jurisdiction-Specific AdjustmentsFor Recovery And Issue RatingsStandard & Poor’s due diligence for extend-ing recovery ratings beyond the U.S. hasentailed an assessment of how insolvencyproceedings in practice in various countriesaffect post-default recovery prospects. Thiswork has enabled us to consistently incorpo-rate jurisdiction-specific adjustments when weassign recovery and issue ratings outside theU.S. With the help of local insolvency practi-tioners, we have assessed each jurisdiction’screditor friendliness in theory as well as howthe law works in practice. For the latter, weso far lack empirical data, as outside of theU.S. very little reliable historical default andrecovery data is available to verify in practicethe predictability of insolvency proceedingsand actual recovery rates. We will refine andupdate our analysis and methodology overtime as appropriate if more actual loss dataand practical evidence becomes available.

The four main factors that shape our analy-sis of the jurisdictions’ creditor friendliness are:● Security,● Creditor participation/influence,● Distribution of value/certainty of

priorities, and● Time to resolution.

Based on the score reached on each ofthese factors, we have classified the reviewedcountries into three categories, according totheir creditor-friendliness. This classificationhas enabled us to make jurisdiction-specificadjustments to our recovery analysis. Namely,relative to our standard assignment of recov-ery and debt issue ratings, we cap both recov-ery ratings and the differential between theissuer credit and debt issue ratings in coun-tries if and to the extent we expect the recov-ery process and actual recovery rates to benegatively affected by insolvency regimes thatfavor debtors or other noncreditor con-stituencies. We believe that by transparentlyoverlaying analytical judgment on top of pure

numerical analysis, we increase the trans-parency and consistency of our assessmentsof the impact of countries’ insolvency rules—especially those that are less creditor friendlywhen assigning recovery and issue ratings.

To review the details of our adjustments,the grouping of various countries into groupswith similar characteristics, and the extent ofour issue-notching caps for each group, see“Jurisdiction-Specific Adjustments ToRecovery And Issue Ratings”.

General Recovery Methodology And Approach For Global IndustrialsRecovery analytics for Industrials issuers hasthree basic components: (1) determining themost likely path to default for a company; (2)valuing the company following default; and(3) distributing that value to claimants basedupon the relative priority of each claimant.Our analytical process breaks down thesecomponents into the following steps:● Establishing a simulated path to default;● Forecasting the company’s profitability

and/or cash flow at default based on oursimulated default scenario;

● Determining an appropriate valuation forthe company following default;

● Identifying and estimating debt and nondebtclaims in our simulated default scenario;

● Determining the distribution of value basedon relative priorities;

● Assigning a recovery rating (or ratings),including a published “recovery report” thatsummarizes our assumptions and conclusions.

Establishing a simulated path to default

This is a fundamental part of our recoveryanalysis because we must first understand theforces most likely to cause a default beforewe can estimate a reasonable valuation givendefault. This step draws on the company andsector knowledge of Standard & Poor’scredit analysts to formulate and quantify thefactors most likely to cause a company todefault given its unique business risks andthe financial risk inherent in the capitalstructure that we are evaluating in ourdefault and recovery analysis.


At the outset of this process, we decon-struct the borrower’s projections to under-stand management’s general business,industry, and economic expectations. Oncewe understand management’s view, we makeappropriate adjustments to key economic,industry, and firm specific factors to simulatethe most likely path to a payment default.

Forecasting profitability and/or cash flow at default

The simulated default scenario is our assess-ment of the borrower’s most likely path to apayment default. The “insolvency proxy” isthe point along that path at which we expectthe borrower to default. In other words, theinsolvency proxy is the point at which fundsavailable plus free cash flow is insufficient topay fixed charges:

(Funds available + Free cash flow) / Fixed charges <= 1.0

The terms in this equation are defined as:Funds available. The sum of balance sheet

cash and revolving credit facility availability (inexcess of the minimal amount a company needsto operate its business at its seasonal peak).

Free cash flow. EBITDA in the year ofdefault, less a minimal level of requiredmaintenance capital expenditures, less cashtaxes, plus or minus changes in working cap-ital. For default modeling and recovery esti-mates, our EBITDA and free cash flowestimates ignore noncash compensationexpenses and do not use Standard & Poor’sadjustments for operating leases.

Fixed charges. The sum, in the year ofdefault, of:● Scheduled principal amortization (We gen-

erally do not include “bullet” or “balloon-ing” maturities as fixed charges, as lenderstypically would expect such amounts to berefinanced and would presumably be reluc-tant to force a company into default thatcan otherwise comfortably service its fixedcharges. Consequently, our default andrecovery modeling will typically assumethat additional business and cash flow dete-rioration is necessary to trigger a default.);

● Required cash interest payments (includingassumed increases to LIBOR rates on float-ing-rate debt and to the margin charged ondebt obligations that have maintenancefinancial covenants); and

● Other cash payments the borrower is eithercontractually or practically obligated topay that are not already captured as anexpense on the borrower’s income state-ment. (Lease payments, for example, areaccounted for within free cash flow and,thus, are not considered a fixed charge.)The insolvency proxy at the point of pro-

jected default may be greater than 1.0x in afew special circumstances:● For “strategic” bankruptcy filings, when

a borrower may attempt to take advan-tage of the insolvency process primarilyto obtain relief from legal claims oronerous contracts;

● When a borrower may rationally be expectedto retain a greater amount of cash (e.g., toprepare for a complex, protracted restructur-ing; if it is in a very capital-intensive industry;or if it is in a jurisdiction that does not allowfor super-priority standing for new credit in apost-petition financing); and

● When a borrower’s financial covenantshave deteriorated beyond the level atwhich even the most patient lender couldtolerate further amendments or waivers.(Lenders with no financial maintenancecovenants have effectively surrendered thisoption and have reduced their ability toinfluence company behavior.)Conversely, free cash flow may decline

below the insolvency proxy when the bor-rower’s operating performance is expected tocontinue to deteriorate due to cyclicality orbusiness model contraction resulting from thecompetitive and economic conditions assumedin the simulated default scenario. In anyevent, our analysis will identify the level ofcash flow used as the basis for our valuation.

Determining valuation

To help us determine an appropriate valuationfor a company (given our simulated defaultscenario), we may consider a variety of valua-tion methodologies, including market multi-ples, discounted cash flow (DCF) modeling,



and discrete asset analysis. The market multi-ples and DCF methods are used to determinea company’s enterprise value as a going con-cern. This is generally the most appropriateapproach when our simulated default andrecovery analysis indicates that the borrower’sreorganization (or the outright sale of theongoing business or certain segments) is themost likely outcome of an insolvency proceed-ing. We use discrete asset valuation most oftenfor industries in which this valuationapproach is typically used, or when the simu-lated default scenario indicates that the bor-rower’s liquidation is the most likely outcomeof insolvency. In addition, we may use a com-bination of the discrete and enterprise valua-tion methods when we believe that a companywill reorganize, but that its debt and organi-zational structure provides certain creditorswith priority claims against particular assetsor subsidiaries. For example, Standard &Poor’s will consider whether a company’sdecision to securitize or not securitize materialassets impacts the value available to distributeto other creditors.

Market multiples. The key to valuing afirm using a market multiples approach is toselect appropriate comparable companies, or“comps.” The analysis should include severalcomps that are similar to the firm being val-ued with respect to business lines, geographicmarkets, margins, revenue, capital require-ments, and competitive position. Of course,an ideal set of comps does not always exist,so analytical judgment is often required toadjust for differences in size, business pro-files, and other attributes. In addition, in thecontext of a recovery analysis, our multiplesmust consider the competitive and economicenvironments assumed in our simulateddefault scenario, which are often very differ-ent than present conditions. As a result, ouranalysis strives to consider a selection of mul-tiples and types of multiples.

Ideally, we are interested in multiples forsimilar firms that have reorganized due to cir-cumstances consistent with our simulateddefault scenario. In practice, however, theexistence of such “emergence” multiple compsis rare. As a result, our analysis often turns to“transaction” or “purchase” multiples for

comparable firms because these are generallymore numerous. With transaction multiples,we try to use forward multiples (purchaseprice divided by projected EBITDA) ratherthan trailing multiples (purchase price dividedby historical EBITDA). This is because webelieve that forward multiples, which are gen-erally lower because they incorporate the ben-efit of perceived cash flow synergies used tojustify the purchase price, provide a moreappropriate reference point. In addition,“trading” multiples for publicly traded firmscan be useful because they allow us to trackhow multiples have changed over economicand business cycles. This is especially relevantfor cyclical industries and for sectors enteringa different stage of development or experienc-ing changing competitive conditions.

A selection of multiples helps match ourvaluation with the conditions assumed in oursimulated default scenario. For example, afirm projected to default in a cyclical troughmay warrant a higher multiple than oneexpected to default at a cyclical midpoint.Furthermore, two companies in the sameindustry may merit meaningfully differentmultiples if their simulated default scenariosare very different. For example, if one ishighly levered and at risk of default from rel-atively normal competitive stresses while theother is unlikely to default unless there is alarge unexpected fundamental deteriorationin the cash flow potential of the businessmodel (which could make historical sectormultiples irrelevant).

Our multiples analysis may also consideralternative industry specific multiples—such assubscribers, hospital beds, recurring revenue,etc.—where appropriate. Alternatively, suchmetrics may serve as a check on the soundnessof a valuation that relied on an EBITDA mul-tiple, DCF, or discrete asset approach.

Discounted cash flow (DCF). Standard &Poor’s DCF valuation analysis for recoveryanalytics generally uses a three-stage model.The first stage is the simulated default sce-nario; the second stage is the period duringinsolvency; and the third stage represents thelong-term operating performance of the reor-ganized firm. Our valuation is based on thethird stage, which typically values a company


using a perpetuity growth formula, whichcontemplates a long-term steady-state growthrate deemed appropriate for the borrower’sbusiness. However, the third stage may alsoinclude specific annual cash flow forecasts fora period of time following reorganizationbefore assigning a terminal value through theperpetuity growth formula. In any case, thespecifics underlying our cash flow forecastand valuation are outlined in Standard &Poor’s recovery reports.

Discrete asset valuation. We value the rele-vant assets by applying industry- and asset-specific advance rates in conjunction withthird-party appraisals (when we are providedwith the appraisals).

Identifying and estimating the value of debt and nondebt claims

After valuing a company, we must then iden-tify and quantify the debt obligations andother material liabilities that would beexpected to have a claim against the companyfollowing default. Potential claims fall intothree broad categories:● Principal and accrued interest on all debt

outstanding at the point of default,whether issued at the operating company,subsidiary, or holding company level;

● Bankruptcy-related claims, such as debtor-in-possession (DIP) financing and adminis-trative expenses for professional fees andother bankruptcy costs;

● Other nondebt claims such as taxespayable, certain securitization programs,trade payables, deficiency claims onrejected leases, litigation liabilities, andunfunded post-retirement obligations.Our analysis of these claims and their

potential values strives to consider each bor-rower’s particular facts and circumstances, aswell as the expected impact on the claims asa result of our simulated default scenario.

We estimate debt outstanding at the pointof default by reducing term loans by sched-uled amortization paid prior to our simulateddefault and by assuming that all committeddebt, such as revolving credit facilities anddelayed draw term loans, is fully funded. Forasset-based lending (ABL) facilities, we willconsider whether the borrowing base formula

would allow the company to fully draw thefacility in a simulated default scenario. Forletters of credit, especially those issued underdedicated synthetic letter of credit tranches,we will assess whether these contingent obli-gations are likely to be drawn followingdefault. Our estimate of debt outstanding atdefault also includes an estimate of pre-peti-tion interest, which is calculated by adding sixmonths of interest (based on historical datafrom Standard & Poor’s LossStats® database)to our estimated principal amount at default.The inclusion of pre-petition interest makesour recovery analysis more consistent withregulatory credit risk capital requirements.

Our analysis focuses on the recoveryprospects for the debt instruments in a com-pany’s current or pro forma debt structure,and generally does not make estimates forother debt that may be issued prior to adefault. We feel that this approach is prudentand more relevant to investors because theamount and composition of any additionaldebt (secured, unsecured, and/or subordi-nated) may materially impact lender recoveryrates, and it is not possible to know these par-ticulars in advance. Further, incremental debtadded to a company’s capital structure maymaterially affect its probability of default,which, in turn, could impact all aspects of ourrecovery analysis (i.e., the most likely path todefault, valuation given default, and loss givendefault). Consequently, changes to a com-pany’s debt structure are treated as events thatrequire a reevaluation of our default andrecovery analysis. This is a key aspect of ourongoing surveillance of our default and recov-ery ratings. We do, however, make someexceptions to this approach. Such exceptionswill be outlined in our recovery reports andgenerally fall under two categories:● Permitted, but uncommitted, incremental

debt may be included as part of our defaultand recovery analysis if this is consistentwith our expectations and our underlyingcorporate credit rating on a given issuer.

● Our default and recovery analysis mayassume the repayment of near-term debtmaturities if the company is expected toretire these obligations and has the liquidityto do so. Similarly, principal prepayments—



whether voluntary or part of an excesscash flow sweep provision—may be consid-ered for certain credits when deemedappropriate. Otherwise, we generallyassume that debt that matures prior to oursimulated default date is rolled over onsimilar terms but at current market rates.Our analytical treatment and estimates for

bankruptcy-related and other nondebt claimsin default is generally specific to the laws andcustoms of the jurisdictions involved in oursimulated default scenario. Please refer toAppendix 1 for a review of our approach andmethodology for these claims in the U.S.

Determining distribution of value

The distribution follows a “waterfall”approach that reflects the relative seniority ofthe claimants and will be specific to the laws,customs, and insolvency regime practices forthe relevant jurisdictions for a company. Forexample, the quantification and classificationof bankruptcy-related and nondebt claims forinsolvencies outside of the U.S. might be verydifferent from the methodology for U.S.Industrials companies discussed in theAppendix. Furthermore, local laws and cus-toms may warrant deviations from the water-fall distribution we follow in the U.S. Whererelevant, we will publish our guidelines andrationale for these differences before rolling outour unsecured recovery ratings in these juris-dictions. In the U.S., our general assumption ofthe relative priority of claimants is as follows:● Super-priority claims, such as DIP financing,● Administrative expenses,● Federal and state tax claims,● Senior secured claims,● Junior secured claims,● Senior unsecured claims,● Subordinated claims,● Preferred stock,● Common stock.

However, this priority of claims is subjectto two critical caveats:● The beneficial position of secured creditor

claims, whether first-priority or otherwise, isvalid only to the extent that the collateralsupporting such claims is equal to, or greaterthan, the amount of the claim (includinghigher priority and pari passu claims). If the

collateral value is insufficient to fully cover asecured claim, the uncovered amount or“deficiency balance” will be pari passu withall other senior unsecured claims.

● Structural issues and contractual agree-ments can also alter the priority of certainclaims relative to each other or to the valueattributable to specific assets or entities inan organization.As a result of these caveats, the recovery

prospects for different debt instruments of thesame type (whether they be senior secured, sen-ior unsecured, senior subordinated, etc.) mightbe very different, depending on the structure ofthe transactions. While the debt type of aninstrument may provide some indication as toits relative seniority, it is the legal structure andassociated terms and conditions that are theultimate arbiter of priority. Consequently, afundamental review of a company’s debt andlegal entity structure is required to properlyevaluate the relative priority of claimants. Thisrequires an understanding of the terms andconditions of the various debt instruments asthey pertain to borrower and guarantor rela-tionships, collateral pledges and exclusions,facility amounts, covenants, and debt maturi-ties. In addition, we must understand thebreakout of the company’s cash flow and assetsas it pertains to its legal organizational struc-ture and consider the effect of key jurisdic-tional and intercreditor issues.

Key structural issues to explore includeidentifying:● Higher priority liens on specific assets by

forms of secured debt such as mortgages,industrial revenue bonds, and ABL facilities;

● Non-guarantor subsidiaries (domestic orforeign) that do not guarantee a com-pany’s primary debt obligations or provideasset pledges to support the company’ssecured debt;

● Claims at non-guarantor subsidiaries thatwill have a higher priority (i.e., a “struc-turally superior”) claim on the valuerelated to such entities;

● Material exclusions to the collateral pledgedto secured lenders, including the lack ofasset pledges by foreign subsidiaries or theabsence of liens on significant domesticassets, including the stock of foreign or


domestic non-guarantor subsidiaries(whether due to concessions demanded byand granted to the borrower, poor transac-tion structuring, regulatory restrictions, orlimitations imposed by other debt inden-tures); and

● Whether a company’s foreign subsidiariesare likely to file for bankruptcy in theirlocal jurisdictions as part of the default andrestructuring process.The presence of obligations with higher-pri-

ority liens on certain assets means that theenterprise value available to other creditorsmust be reduced to account for the distributionof value to satisfy these creditors first. In mostinstances, asset-specific secured debt claims(such as those previously listed) are structuredto ensure full collateral coverage even in adefault scenario. As such, our analysis will typi-cally reduce the enterprise value by the amountof these claims to determine the remainingenterprise value available for other creditors.That said, there may be exceptions that will beconsidered on a case-by-case basis if theamounts are material. Well-structured securedbank or bond debt that does not have a firstlien on certain assets will get second-priorityliens on assets that are significant and may havemeaningful excess collateral value. For exam-ple, this is often the case when secured debt col-lateralized by a first lien on all noncurrentassets also takes a second-priority lien on work-ing capital assets that are already pledged tosupport an asset-based revolving credit facility.

Significant domestic or foreign non-guaran-tor entities must be identified because theseentities have not explicitly promised to repaythe debt. Thus, the portion of enterprise valuederived from these subsidiaries does notdirectly support the rated debt. As a result,debt and certain nondebt claims at these sub-sidiaries have a structurally higher priorityclaim against the subsidiary value.Accordingly, the portion of the company’senterprise value stemming from these sub-sidiaries must be estimated and treated sepa-rately in the distribution of value to creditors.This requires an understanding of the break-out of a company’s cash flow and assets.Because these subsidiaries are still part of theenterprise being evaluated, any equity value

that remains after satisfying the structurallysuperior claims would be available to satisfyother creditors of the entities that own thesesubsidiaries. Well-structured debt will ofteninclude covenants to restrict the amount ofstructurally superior debt that can be placed atsuch subsidiaries. Furthermore, well-structuredsecured debt will take a lien on the stock ofsuch subsidiaries to ensure a priority interestin the equity value available to support othercreditors. In practice, the pledge of foreignsubsidiary stock owned by U.S. entities is usu-ally limited to 65% of voting stock for taxreasons. The residual value that is not cap-tured by secured lenders through stock pledgeswould be expected to be available to all seniorunsecured creditors on a pro rata basis.

The exclusion of other material assets (otherthan whole subsidiaries or subsidiary stock)from the collateral pledged to support secureddebt must also be incorporated into our analy-sis. The value of such assets is typically deter-mined using a discrete asset valuationapproach, and our estimated value and relatedassumptions will be disclosed in our recoveryreport as appropriate. We expect the value ofexcluded assets would be shared by all seniorunsecured creditors on a pro rata basis.

An evaluation of whether foreign sub-sidiaries would also be likely to file for bank-ruptcy is also required, because this wouldlikely increase the cost of the bankruptcyprocess and create potential multijurisdic-tional issues that could impact lender recov-ery rates. The involvement of foreign courtsin a bankruptcy process presents a myriad ofcomplexities and uncertainties. For thesesame reasons, however, U.S.-domiciled bor-rowers that file for bankruptcy seldom alsofile their foreign subsidiaries without a spe-cific benefit or reason for doing so.Consequently, we generally assume that for-eign subsidiaries of U.S. borrowers do not filefor bankruptcy unless there is a compellingreason to assume otherwise, such as a largeamount of foreign debt that needs to berestructured to enable the company to emergefrom bankruptcy. When foreign subsidiariesare expected to file bankruptcy, our analysiswill be tailored to incorporate the particularsof the relevant bankruptcy regimes.



Intercreditor issues may affect the distri-bution of value and result in deviationsfrom “absolute priority” (i.e., maintenanceof the relative priority of the claims, subjectto structural and contractual considera-tions, so that a class of claims will notreceive any distribution until all classesabove it are fully satisfied), which isassumed by Standard & Poor’s methodol-ogy. In practice, however, Chapter 11 bank-ruptcies are negotiated settlements and thedistribution of value may vary somewhatfrom the ideal implied by absolute priorityfor a variety of intercreditor reasons,including, in the U.S., “accommodations”and “substantive consolidation.”

Accommodations refer to concessionsgranted by senior creditors to juniorclaimants in negotiations to gain theircooperation in a timely restructuring. Wegenerally do not explicitly model foraccommodations because it is uncertainwhether any concessions will be granted, ifthose granted will ultimately have value(e.g., warrants as a contingent equityclaim), or whether the value will be mate-rial enough to meaningfully affect our pro-jected recovery rates.

Substantive consolidation represents apotentially more meaningful deviation fromthe distribution of value according toabsolute priority. In a substantive consolida-tion, the entities of a corporate group may betreated as a single consolidated entity for thepurposes of a bankruptcy reorganization.This effectively would eliminate the creditsupport provided by unsecured guarantees orthe pledge of intercompany loans or sub-sidiary stock, and dilutes the recoveryprospects of creditors that relied on these fea-tures to the benefit of those that did not.Even the threat of substantive consolidationmay result in a negotiated settlement thatcould affect recovery distribution. While sub-stantive consolidation can meaningfullyimpact the recovery prospects of certain cred-itors, it is a discretionary judicial doctrinethat is only relevant in certain situations. It isdifficult to predict whether any party wouldseek to ask a bankruptcy court to apply it ina specific case, or the likelihood that party

would succeed in persuading the court to doso. As such, our analysis does not evaluatethe likelihood of substantive consolidation,though we acknowledge that this risk couldaffect recoveries in certain cases.

Assigning recovery ratings

We estimate recovery rates by dividing theportion of enterprise or liquidation value pro-jected to be available to cover the debt towhich the recovery rating applies, by the esti-mated amount of debt (principal and pre-petition interest) and pari passu claimsoutstanding at default. We then map therecovery rate to our recovery rating chart todetermine the issue and recovery ratings.Standard & Poor’s accompanies its recoveryratings with written recovery reports, whichidentify the simulated payment default, valua-tion assumptions, and other factors on whichthe recovery ratings are based. This disclosureis intended to improve the utility of ouranalysis by providing investors with moreinformation with which to evaluate our con-clusions and to allow them to consider differ-ent assumptions as they deem appropriate.

Surveillance of recovery ratings

After our initial analysis at debt origination,we monitor material changes affecting theborrower and its debt and liability structureto determine if the changes might also altercreditor recovery prospects. This is essentialgiven the dynamic nature of credit in generaland default and recovery modeling in particu-lar. Therefore, a fundamental component ofrecovery analysis is periodic and event spe-cific surveillance designed to monitor devel-oping risk exposures that might affectrecovery. Any material changes to our defaultand recovery ratings or analysis will be dis-closed in updates to our recovery reports.Factors that could impact our default andrecovery analysis or ratings include:● Acquisitions and divestitures;● Updated valuation assumptions;● Shifts in the profit and cash flow contri-

butions of borrower, guarantor, or non-guarantor entities;

● Changes in debt or the exposure to non-debt liabilities;


● Intercreditor dynamics; and● Changes in bankruptcy law or case histories.

ConclusionWe believe that our recovery ratings are bene-ficial because they allow market participants

to consider disaggregated analyses for proba-bility of default and recovery given default.We also believe our recovery analysis mayprovide investors insight into how a com-pany’s debt and organizational structure mayaffect recovery rates. ●



This appendix covers Standard & Poor’s ana-lytical considerations regarding the treatmentof bankruptcy-specific and other nondebtclaims in our default and recovery analysis ofU.S.-domiciled Industrials borrowers. Ourapproach endeavors to consider the bor-rower’s particular facts and circumstances, aswell as the expected impact on the claims asa result of the simulated default scenario.Still, the potential amount of many of theseclaims is highly variable and difficult to pre-dict. In addition, these claims are likely todisproportionately affect the recoveryprospects of unsecured creditors becausemost of these claims would be expected tobe classified as general unsecured claims inbankruptcy. This contributes to the histori-cally higher standard deviation of recoveryrates for unsecured lenders (relative tosecured lenders).

While these issues make projecting recov-ery rates for unsecured debt challenging, webelieve that an understanding of the analyticalconsiderations related to these claims can helpinvestors make better decisions regarding aninvestment’s risks and recovery prospects. Ourrecovery reports endeavor to comment on ourassumptions regarding the types and amountsof the claims as appropriate.

Bankruptcy-specific priority claims

Debtor in possession financing. DIP facilitiesare usually super-priority claims that enjoyrepayment precedence over unsecured debtand, often, secured debt. However, it isexceedingly difficult to accurately quantifythe size or likelihood of DIP financing or toforecast how DIP financing may affect therecovery prospects for different creditors.This is because the size or existence of a theo-retical DIP commitment is unpredictable, DIPborrowings at emergence may be substan-tially less than the DIP commitment, andsuch facilities may be used to fully or par-tially repay some pre-petition secured debt.Furthermore, the presence of DIP financingmight actually help creditor recovery

prospects by allowing companies to restruc-ture their operations and preserve the valueof their business. As a result of these uncer-tainties, estimating the impact of a DIP facil-ity is generally beyond the scope of ouranalysis, even though we recognize that DIPfacilities may materially impact recoveryprospects in certain cases.

Administrative expenses. Administrativeexpenses relate to professional fees and othercosts associated with bankruptcy that arerequired to preserve the value of the estateand complete the bankruptcy process. Thesecosts must be paid prior to exiting bank-ruptcy, making them effectively senior tothose of all other creditors. The dollaramount and materiality of administrativeclaims usually correspond to the company’ssize and the complexity of its capital struc-ture. We expect that these costs will be lessfor simple capital structures that can usuallynegotiate an end to a bankruptcy quickly andmay even use a pre-packaged bankruptcyplan. Conversely, these costs are expected tobe greater for large borrowers with complexcapital structures where the insolvencyprocess is often characterized by protractedmultiple party disputes that drive up bank-ruptcy costs and diminish lender recoveries.When using an enterprise value approach,our methodology estimates the value of theseclaims as a percentage of the borrower’semergence enterprise value as follows:● Three percent for capital structures with

one primary class of debt;● Five percent for two primary classes of

debt (first- and second-lien creditors maybe adversaries in a bankruptcy proceedingand are treated as separate classes byStandard & Poor’s);

● Seven percent for three primary classes ofdebt; and

● Ten percent for certain complex capitalstructures.When using a discrete asset valuation

approach, these costs may be implicitlyaccounted for in the orderly liquidation valuediscounts used to value a company’s assets.

Appendix: U.S. Industrials Analysis Of Claims And Estimation Of Amounts


Other nondebt claims

Taxes. Various U.S. government authoritiessuccessfully assert tax claims as either admin-istrative, priority, or secured claims. However,it is very difficult to project the level and sta-tus of such claims at origination (e.g., tax dis-putes en route to default are extremely hardto predict). We also expect that, while suchclaims will normally be paid before seniorsecured claims, their overall amount is sel-dom material enough to impact lender recov-eries. Therefore, we acknowledge that taxclaims may indeed be priority claims, but wegenerally do not, at origination, reduce ourexpectation for lenders’ recovery by estimat-ing the amount of potential tax claims.

Swap termination costs. The BankruptcyCode accords special treatment for counter-parties to financial contracts, such as swaps,repurchase agreements, securities contracts,and forward contracts, to ensure continuityin the financial markets and to avoid systemicrisk (so long as both the type of contract andthe type of counterparty fall within certainstatutory provisions). In addition to not beingsubject to the automatic stay that generallyprecludes creditors from exercising theirremedies against the debtor, financial contractcounterparties have the right to liquidate, ter-minate, or accelerate the contract in a bank-ruptcy. Most currency and interest rate swapsrelated to secured debt are secured on a paripassu basis with the respective loans. Otherswaps are likely to be unsecured. While weacknowledge the potential for such claims,quantifying such claims will usually beimpractical and beyond the scope of ouranalysis at origination. That said, makingestimates for these claims may be more prac-tical in surveillance as a company approachesbankruptcy and the potential impact of thesetypes of claims becomes clearer.

Cash management obligations. Obligationsunder automated clearing house programsand other cash management services providedby a borrower’s banks may be incremental toits exposure to its bank lenders under itscredit facilities. In some cases, these obliga-tions may be material and may be secured ona pari passu basis by the bank collateral.When we are aware of these situations, our

estimates for these claims will be disclosed inour recovery reports.

Regulatory and litigation claims. Theseclaims are fact- and borrower-specific and areexpected to be immaterial for the vast major-ity of issuers. For others, however, they mayplay a significant role in our simulateddefault scenario and represent a sizable liabil-ity that impairs the recovery prospects ofother creditors. Borrowers that fall into thiscategory may be in the tobacco, chemical,building materials, environmental services,mining, or pharmaceutical industries. Evenwithin these sectors, however, we are mostlikely to factor these issues into our analysisin a meaningful way when a borrower iseither already facing significant exposure tothese liabilities or is unlikely to default with-out a shock of this type to its business (suchas a high speculative-grade-rated companywith low to moderate leverage and relativelystable cash flow).

After determining whether it is reasonableto include such claims in our default andrecovery analysis, we are left with the chal-lenge of sizing the claims and determininghow they might impact creditor recoveryprospects. Unfortunately, the case history isvery limited in this area and does not offerclear guidelines on how to best handle theseinherent uncertainties. As such, we tailor ourapproach on a case-by-case basis to the bor-rower’s specific circumstances to help us reachan appropriate solution. When significant, ourapproach and assumptions will be outlined inour recovery report so that investors can eval-uate our treatment, and consider alternativeassumptions if desired, as part of their invest-ment decision. We note that claims in this cat-egory would typically be expected to havegeneral unsecured status in a bankruptcy,although they may remain ongoing costs of areorganized entity and thus reduce the valueavailable to other creditors.

Securitizations. Standard accounts receivablesecuritization programs involve the sale of cer-tain receivables to a bankruptcy-remote specialpurpose entity in an arms length transactionunder commercially reasonable terms. Theassets sold are not legally part of the debtor’sestate (although in some circumstances they



may continue to be reported on the company’sbalance sheet for accounting purposes), andthe securitization investors are completelyreliant on the value of the assets they pur-chased to generate their return. As a result, thesecuritization investors do not have anyrecourse against the estate, although the saleof the assets may affect the value available toother creditors. When a discrete asset valua-tion approach is used and the sold receivablescontinue to be reported on the company’s bal-ance sheet, we will consider the securitizeddebt from such programs to be a secured claimwith priority on the value from the receivableswithin the securitization.

Securitizations may also be in the form of afuture flow-type structure, which securitizesall or a portion of the borrower’s future rev-enue and cash flow (typically related to par-ticular contracts, patents, trademarks, orother intangible assets), would have a claimagainst our estimated valuation. Such transac-tions effectively securitize all or a part of theborrower’s future earnings, and the relatedclaims would have priority claim to the valuestemming from the securitized assets. Thisclaim would diminish the enterprise valueavailable to other corporate creditors. Suchtransactions are typically highly individual-ized, and the amount of the claims and thevalue of the assets in our simulated defaultanalysis are evaluated on a case-by-case basis.

Trade creditor claims. Typically, trade cred-itor claims are unsecured claims that wouldrank pari passu with a borrower’s other unse-cured obligations. However, because a bor-rower’s viability as a going concern hingesupon continued access to goods and services,many pre-petition claims are either paid inthe ordinary course or treated as priorityadministrative claims. This concession to crit-ical trade vendors ensures that they remainwilling to carry on their relationships withthe borrower during the insolvency proceed-ings, which preserves the value of the estateand enhances the recovery prospects for allcreditors. Consequently, our analysis does notmake an explicit estimate for trade creditorclaims in bankruptcy for companies that areexpected to reorganize, but rather, it assumesthat these costs continue to be paid as part of

the company’s normal working capital cycle(and, thus, are already accounted for in ourvaluations using market multiples or DCF).For firms expected to liquidate, an estimateof accounts payable will be made, with theamount treated as an unsecured claim.

Leases. U.S. bankruptcy law provides com-panies the opportunity to accept or rejectleases during the bankruptcy process (forcommercial real property leases, the reviewperiod is limited to 210 days, including aone-time 90-day extension, unless the lessoragrees to an extension). If a lease is accepted,the company is required to keep rent pay-ments on the lease current, meaning thatthere will be no claim against the estate. Thisalso allows the lessee to continue to use theleased asset, with the cash flow (i.e., value)derived from the asset available to supportother creditors.

If a lease is rejected, the company must dis-continue using the asset, and the lessor mayfile a general unsecured claim against theestate. As a result, we must estimate a reason-able lease rejection rate for the firm given thetypes of assets leased, the industry, and oursimulated default scenario. Leases are typi-cally rejected for one of three reasons:● The lease is priced above market rates;● The leased asset is generating negative or

insufficient returns; or● The leased asset is highly vulnerable to

obsolescence during the term of the lease.Our evaluation may ballpark the rejection

rate by assuming it matches the percentagedecline in revenue in our simulated defaultscenario or, if applicable, by looking at com-mon industry lease rejection rates. If leases arematerial, we may further evaluate whetherour knowledge of a company’s portfolio ofleased assets is likely to result in a higher orlower level of unattractive leases (and rejec-tions) in a default scenario. For example, if acompany’s leased assets are unusually old,underutilized, or priced above current marketrates, then a higher rejection rate may be war-ranted. In practice, this level of refinement inour analysis will be most relevant when acompany has a substantial amount of leaseobligations and a significant risk of near-termdefault. Uneconomical leases that are


amended through renegotiation in bankruptcyare considered to be rejected.

In bankruptcy, the amount of unsecuredclaims from rejected leases is determined bytaking the amount of lost rental income andsubtracting the net value available to the lessorby selling or re-leasing the asset in its next bestuse. However, the deficiency claims of com-mercial real estate lessors is further restrictedto the greater of one year’s rent or 15% of theremaining rental payments not to exceed threeyears’ rent. Lessors of assets other than com-mercial real property do not have their poten-tial deficiency claims capped, but such leasesare generally not material and are usually forrelatively short periods of time. With theseissues in mind, Standard & Poor’s quantifieslease deficiency claims for most companies bymultiplying their estimated lease rejection rateby three times their annual rent.

However, there are a few exceptions to ourgeneral approach. Deficiency claims for leasesof major transportation equipment (e.g., air-craft, railcars, and ships) are estimated on acase-by-case basis, with our assumptions dis-closed in our recovery reports. This is neces-sary because these lease obligations do nothave their claims capped, may be longerterm, and are typically for substantialamounts. In addition, we use a lower-rentmultiple for cases in which a company reliesprimarily on very short-term leases (threeyears or less). Furthermore, we do notinclude any deficiency claim for leases heldby individual asset-specific subsidiaries thatdo not have credit support from other entities(by virtue of guarantees or co-lessee relation-ships) due to the lack of recourse againstother entities and the likelihood that thesesubsidiaries are likely to be worthless if theleases are rejected. This situation was relevantin many of the movie exhibitor bankruptciesin the early 2000 time period.

Employment-related claims. Material unse-cured claims may arise when a debtor rejects,terminates, or modifies the terms of employ-ment or benefits for its current or retiredemployees. Principally, these claims wouldarise from the rejection of labor contracts,the voluntary or involuntary termination ofdefined benefit pension plans, or the modifi-

cation of retiree benefits. Because these typesof employee arrangements are not common inmany industries, these liabilities would onlybe relevant for certain companies. Where rel-evant, the key issue is whether these obliga-tions are likely to be renounced or changedafter default, since no claim results if they areunaltered. Of course, employment-relatedclaims are more likely to arise when a com-pany is at a competitive disadvantage becauseof the costs of maintaining these commit-ments. Even then, some past bankruptciessuggest that some companies may not use thebankruptcy process to fully address theseproblems. What is clear, however, is thatemployment-related claims may significantlydilute recoveries for the unsecured creditorsof certain companies and that these risks aremost acute for companies that are grapplingwith burdensome labor costs. To reflect thisrisk, we are likely to include some level ofemployment-related claims for companieswhere uncompetitive labor or benefits costsare a factor in our simulated default scenario.

Collective bargaining agreement rejectionclaims. A borrower that has collective bargain-ing agreements (CBA), including above-marketwages, benefits, or work rules, is likely to seekto reject these contracts in a bankruptcy. Inorder to reject a CBA, the borrower mustestablish, and the bankruptcy court must findthat the borrower has proposed, modificationsto the CBA that are necessary for its successfulreorganization. In addition, the court mustfind that all creditors and affected parties aretreated fairly and equitably, that the borrowerhas bargained fairly with the relevant union,that the union rejected the proposal withoutgood cause, and that equity considerationsclearly favor rejection. Proceedings to reject aCBA typically result in a consensual reductionin wages and benefits, and modified workrules under a replacement or modified agree-ment prior to the bankruptcy court’s decisionon the motion to reject.

If a CBA were rejected, the affectedemployees would have unsecured claims fordamages that would be limited to one year’scompensation plus any unpaid compensa-tion due under the CBA. However, if a CBAwere modified through negotiation without



rejection, the damages for lost wages andbenefits and modified work rules may notbe limited to this amount.

Pension plan termination claims. The abil-ity to terminate a defined benefit pensionplan is provided under the U.S. EmployeeRetirement Income Security Act (ERISA).Under ERISA, these plans may be terminatedvoluntarily by the debtor as the plan sponsor,or involuntarily by the Pension BenefitGuaranty Corp. (PBGC) as the agency thatinsures plan benefits. Typically, any termina-tion during bankruptcy will be a “distress ter-mination,” in which the plan assets are, orwould be, insufficient to pay benefits underthe plan. However, the bankruptcy of theplan sponsor does not automatically result inthe termination of its pension plans, and evenunderfunded plans may not necessarily be ter-minated. For example, a borrower may electto maintain underfunded plans, or may notsucceed in terminating a plan, if it fails todemonstrate that it would not be able to payits debts and successfully reorganize unlessthe plan is terminated.

In a distress termination, the PBGCassumes the liabilities of the pension plan upto the limits prescribed under ERISA and getsan unsecured claim in bankruptcy against thedebtor for the unfunded benefits. The calcula-tion of this liability is based on differentassumptions than the borrower’s reported lia-bility in its financial statements. This, in addi-tion to the difficulty of predicting the fundedstatus of a plan at some point in the future,complicates our ability to accurately assessthe value of these claims.

Retiree benefits modification claims. Non-pension retiree benefits are payments toretirees for medical, surgical, or hospital

care benefits, or benefits in the event of sick-ness, accident, disability, or death. Therequirements for modifying these benefitsfor plans covered under a union contractduring bankruptcy are similar to the require-ments for the rejection of a CBA, but theymay be modified by order of the bankruptcycourt without rejecting the plan or programunder which the benefits are provided in itsentirety. However, these obligations areoften amended prior to bankruptcy for com-panies that are placed at a competitive dis-advantage because of these costs. As such,we must consider whether the borrower hasmodified, or is likely to modify, the benefitsprior to bankruptcy.

In the case of benefits provided to employ-ees that were not represented by unions, theborrower may be able to revise the benefitsprior to bankruptcy with little or no negotia-tion with the retirees. For union retirees, ben-efit modifications prior to bankruptcy likelywould occur in the context of concessions innegotiations with the relevant union. In eithercase, modifications prior to bankruptcywould not result in claims in bankruptcy thatcould dilute recoveries. If the borrowerreduces its retiree benefits liability prior tobankruptcy, further modifications in bank-ruptcy may result in a smaller unsecuredclaim than if it had entered the proceedingwith a greater liability. If we conclude thatthe borrower will modify its retiree benefitsprior to bankruptcy, our recovery analysiswill consider the likely effect of that modifi-cation on the borrower’s reduced benefit lia-bility in bankruptcy. Conversely, if weconclude that these plans will be modified inbankruptcy, but not before, then the potentialliability will be more significant. ●

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Key Contacts


Bank Loan &Recovery RatingsNew York

Marketing and Syndication LiaisonScott CassieV.P. & North American Head—IndustrialsClient Business [email protected]

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David HauffDirector, Loan & Recovery Rating [email protected]

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Sucheet [email protected]

S&P/LSTA LeveragedLoan IndexRobert PolenbergVice [email protected]

Standard & Poor’s EuropeanLeveraged Loan IndexSucheet [email protected]

Syndicated Bank Loan EvaluationsMark AbramowitzDirector Taxable [email protected]

Jason OsterSenior Pricing [email protected]

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s&p a guide to the loan market - sept 2011

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