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By David Brooke
NEW YORK, April 24 (LPC) - The imbedded risk of US leveraged loan packages with reduced lender protections is not reflecting on the trading values, to the dismay of investors who want to see a greater premium for the heightened risk exposure.
Some of the largest leverage buyouts completed last year, including financings for Refinitiv and Envision, pushed the boundaries on documentation, securing tight pricing and narrow discounts with little pushback from a market that had seen red-hot demand for loans paired with low supply.
“There should be more of a gap in the price and yield of deals that are constructed conservatively versus those that have super loose documentation,” said Leland Hart, head of US loans and high yield at Alcentra, an asset manager. “The implied variability in recovery rates due to loose documentation and potential dispersion of outcomes to the lender should be better reflected in the way a loan trades.”
But a number of those deals since breaking for trading have changed hands in the secondary market close to or above the discounts they were sold at, raising concern among investors that such loans do not offer adequate return for their risk.
Priced aggressively at the outset, these loans held steady at the issuance price or even moved higher in secondary trading. But those looking toward the secondary market for yield are feeling the pinch, as the little paper available is not priced all that attractively considering the shrinking protections.
In an efficient market, assets perceived as “riskier” should trade at lower levels as their values factor in a premium. Investors would bid up loans with stronger protections and steer clear from the more aggressive offerings, said one portfolio manager.
Refinitiv’s US$6.5bn term loan B issued last year to back its US$20bn buyout by Blackstone was quoted at 98.95 by IHS Markit on Tuesday and its €2.7bn portion at 100.03, close to the 99.75 original issue discount (OID) that cleared the market when the deal priced. Investors cited the flexibility around taking cash out at the expense of senior creditors, restricted payments and lien subordination as key concerns in Refinitiv’s documentation that should translate into a deeper price drop.
LPC is a unit of Refinitiv.
“The flexible documentation is not materially priced in. Refinitiv trades a point or two below where it should comparatively. Is that the right premium for a credit agreement that is aggressive with so many loopholes?” said a portfolio manager. “It should be traded with an embedded premium, but the loan market is not efficiently priced.”
Akzo Nobel’s US$4.34bn TLB was quoted at 100.09 and its €2.1bn TLB at 100.375, above its OID of 99.75. Envision’s US$5.45bn was quoted at 96.23 after clearing with a 99.75 OID, according to IHS Markit. Private equity firm Carlyle, alongside Singaporean investment firm GIC, acquired Akzo Nobel in a €10.1bn buyout, while KKR purchased Envision for US$9.9bn.
Covenant Review ranks the quality of a loan’s documentation, with 1 being the most protective for lenders and 5 marked as seriously deficient. Collateral protection is the most heavily weighted consideration.
Refinitiv scored a 5+ for default protection, while Akzo Nobel received a 5+ for collateral protection. Both credits plus Envision scored 5+ for adjusted Ebitda. There were also high scores for builder baskets and ability for borrowers to amend the loan.
“Third parties are providing covenant review services at present, and recently are including numerical values for covenants individually and as a whole package. This will lead to a difference in where deals trade on the secondary market for a very aggressive covenant package as well as impact the cost to issue aggressive deals in the first place,” said Hart.
Despite the market’s inefficiencies, investors, looking to diversify their portfolios, are still taking what’s available.
“Investing in these new-issue loan deals may be seen by some managers as ‘renting’ credits, rather than a long-term underwrite. For some portfolios, exposure to these deals can be significant, but it’s a high-risk proposition,” said Dagmara Michalczuk, portfolio manager for Tetragon Credit Income Partners.
While the bigger deals with aggressive docs are trading at robust levels, the secondary loan market paints a seemingly contradictory picture given some new issuance has suffered amid a shrinking investor base.
Retailer Staples, for instance, saw its US$2bn loan funding a dividend recapitalization drop a point to 98.25-98.375 on the break after wrapping up earlier this month, among the largest issuances this year in a slow leveraged loan market.
Loans are trading lower than they used to be. After a volatile winter when the number of loans trading at or above par hit a three-year low of just 1% in December, the number of loans trading at those levels rose to 13.55% on Tuesday, according to LPC data. It is still well below the 47% in October before the market sell-off.
The S&P/LSTA US Leveraged Loan 100 Index, meanwhile, shows returns for year to date at a healthy 7%.
“It has been a very strong start to the year from a return perspective, but when you look at the secondary market today, it doesn’t look as strong as returns suggest,” said Robert Hoffman, head of investment research at FS Investments. (Reporting by David Brooke. Editing by Michelle Sierra, Lynn Adler and Kristen Haunss.) ))