funding sources in troubled times · funding sources in troubled times ravi bhagavatula, cfa...

Funding Sources In Troubled Times

Ravi Bhagavatula, CFA

Managing Director

Special Assets Group

Republic Financial Corporation

January 28, 2009

Howard BaileySenior Vice PresidentGE Commercial Finance

2

“The Perfect Storm”

1.

Uncertainly in the Economic Environment

2.

Unprecedented Credit Problems at Financial Institutions

3.

Fewer Lending Sources

4.

Collapsed Loan Syndication Market

5.

Shrinking Number of Financial Products

6.

Increasing Relevancy of 4C’s –

Credit Risk, Credit Support, Credit Capacity and Covenants

3

U.S. Loan Market Review: “BOOM to BUST”

Year 2008 proved to be disastrous for the loan market , while the outlook for 2009 is not looking any better.

Banks were focused on repairing their balance sheets and had little appetite for underwriting riskier deals.

Loan issuance in the U.S. for 2008 came in at only $763.98 billion, which is down 55% from 2007.

Loan issuance contracted across all segments:Leveraged loan issuance decreased by 57% in 2008 to $294.45 billion;

Loans purchased by institutional investors, such CLOs, contracted in 2008 by 84% to $69.6 billion;

Loans backing leveraged buyouts, which fueled the growth of the loan asset class for the last several years, were down by 80% to just $41.3 billion;

U.S. high yield bond issuance during 2008 was only at $39.5 billion, a fall of 71% compared to a year ago†; and

Investment grade lending for the year was off by 52% and ended up at $318.8 billion

Percentage Change (%)

Overall*** 1,686.81 763.98 -55%Investment Grade 657.75 318.77 -52%Leveraged*** 688.5 294.45 -57%Institutional*** 425.81 69.6 -84%LBO* 209.91 41.28 -80%HY Bonds 136.33 39.51 -71%

U.S. New Money Issuance**

2007 Issuance ($Bils.)


Percentage Change (%)

Overall *** 838.95 437.9 -48%Investment Grade 209.32 161.05 -23%Leveraged*** 471.81 193.5 -59%Institutional*** 315.09 59.46 -81%

U.S. Total Issuance



Source: Thomson Reuters LPC†

Reuters Fixed Income Data/EJV.

*Excludes bridge loans **Includes only new financings, such as M&A, LBO, dividend payments, and incremental fundraising *** Excludes secondary institutional sell-downs

Market Statistics

4

Consumer Confidence IndexLabor markets are expected to deteriorate further in 2009. According to Wachovia economists, unemployment may top around 9.5% in 2010.

Consumer confidence is expected to be depressed during 2009.

Source: U.S. Outlook, Wachovia Economics Group

•

More than 1.5 million jobs lost•

Total hours worked plummeted at a 7.7% annual rate

1. Uncertainly in the Economic Environment

5

Real GDPReal GDP is expected to be -5.3% annual rate. The decline in GDP will persist for another five consecutive quarters (possibly the longest decline).

Recovery is not expected until sometime in 2010.

Source: U.S. Outlook, Wachovia Economics Group


6

Excesses in Credit Markets

Credit expansion led to the unprecedented economic growth over the past few decades, especially during the recent upturn that lasted from 2001 to 2007.

Excesses in the credit markets were rampant and characterized by relaxed lending standards.

Sharp curtailment of credit has led to the current economic downturn.

With unemployment rising, consumers will also likely remain reluctant to add to their debt burden.

It is anticipated that the efforts by government may prevent credit from completely freezing up, but credit will be harder to get in 2009.

Source: Federal Reserve Board, U.S. Department of Commerce and Wachovia


7

Declining Corporate Earnings

Forward 2009 S&P 500 earnings estimates have been declining quickly, but still show a second-half recovery.

There is optimism that liquidity is starting to work its way through the markets, and that additional stimulus and guarantee programs will give consumers confidence.

Source: S&P 500


8

Leveraged Loans & High Yield

As of August 2008Source: Standard and Poor’s and Goldman Sachs Research

2005-2007 saw an unprecedented amount of new issuances for leveraged and high yield debt instruments, in excess of USD 1.4 Trillion and USD 490 Billion, respectively.


9

Speculative Grade Default Rate

“Corporate default rate have significantly increased in 2008.”Source: Wall Street Research

Sourcce: Capital IQ Market Observation Nov‘

08

Number of Corporate Defaults

Based on Capital IQ, the projected speculative default rate for next 12 months is expected to between 6.1% to 9.6%.

Credit Problems at Financial Institutions1. Uncertainly in the Economic Environment

Shaded areas are periods of recession as defined by the National

Bureau of Economic Research (NBER)

10

Bank FailuresFailed bank asset amounts, in the aggregate, have reached unprecedented levels while the number of failed banks is relatively small.

Number of banks with problems has nearly doubled since 2000.

2. Credit Problems at Financial Institutions

Source: U.S. Distress Debt Monitor: Distress Ratio Continues to Soar

11

Are Banks “Hoarding” Cash?

‘Cash on hand’ at the U.S. commercial banks rose by $700 Billion from June ’08 to Dec ’08.

Liabilities rose by $250 Billion during the same period.

Residuals ( Assets – Liabilities) rose by ONLY $33 Billion during the same period.

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Bank Loans and Leases / Total Assets($s in billions)

Loans and Leases Cash Other Assets

Source: Current and Historical H.8 data from the Federal Reserve Board


12

Are Banks Lending?Loans and Leases (includes the allowance for loan and lease losses) rose by $233 Billion† from June ’08 to Jan ’09.

Loans and Leases as a percentage of total assets declined by 4% during the same period.

Loans and Leases as % of Total Assets

55.00%

56.00%

57.00%

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59.00%

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63.00%

64.00%

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Loans/Leases to Assets %

Source: Current and Historical H.8 data from the Federal Reserve Board


†

Includes significant revolver draw downs toward year-end.

13

Defaults by Asset Class

Continued widening of non-performing assets and delinquent loan balances, as compared to net charge-offs, indicates substantial amount of debt charge offs on the horizon.


14

Current Situation with Lending SourcesMoney Center Banks

Large credits and higher quality

ABL structures

Regional Banks

Geographic niche

Slowdown in middle market lending

Commercial Finance Companies

Few remaining

Very selective

BDCs

Funding constraints

No new capital

Hedge Funds

Few remaining

Higher yield deals

Mezzanine Funds

Very selective

Premium pricing with warrants

3. Fewer Lending Sources

15

CLO Market“Leveraged loan paper was driven by a reliable bid by CLOs, which accounted for approximately $100 billion in early 2007. Recently though, issuance of CLOs has collapsed.”

CLO issuance down by more than 90% in 2008

Source: James H.M. Sprayregen: Goldman, Sachs & Co.

4. Collapsed Loan Syndication Market

16

Financial Products Between 1H03 – 1H07

5. Shrinking Number of Financial Products

17

Financial Products (2H07 – Present)

5. Shrinking Number of Financial Products

18

Increasing Relevancy of 4C’s

Credit RiskCredit

SupportCredit

CapacityCovenants New Issues+ + + =

Risk Mitigation

Credit Risk – The probability that the company is not able to make their contractual payments and the recovery probability of principal in event of default.Credit Support – Source of funds available to pay debt either through collateral (quality, spread and marketability) or cash flow (adequacy, volatility and certainty).Credit Capacity – How much debt a firm can incur and can be supported by cash flows - based on magnitude and stability of cash flows. Covenants– Covenant-Lite deals ended in 1H 2007. More formal credit standard are being upheld, such as: terms not being stretched, covenants with 10-15% cushion are being required, mandatory amortization and more manageable balloon at maturity.

6. Increasing Relevancy of 4C’s

19

Funding SourcesThe number of active participants in the senior lending market has shrunk., Senior lenders are cautious and structures are more conservative.

Decreasing number of senior lenders is causing pricing to increase, while the availability of senior funding decreases.

Mezzanine lending is becoming expensive. Due primarily to other investment opportunities in the secondary market offering attractive unlevered returns (in excess of 15%).

Availability of DIP financing is at historical lows. Pricing has gone up and duration of DIP is shrinking.

Exit financing for bankrupt companies is very limited.

Despite negativity in the market, well run and well capitalized businesses will still be able to receive competitive terms from liquid banks.

Funding Sources that are actively lending in this market: Golub Capital, Charter One Bank, Churchill Financial, Madison Capital Funding and Core Business Credit.

A new government-backed bank, an “Aggregator Bank”, to remove toxic assets from lenders’ balance sheets will help the commercial banks and potentially unfreeze the credit markets.

20

Indicative Terms - Trends

†

Nearly half of all loans included LIBOR floor††

Source: Ron Khan, Lincoln International

< $10mm EBITDA $10 - 20mm EBITDA†† > $20mm EBITDA††

Total Debt Multiple 2.0-3.0x 3.75-4.25x 4.00-4.75x

Senior Debt Multiple 2.0-3.0x 2.5-3.0x 2.75-3.25xSub/Mzz Debt Multiple N/A 1.25-2.25x 1.25-2.5x

Pricing†

1st lien L+500 L+450 L+4502nd lien N/A L+800 L+800Mezz N/A 12%, Cash 4-6% PIK 12%, Cash 2-4% PIK

Amortization1st lien 15-20% annually 5-10% annually 5-10% annually2nd lien N/A Bullet Bullet

Typical Loan Terms:

Terms are not being stretched;Covenants with 10-15% cushion is being required;Mandatory amortization;Manageable balloon at maturity;Excess cash flow recapture requirements;Pre payment penalties;Limitation on Capex; and Permitted acquisitions and dividend distribution

21

RecapSituation will get worse before it gets better. Default rates are likely to reach 15-17% by 2H08.

Commercial Banks are judiciously using capital. Flight to quality is creating a higher bar for companies to obtain leverage.

Banks are de-levering their balance sheets leading to less capital for lending, higher cost of capital and stricter underwriting.

Without CLO market, major finance companies are challenged to raise capital and forced to draw down their warehouse lines. This is leading to less capital for lending.

Sponsors who were able to add leverage for returns will be required to create value in the companies they own.

Senior debt multiples will continue to tighten and Mezzanine lending will become more prevalent in the capital structure.

Will the current credit dislocation result in a permanent change in lending?

LEGAL DISCLAIMERANY ESTIMATES AND PROJECTIONS CONTAINED IN THIS PRESENTATION HAVE BEEN PREPARED BY REPUBLIC FINANCIAL CORPORATION, AND INVOLVE SIGNIFICANT ELEMENTS OF SUBJECTIVE JUDGMENT AND ANALYSIS OF DATA

OBTAINED FROM MANY SOURCES, WHICH MAY OR MAY NOT BE CORRECT. NEITHER REPUBLIC FINANCIAL CORPORATION, NOR ANY OF ITS RESPECTIVE AFFILIATES OR REPRESENTATIVES MAKES, AND THEY EXPRESSLY DISCLAIM, ANY REPRESENTATION OR WARRANTY (EXPRESSED OR IMPLIED) AS TO THE ACCURACY OR COMPLETENESS OF ANY OF THE INFORMATION OR STATEMENTS CONTAINED IN THIS PRESENTATION OR ANY OTHER WRITTEN OR ORAL COMMUNICATION TRANSMITTED OR MADE AVAILABLE TO ANY PARTY, AND NEITHER REPUBLIC FINANCIAL CORPORATION, NOR ITS AFFILIATES OR REPRESENTATIVES SHALL HAVE, AND THEY EXPRESSLY DISCLAIM, ANY AND ALL LIABILITY FOR, OR BASED IN WHOLE OR IN PART ON, SUCH INFORMATION, STATEMENTS OR OTHER WRITTEN OR ORAL COMMUNICATION (INCLUDING WITHOUT LIMITATION ANY EXPRESSED OR IMPLIED REPRESENTATIONS), ERRORS THEREIN, OR OMMISSIONS THEREFROM. THIS PRESENTATION SHOULD NOT BE CONSTRUED AS PROFESSIONAL ADVICE

ON ANY PARTICULAR SET OF FACTS OR CIRCUMSTANCES.

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