A Guide to the Loan MarketSeptember 2011I dont like surprisesespecially in my leveraged loan portfolio.Thats why I insist on Standard & Poors Bank Loan & Recovery Ratings.All loans are not created equal. And distinguishing the well secured from those thatarent is easier with a Standard& Poors Bank Loan & Recovery Rating. Objective,widelyrecognizedbenchmarksdevelopedbydedicatedloanandrecoveryanalysts,Standard&PoorsBankLoan&RecoveryRatingsaredeterminedthroughfundamental, deal-specic analysis. The kind of analysis you want behind you whenyoure trying to gauge your chances of capital recovery. Get the information you need.Insist on Standard & Poors Bank Loan & Recovery Ratings.The credit-related analyses, including ratings, of Standard & Poors and its affiliates are statements of opinion as of the date they are expressed and not statements of fact orrecommendations to purchase, hold, or sell any securities or to make any investment decisions. Ratings, credit-related analyses, data, models, software and output therefromshould not be relied on when making any investment decision. Standard & Poors opinions and analyses do not address the suitability of any security. Standard & Poors doesnot act as a fiduciary or an investment advisor.Copyright 2011 Standard & Poors Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.STANDARD & POORS is a registered trademark of Standard & Poors Financial Services LLC.New ork WiIIia 6hew212.438.1981biII_chew@staodardaodpoors.coLoodoo FauI Watters+44.201.11.3542pauI_watters@staodardaodpoors.co www.staodardaodpoors.coA Guide To The Loan MarketSeptember 2011Copyright 2011 by Standard & Poors Financial Services LLC (S&P) a subsidiary of The McGraw-Hill Companies, Inc. 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Additional information about our ratings fees is availableat www.standardandpoors.com/usratingsfees.Steven Miller William ChewStandard & Poors A Guide To The Loan Market September 2011 3To Our ClientsStandard & 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 aswell as our analytical approach to evaluating loss and recovery in the event of default.Standard & Poors Ratings is the leading provider of credit and recovery ratings for leveragedloans. 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 & Poors 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 theleading 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 & Poors 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 contactinformation 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 todominic_inzana@standardandpoors.com 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 marc_auerbach@standardandpoors.com or(1) 212-438-2703. You can also follow us on Twitter, Facebook, or LinkedIn.ContentsA Syndicated Loan Primer 7Rating Leveraged Loans: An Overview 31Criteria Guidelines For Recovery Ratings On Global IndustrialsIssuers Speculative-Grade Debt 36Key Contacts 53Standard & Poors A Guide To The Loan Market September 2011 5At 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 borrowersissuers 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 inA Syndicated Loan Primer Asyndicated loan is one that is provided by a group of lendersand is structured, arranged, and administered by one orseveral 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 wayfor issuers to tap banks and other institutional capital providersfor 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) 212-438-2715steven_miller@standardandpoors.comStandard & Poors A Guide To The Loan Market September 2011 7www.standardandpoors.com 8arranging 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 demandin some cases within apredetermined rangeas 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, thearranger 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 dealAn 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 creditsfundamentals, 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 syndicationA 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 notcloseor 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.A Syndicated Loan PrimerClub dealA 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 bookBefore 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 companys 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 IMsalong with otherinformation related to the loan, pre- andpost-closingto 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,managements 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 companys industry and competitiveposition relative to its industry peers.The financial model will be a detailedmodel of the issuers historical, pro forma,and projected financials including manage-ments 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 requireStandard & Poors A Guide To The Loan Market September 2011 9www.standardandpoors.com 10different 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 marketThere 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, andalthough they are becoming increasingly lesscommonamortizing 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 asprime 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 AAArated 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 notrated. 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 leveragedtypically 3 to 5timesand 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, CLOsshare had fallen to roughly 30%.Loan mutual funds are how retail investorscan access the loan market. They are mutualfunds that invest in leveraged loans. Thesefundsoriginally known as prime fundsbecause they offered investors the chance toearn the prime interest rate that banks chargeon commercial loanswere first introducedin the late 1980s. Today there are three maincategories of funds: Daily-access funds: These are traditionalopen-end mutual fund products into whichinvestors can buy or redeem shares eachday at the funds net asset value. Continuously offered, closed-end funds:These were the first loan mutual fundproducts. Investors can buy into thesefunds each day at the funds 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, theyA Syndicated Loan Primerare only able to do so when the fund istrading at a premium to NAV, howeveraprovision that is typical of closed-end fundsregardless of the asset class.In March 2011, Invesco introduced thefirst 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 werenot (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, bytheir 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 vastmajority 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), orStandard & Poors A Guide To The Loan Market September 2011 11Assets under management (bil. $)Eaton Vance Management 13.39Fidelity Investments 12.12Hartford Mutual Funds 7.25Oppenheimer Funds 6.39Invesco Advisers 4.44PIMCO Funds 4.16Lord Abbett 4.16RidgeWorth Funds 4.13Franklin Templeton Investment Funds 2.71John Hancock Funds 2.61Source: Lipper FMI.DWS Investments 2.61T. Rowe Price 2.00BlackRock Advisors LLC 1.84ING Pilgrim Funds 1.84RS Investments 1.51Nuveen Investments 1.37MainStay Investments 1.34Pioneer Investments 0.88Highland Funds 0.74Goldman Sachs 0.64Largest Loan Mutual Fund Managerswww.standardandpoors.com 12some 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 onthe 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. Butits 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. Constitutions FirstAmendment and report on information ina way that anyone can simultaneouslyreceive itfor a price of course.Therefore, the information is essentiallymade public in a way that doesnt deliber-ately disadvantage any party, whether itsa news story discussing the progress of anamendment or an acquisition, or its aprice change reported by a mark-to-mar-ket service. This, of course, doesnt dealwith the underlying issue that someonewho is a party to confidential informationis making it available via the press orprices to a broader audience.A Syndicated Loan PrimerAnother 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 riskDefault risk is simply the likelihood of a bor-rowers being unable to pay interest or princi-pal on time. It is based on the issuersfinancial 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 & Poors 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 theoverall 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 riskLoss-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 earlythat is, before other credi-torsand 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 statisticsCredit 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-Standard & Poors A Guide To The Loan Market September 2011 13www.standardandpoors.com 14agements projections and the assumptionsbehind these projections to see if the issuersgame 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 sectorIndustry 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.SponsorshipSponsorship 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 sponsors equity fund. Among institu-tional investors, weight is given to an individ-ual deal sponsors 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 revolvingcredit 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-A Syndicated Loan Primercals. 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 investorsSince 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 attractivereturnswhether 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 loans yield, but also at othersources of revenue from the relationship,including noncredit businesseslike cash-management services and pension-fund man-agementand economics from other capitalmarkets activities, like bonds, equities, orM&A advisory work.This process has had a breathtaking resulton the leveraged loan marketto 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 lions 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 andother fee-generating business to banks thatare part of its loan syndicate.Pricing loans for institutional playersFor 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,its 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 daysbeforeinstitutional investors were the dominantinvestors and banks were less focused onportfolio managementthe size of a loandidnt 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 executionsgenerally those of$200 million or lesstend 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-Markets EffectBeginning in 2000, the SEC directed bankloan mutual fund managers to use availablemark-to-market data (bid/ask levelsreported by secondary traders and compiledStandard & Poors A Guide To The Loan Market September 2011 15www.standardandpoors.com 16by 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 issuers 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 areoptions for swingline loans, multicurrency-borrowing, competitive-bid options, term-out, and evergreen extensions); A term loan; An LOC; and An acquisition or equipment line (adelayed-draw term loan).A revolving credit line allows borrowersto 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 creditscalled, notsurprisingly, 364-day facilitiesare 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) allowsborrowers 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-rowerwith consent of the syndicategroupto 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, orTLa) 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-lienA Syndicated Loan Primerloans 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 abridge 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 issuersstruggling with liquidity problems. By 2007,the market had accepted second-lien loans tofinance a wide array of transactions, includingacquisitions and recapitalizations. Arrangerstap nontraditional accountshedge funds,distress investors, and high-yield accountsaswell 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. Heres 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-lienStandard & Poors A Guide To The Loan Market September 2011 17www.standardandpoors.com 18lenders 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 suggestLatham & Watkins terrific overview andanalysis of second-lien loans, which waspublished on April 15, 2004 in the firmsCreditAlert 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. Whats 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. Whats 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 thathandles all interest and principal paymentsand monitors the loan.A Syndicated Loan Primer 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.AssignmentsIn 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, butthese 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 witharrangeror a deterrent to not trade away,depending on your perspectivebecause a$3,500 fee amounts to between 7 bps to 35bps of a $1 million to $5 million trade.Primary assignmentsThis 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.ParticipationsA participation is an agreement between anexisting lender and a participant. As thename implies, it means the buyer is takinga participating interest in the existinglenders 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.Standard & Poors A Guide To The Loan Market September 2011 19www.standardandpoors.com 20Loan DerivativesLoan credit default swapsTraditionally, 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 doesnt 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. Cashsettlement could also be employed if theresnot enough paper to physically settle allLCDS contracts on a particular loan.LCDXIntroduced 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.A Syndicated Loan PrimerHeres 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, plus200 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 amountor equity contri-butionof $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-sonmarket spreads widen, it is down-graded, its financial conditiondeterioratesthe 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 TermsRatesLoans 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 borrowers 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 banks 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 (thebanks own funding rate).LIBOR floorsAs 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.FeesThe 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 atclose. 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 lenders 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 initialStandard & Poors A Guide To The Loan Market September 2011 21www.standardandpoors.com 22commitment, 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 lenders 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 aprimary 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 facilitysentire 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 oneand 1% in year two. The fee may beapplied to all repayments under a loan orsoft 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 severaltypes. The most commona fee for standbyor financial LOCsguarantees 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 FeesAt 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.A Syndicated Loan PrimerFrom the perspective of the lender, actually,there isnt 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 rightsAmendments 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 asimple 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 materialchanges 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 borrowers 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 borrowersactivities in some way, such as regarding newinvestments. Negative covenants, which arehighly structured and customized to a bor-rowers 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 higherStandard & Poors A Guide To The Loan Market September 2011 23www.standardandpoors.com 24level of current assets than of current liabili-ties. The presence of these maintenancecovenantsso called because the issuer mustmaintain quarterly compliance or suffer atechnical default on the loan agreementis acritical difference between loans and bonds.Bonds and covenant-lite loans (see above), bycontrast, usually contain incurrence covenantsthat restrict the borrowers 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 companys 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 borrowers risk increases, financialcovenants in the loan agreement becomemore tightly wound and extensive. In general,there are five types of financial covenantscoverage, leverage, current ratio, tangible networth, and maximum capital expenditures: A coverage covenant requires the borrowerto 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 ascash 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 flowand equity issuance are waived if the issuermeets a preset financial hurdle, most oftenstructured as a debt/EBITDA test.Collateral and other protective loan provisionsIn 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,A Syndicated Loan Primerwith 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 releaseSome loans have provisions that borrowersthat sit on the cusp of investment-grade andspeculative-grade must either attach collateralor release it if the issuers 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 issuers credit quality deterio-rates. Often, an issuers 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 controlInvariably, 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 issuers equity by a third party, or achange in the majority of the board of direc-tors. For sponsor-backed leveraged issuers,the sponsors lowering its stake below a pre-set amount can also trip this clause.Equity curesThese provision allow issuers to fix acovenant violationexceeding the maximumdebt to EBITDA test for instanceby 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 thinkits 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 dont limitthe number of equity cures while others capthe number to, say, one a year or two overthe life of the loan. Its 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 lendingMost of the information above refers tocash 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 issuers 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%Standard & Poors A Guide To The Loan Market September 2011 25www.standardandpoors.com 26range. In addition, the borrowing base maybe further divided into subcategoriesforinstance, 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 structuresMost 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 guaranteesThose 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 pledgeThis 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 maththe art of spread calculationCalculating 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 issuers 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 doesnt meet a financialcovenant test or fails to provide lenders withfinancial information or some other viola-tion that doesnt involve payments.When this occurs, the lenders can acceler-ate the loan and force the issuer into bank-ruptcy. Thats 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.A Syndicated Loan PrimerIf 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 issuers 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 debtors 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 len