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1. What is a Leveraged Loan?

2. Leveraged Loan Purposes
3. Market background
What is a Leveraged Loan?
4. How are Loans Syndicated? A leveraged loan is a commercial loan provided by a group of lenders. It is first structured, arranged, and
5. Types of Syndications administered by one or several commercial or investment banks, known as arrangers. It is then sold, (or
6. The Bank Book (IM) syndicated) to other banks or institutional investors.
7. Leveraged Loan Investor Market
8. Public vs. Private Markets
Defining "leveraged"
9. Credit Risk – Overview
10. Syndicating a Loan – by Facility Just what qualifies as a leveraged loan is a discussion of long standing.
11. Pricing a Loan – Primary Market
Some participants use a spread cut-off. For example, any loan with a spread of at least LIBOR+125, or maybe
12. Types of Syndicated Loan
LIBOR+150, would qualify as “leveraged.”
Facilities
13. Second-Lien Loans Others use rating criteria: any loan rated BB+ or lower would qualify.
14. Covenant-Lite Loans
15. Lender Titles But what of loans that are not rated?
16. Secondary Sales
At LCD we have developed a more complex definition. We include a loan in the leveraged universe if:
17. Loan Derivatives
18. Pricing Terms/Rates it is rated BB+ or lower or
19. Fees it is not rated or rated ‘BBB-‘ or higher but has
20. Original-Issue Discounts
(1) a spread of LIBOR +125 or higher and
21. Voting Rights
(2) is secured by a first or second lien
22. Covenants
23. Mandatory Prepayments Under this definition, a loan rated BB+ that has a spread of LIBOR+75 would qualify as leveraged, but a nonrated
24. Collateral loan with the same spread would not.
25. Spread Calculation
It is hardly a perfect definition, but one that LCD thinks best captures the spirit of loan market participants when
26. Default/Restructuring they talk about “leveraged loans.”
27. Amend-to-Extend
28. Download the Primer
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 28. Download the Primer
29. Author, Copyright Leveraged Loan Purposes
For the most part, issuers undertake leveraged loans for four reasons:

To support an M&A-related transaction

To back a recapitalzation of a company’s balance sheet
To refinance debt
To fund general corporate purposes or project finance

M&A/LBOs
M&A is the lifeblood of leveraged finance. There are the three primary types of acquisition loans:

1) Leveraged buyouts (LBOs)

Most LBOs are backed by a private equity firm, which funds the transaction with a significant amount of debt in the
form of leveraged loans, mezzanine finance, high-yield bonds and/or seller notes. Debt as a share of total sources of
funding for the LBO can range from 50% to upwards of 75%. The nature of the transaction will determine how highly
it is leveraged. Issuers with large, stable cash flows usually are able to support higher leverage. Similarly, issuers in
defensive, less-cyclical sectors are given more latitude than those in cyclical industry segments. Finally, the
reputation of the private equity backer (sponsor) also plays a role, as does market liquidity (the amount of
institutional investor cash available). Stronger markets usually allow for higher leverage; in weaker markets lenders
want to keep leverage in check.

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 Obviously, LBO activity depends on how active the M&A mark et is. During the most-recent M&A boom cycle, in
2006-07, transaction volume of LBOs and leveraged loans back ing them hit record highs as bank s scrambled to
originate these deals – usually earning hefty fees – while institutional investors clamored to invest in these
credits. After the Lehman Bank ruptcy in 2008 and subsequent economic free-fall, of course, the LBO/ LBO loan
mark ets all but disappeared. They began to recover in 2011, with more cautious deals, pick ing up noticeably in
2013. Marquee “jumbo” LBO loans, however, remain scarce.

There are three main types of LBO deals:

Public-to-private (P2P) – also called go-private deals – in which the private equity firm purchases a publicly
traded company via a tender offer. In some P2P deals a stub portion of the equity continues to trade on an
exchange. In others the company is bought outright
Sponsor-to-sponsor (S2S) deals, where one private equity firm sells a portfolio property to another
Non-core acquisitions, in which a corporate issuer sells a division to a private equity firm.

2) Platform acquisitions

Transactions in which private-equity-backed issuers buys a business that they judge will be accretive by either

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 creating cost savings and/or generating expansion synergies.

3) Strategic acquisitions

These are similar to a platform acquisitions but are executed by an issuer that is not owned by a private equity firm.

Recapitalizations
Recapitalizations
A leveraged loan backing a recapitalization results in changes in the composition of an entity’s balance sheet mix
between debt and equity either by (1) issuing debt to pay a dividend or repurchase stock or (2) selling new equity, in
some cases to repay debt.

Some common examples:

Dividend. Dividend financing is straightforward. A company takes on debt and uses proceeds to pay a
dividend to shareholders. Activity here tends to track market conditions. Bull markets inspire more dividend
deals as issuers tap excess liquidity to pay out equity holders. In weaker markets activity slows as lenders
tighten the reins, and usually look skeptically upon transactions that weaken an issuer’s balance sheet.
Stock repurchase. In this form of recap deal a company uses debt proceeds to repurchase stock. The effect
on the balance sheet is the same as a dividend, with the mix shifting toward debt.
Equity infusion. These transactions typically are seen in distressed situations. In some cases, the private
equity owners agree to make an equity infusion in the company, in exchange for a new debt package. In
others, a new investor steps in to provide fresh capital. Either way, the deal strengthens the company’s
balance sheet.
IPO (reverse LBO). An issuer lists – or, in the case of a P2P LBO, relists – on an exchange. As part of such
a deleveraging the company might revamp its loans or bonds at more favorable terms.

Refi/GCP/Build-outs
Refinancing
Simply put, this entails a new loan or bonds issue to refinance existing debt.

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 When mark et technicals favor issuers, companies and private equity firms rush in for opportunistic credits.
During 2013, for instance, CLO issuance boomed, filling investor coffers, leading to record repricing volume.

General corporate purposes

These deals support working capital, general operations and other business-as-usual purposes.

Build-outs
Build-out financing supports a particular project, such as a utility plant, a land development deal, a casino or an
energy pipeline.

Market background
Starting with the large leveraged buyout (LBO) loans of the mid-1980s, the leveraged/syndicated loan market has
become the dominant way for corporate borrowers (issuers) to tap banks and other institutional capital providers for
loans. The reason is simple: Syndicated loans are less expensive and more efficient to administer than traditional
bilateral – one company, one lender – credit lines.

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 After plummeting in 2008-09, thank s to the financial mark et meltdown that started with the Lehman
Brothers collapse, the US leveraged loan mark et has rebounded in impressive fashion, hitting an
all-time high of $605 billion in “new money” deals during 2013.

Arrangers serve the time-honored investment-banking role of raising investor dollars for an issuer in need of capital.
The issuer pays the arranger a fee for this service and, naturally, this fee increases with the complexity and
riskiness of the loan.

As a result, the most profitable loans are those to leveraged borrowers – those whose credit ratings are speculative
grade (traditionally double-B plus and lower), and who are paying spreads (premiums above LIBOR or another base
rate) sufficient to attract the interest of nonbank term loan investors, (that spread typically will be LIBOR+200 or
higher, though this threshold rises and falls, depending on market conditions).

By contrast, large, high-quality, investment-grade companies – those rated triple-B minus and higher – usually
forego leveraged loans and pay little or no fee for a plain-vanilla loan, typically an unsecured revolving credit
instrument that is used to provide support for short-term commercial paper borrowings or for working capital (as
opposed to a fully drawn loan used to fund an acquisition of another company).

In many cases, moreover, these highly rated borrowers will effectively syndicate a loan themselves, using the
arranger simply to craft documents and administer the process.

For a leveraged loan, the story is very different for the arranger. And by different we mean more lucrative.

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 A new leveraged loan can carry an arranger fee of 1% to 5% of the total loan commitment, depending on

1. The complexity of the transaction

2. How strong market conditions are at the time
3. Whether the loan is underwritten

Merger and acquisition (M&A) and recapitalization loans will likely carry high fees, as will bankruptcy exit financings
and restructuring deals. Seasoned leveraged issuers, in contrast, pay lower fees for re-financings and add-on
transactions.

Because investment-grade loans are infrequently drawn down and, therefore, offer drastically lower yields, the
ancillary business that banks hope to see is as important as the credit product in arranging such deals, especially
because many acquisition-related financings for investment-grade companies are large, in relation to the pool of
potential investors, which would consist solely of banks.

How are Loans Syndicated?

Once the loan issuer (borrower) picks an arranging bank or banks and settles on a structure of the deal, the
syndications process moves to the next phase. The “retail” market for a syndicated loan consists of banks and, in
the case of leveraged transactions, finance companies and institutional investors such as mutual funds, structured
finance vehicles and hedge funds (more on that in section 5).

Before formally offering a loan to these retail accounts, arrangers will often read the market by informally polling
select investors to gauge appetite for the credit.

Based on these discussions, the arranger will launch the credit at a spread and fee it believes will “clear” the
market.

Until 1998, this would have been all there is to it. Once the pricing was set, it was set, except in the most extreme
cases. If the loan were undersubscribed – if investor interest in the loan was less than the amount arrangers were
looking to syndicate – the arrangers could very well be left above their desired hold level.

As of 1998, however, the leveraged issuers, arrangers and investors adopted a “market flex” model, which figures
heavily in how the sector operates today. Market Flex is detailed in the following section.

Market Flex
After the Russian debt crisis roiled the market in 1998, arrangers adopted “market-flex” language. Market flex allows
arrangers to change the pricing of the loan based on investor demand—in some cases within a predetermined range
—as well as shift amounts between various tranches of a loan, as a standard feature of loan commitment letters.

Market-flex language, in a single stroke, pushed the loan syndication process, at least in the leveraged arena,

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 across the Rubicon to a full-fledged capital markets exercise.

Initially, arrangers invoked flex language to make loans more attractive to investors by hiking the spread or lowering
the price. This was logical after the volatility introduced by the Russian debt debacle. Over time, however, market-
flex became a tool either to increase or decrease pricing of a loan, based on investor demand.

“Mark et flex” activity has been one of the simplest ways to gauge just how hot the leveraged loan mark et is.
During boom times, when institutional investors have cash to invest, there usually is pronounced downward flex
activity (lots of issuer-friendly revisions during the syndications process).
During the first quarter of 2013, for instance, amid massive issuance of CLO vehicles, nearly 40% of loans
brought to the syndications mark et saw a downward flex. In June of that year, however, the loan mark et was
jolted by the upheaval in the high yield bond mark et, which tank ed after Fed Chairman Ben Bernank e floated
the idea of ‘tapering’ the government’s bond buying program (he quick ly walk ed those comments back ).

Because of market flex, a loan syndication today functions as a “book-building” exercise, in bond-market parlance.

A loan is originally launched to market at a target spread or, as was increasingly common by the late 2000s, with a
range of spreads, referred to as “price talk”(i.e., a target spread of, say, 250-275 basis points over LIBOR). Investors
then will make commitments that in many cases are tiered by the spread.

For example, an account may put in for $25 million at LIBOR+275 or $15 million at LIBOR+250. At the end of the
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 process, the arranger will tally the commitments, then make a call as to where to price, or “print,” the paper.

Following the example above, if the loan is oversubscribed at LIBOR+250, the arranger may slice the spread further.
Conversely, if it is undersubscribed, even at LIBOR+275, then the arranger may be forced to raise the spread to
bring more money to the table.

Types of Syndications
There are three main types of leveraged loan syndications:

An underwritten deal
A best-efforts syndication
A club deal

Underwritten Deal
In an underwritten deal the arrangers guarantee the entire amount committed, then syndicate the loan.

If the arrangers cannot get investors to fully subscribe the loan, they are forced to absorb the difference, which they
may later try to sell sell. This is achievable, in most cases, if market conditions – or the credit’s fundamentals –
improve. If not, the arranger may be forced to sell at a discount and, potentially, even take a loss on the paper
(known as “selling through fees”). Or the arranger may just be left above its desired hold level of the credit.

So, why do arrangers underwrite loans? Two main reasons:

Offering an underwritten loan can be a competitive tool to win mandates.
Underwritten loans usually require more lucrative fees because the agent is on the hook if potential lenders balk.
Of course, with flex-language now common, underwriting a deal does not carry the same risk it once did, when the
pricing was set in stone prior to syndication.

Best-Efforts
In a “best-efforts” syndication the arranger group commits to underwrite less than the entire amount of the loan,
leaving the credit to the vicissitudes of the market. If the loan is undersubscribed, the credit may not close, or may
need major surgery – such as an increase in pricing or additional equity from a private equity sponsor – to clear the
market.

Traditionally, best-efforts syndications were used for riskier borrowers or for complex transactions.

Club Deal
A “club deal” is a smaller loan (usually $25 million to $100 million, but as high as $150 million) that is pre-marketed
to a group of relationship lenders.
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 The arranger is generally a first among equals, and each lender gets a full cut, or nearly a full cut, of the fees.

The Bank Book (IM)

Before awarding a mandate, an issuer might solicit bids from arrangers. The banks will outline their syndication
strategy and qualifications, as well as their view on the way the loan will price in market.

Once the mandate is awarded, the syndication process starts.

The arranger will prepare an information memo (IM) describing the terms of the transactions. The IM typically will
include an executive summary, investment considerations, a list of terms and conditions, an industry overview, and
a financial model. Because loans are not securities, this will be a confidential offering made only to qualified banks
and accredited investors.

If the issuer is speculative grade and seeking capital from non-bank investors, the arranger will often prepare a
“public” version of the IM. This version will be stripped of all confidential material, such as financial projections from
management, so that it can be viewed by accounts that operate on the public side of the wall, or that want to
preserve their ability to buy bonds, stock or other public securities of the particular issuer (see the Public Versus
Private section below).

Naturally, investors that view materially nonpublic information of a company are disqualified from buying the
company’s public securities for some period of time.

As the IM is being prepared the syndicate desk will solicit informal feedback from potential investors regarding
potential appetite for the deal, and at what price they are willing to invest. Once this intelligence has been gathered
the agent will formally market the deal to potential investors.

Arrangers will distribute most IMs—along with other information related to the loan, pre- and post-closing – to
investors through digital platforms. Leading vendors in this space are Intralinks, Syntrak and Debt Domain.

Bank book - Components

The IM typically contain the following sections:

Executive summary: A description of the issuer, an overview of the transaction and rationale, sources and
uses, and key statistics on the financials
Investment considerations: Basically, management’s sales “pitch” for the deal
Terms and conditions: A preliminary term sheet describing the pricing, structure, collateral, covenants, and
other terms of the credit (covenants are usually negotiated in detail after the arranger receives investor
feedback)
Industry overview: A description of the company’s industry and competitive position relative to its industry
peers
Financial model: A detailed model of the issuer’s historical, pro forma, and projected financials, including
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 Financial model: A detailed model of the issuer’s historical, pro forma, and projected financials, including
management’s high, low, and base case for the issuer

The bank meeting

Most new acquisition-related loans kick off at a bank meeting, wherepotential lenders hear management and the
private equity/sponsor group (if there is one) describe what the terms of the loan are and what transaction it backs.
Understandably, bank meetings are more often than not conducted via a Webex or conference call, although some
issuers still prefer old-fashioned, in-person gatherings.

Whatever the format, management uses the bank meeting to provide its vision for the transaction and, most
important, tell why and how the lenders will be repaid on or ahead of schedule. In addition, investors will be briefed
regarding the multiple exit strategies, including second ways out via asset sales. (If it is a small deal or a refinancing
instead of a formal meeting, there may be a series of calls. or one-on-one meetings with potential investors.)

Once the loan is closed, the final terms are then documented in detailed credit and security agreements.
Subsequently, liens are perfected and collateral is attached.

Loans, by their nature, are flexible documents that can be revised and amended from time to time. These
amendments require different levels of approval (see Voting Rights section). Amendments can range from something
as simple as a covenant waiver to as complex as a change in the collateral package, or allowing the issuer to
stretch out its payments or make an acquisition.

Leveraged Loan Investor Market

There are three primary investor consistencies for leveraged loans:

Banks
Finance companies
Institutional investors

Institutional investors can comprise different, distinct, important investor segments, such as CLOs (collateralized
loan obligations) and mutual funds.

Each segment is detailed below.

Banks
A bank investor can be a commercial bank, a savings and loan institution, or a securities firm that usually provides
investment-grade loans. These are typically large revolving credits that back commercial paper or general corporate
purposes. In some cases they support acquisitions.

For leveraged loans, banks typically provide unfunded revolving credits, letters of credit (LOCs) and – less and less,
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 these days – amortizing term loans, under a syndicated loan agreement.

Finance companies
Finance companies have consistently represented less than 10% of the leveraged loan market, and tend to play in
smaller deals – $25 million to $200 million.

These investors often seek asset-based loans that carry wide spreads. These deals often require time-intensive
collateral monitoring.

Institutional investors
Institutional investors in the loan market usually are structured vehicles known as collateralized loan obligations
(CLOs) and loan participation mutual funds (known as “Prime funds” because they were originally pitched to
investors as a money market-like fund that would approximate the Prime rate).

In addition, hedge funds, high-yield bond funds, pension funds, insurance companies, and other proprietary investors
do participate opportunistically in loans focusing usually on wide-margin (or “high-octane”) paper.

CLOs
CLOs are special-purpose vehicles set up to hold and manage pools of leveraged loans.

The special-purpose vehicle is financed with several tranches of debt (typically a ‘AAA’ rated tranche, a ‘AA’
tranche, a ‘BBB’ tranche, and a mezzanine tranche) that have rights to the collateral and payment stream, in
descending order. In addition, there is an equity tranche, but the equity tranche usually is not rated.

CLOs are created as arbitrage vehicles that generate equity returns via leverage, by issuing debt 10 to 11 times their
equity contribution.

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 CLO issuance has rebounded from the grim days of the post-Lehman bank ruptcy credit mark ets, when many
thought all forms of structured finance dead and buried. Indeed, CLO volume during the 2013 hit an all-time high
of $82 billion, thank s largely to the massive inflow of investor cash entering the loan mark et.

There are also market-value CLOs that are less leveraged – typically 3 to 5 times. These vehicles allow managers
greater flexibility than more tightly structured arbitrage deals.

CLOs are usually rated by two of the three major ratings agencies and impose a series of covenant tests on
collateral managers, including minimum rating, industry diversification, and maximum default basket.

Loan mutual funds

Loan mutual funds are how retail investors can access the loan market. They are mutual funds that invest in
leveraged loans. These funds – originally known as Prime funds, because they offered investors the chance to earn
the Prime interest rate that banks charge on commercial loans – were first introduced in the late 1980s.

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 December capped a year of astonishing growth for the sector. In all,
loan-fund AUM increased by $75 billion, or 82%. By dollar amount, it
was the largest increase on record, far past the prior high of $21 billion,
from 2012. On a percentage basis, it was second only to 2004, which
saw a 119% increase.

Today there are three main categories of funds:

Daily-access funds: These are traditional open-end mutual fund products into which investors can buy or
redeem shares each day at the fund’s net asset value.
Continuously offered closed-end funds: These were the first loan mutual fund products. Investors can buy into
these funds each day at the fund’s net asset value (NAV). Redemptions, however, are made via monthly or
quarterly tenders, rather than each day, as with the open-end funds described above. To make sure they can
meet redemptions, many of these funds, as well as daily access funds, set up lines of credit to cover
withdrawals above and beyond cash reserves.

Exchange-traded closed-end funds (ETF): These funds, which have skyrocketed in popularity over the past few
years, trade on a stock exchange. Typically the funds are capitalized by an initial public offering. Thereafter,
investors can buy and sell shares, but may not redeem them. The manager can also expand the fund via rights
offerings. Usually they are able to do so only when the fund is trading at a premium to NAV, however – a provision
that is typical of closed-end funds regardless of the asset class.

In March 2011, Invesco introduced the first index-based exchange traded fund, PowerShares Senior Loan Portfolio
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 (BKLN), which is based on the S&P/LSTA Loan 100 Index. By the second quarter of 2013 BKLN had topped $4.53
billion in assets under management.

Some ETFs related to the loan market:

PowerShares Exchange-Traded Fund Trust II ($BKLN)

iShares iBoxx $ High Yid Corp Bond ($HYG)
SPDR Barclays Capital High Yield Bnd ($JNK)

Public vs. Private Markets

In the old days, a bright red line separated public and private information in the loan market. Leveraged loans were
strictly on the private side of the line, and any information transmitted between the issuer and the lender group
remained confidential.

In the late 1980s that line began to blur as a result of two market innovations.

The first was a more active secondary trading market, which sprung up to support (1) the entry of non-bank investors
into the market (investors such as insurance companies and loan mutual funds) and (2) to help banks sell rapidly
expanding portfolios of distressed and highly leveraged loans that they no longer wanted to hold.

This meant that parties that were insiders on loans might now exchange confidential information with traders and
potential investors who were not (or not yet) a party to the loan.

The second innovation that weakened the public/private divide was trade journalism focusing on the loan market.

Despite these two factors, the public versus private line was well understood, and rarely was controversial, for at
least a decade.

This changed in the early 2000s as a result of:

The proliferation of loan ratings which, by their nature, provide public exposure for loan deals
The explosive growth of non-bank investors groups, which included a growing number of institutions that
operated on the public side of the wall, including a growing number of mutual funds, hedge funds, and even
CLO boutiques
The growth of the credit default swaps market, in which insiders like banks often sold or bought protection
from institutions that were not privy to inside information
Again, a more aggressive effort by the press to report on the loan market

Background - Public v private

Some background is in order. The vast majority of loans are unambiguously private financing arrangements between
issuers and lenders. Even for issuers with public equity or debt, and which file with the SEC, the credit agreement
becomes public only when it is filed – months after closing, usually – as an exhibit to an annual report (10-K), a
quarterly report (10-Q), a current report (8-K), or some other document (proxy statement, securities registration,
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 etc.).

Beyond the credit agreement there is a raft of ongoing correspondence between issuers and lenders that is made
under confidentiality agreements, including quarterly or monthly financial disclosures, covenant compliance
information, amendment and waiver requests, and financial projections, as well as plans for acquisitions or
dispositions. Much of this information may be material to the financial health of the issuer, and may be out of the
public domain until the issuer formally issues a press release, or files an 8-K or some other document with the SEC.

Today's changing market

In recent years there was growing concern among issuers, lenders, and regulators that migration of once-private
information into public hands might breach confidentiality agreements between lenders and issuers. More important,
it could lead to illegal trading. How has the market contended with these issues?

Traders. To insulate themselves from violating regulations, some dealers and buyside firms have set up their
trading desks on the public side of the wall. Consequently, traders, salespeople, and analysts do not receive
private information even if somewhere else in the institution the private data are available. This is the same
technique that investment banks have used from time immemorial to separate their private investment
banking activities from their public trading and sales activities.
Underwriters. As mentioned above, in most primary syndications, arrangers will prepare a public version of
information memoranda that is scrubbed of private information (such as projections). These IMs will be
distributed to accounts that are on the public side of the wall. As well, underwriters will ask public accounts
to attend a public version of the bank meeting, and will distribute to these accounts only scrubbed financial
information.
Buyside accounts. On the buyside there are firms that operate on either side of the public-private divide.

Accounts that operate on the private side receive all confidential materials and agree not to trade in public
securities of the issuers in question. These groups are often part of wider investment complexes that do have
public funds and portfolios but, via Chinese walls, are sealed from these parts of the firms.

There are also accounts that are public. These firms take only public IMs and public materials and, therefore,
retain the option to trade in the public securities markets even when an issuer for which they own a loan is
involved. This can be tricky to pull off in practice because, in the case of an amendment, the lender could be
called on to approve or decline in the absence of any real information. To contend with this issue the account
could either designate one person who is on the private side of the wall to sign off on amendments or empower
its trustee, or the loan arranger to do so. But it’s a complex proposition.

Vendors. Vendors of loan data, news, and prices also face many challenges in managing the flow of public
and private information. In general, the vendors operate under the freedom of the press provision of the U.S.
Constitution’s First Amendment and report on information in a way that anyone can simultaneously receive it
(for a price, of course). Therefore, the information is essentially made public in a way that doesn’t deliberately
disadvantage any party, whether it’s a news story discussing the progress of an amendment or an
acquisition, or a price change reported by a mark-to-market service. This, of course, doesn’t deal with the
underlying issue: That someone who is a party to confidential information is making it available via the press
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 or pricing services, to a broader audience.

Another way in which participants deal with the public-versus-private issue is to ask counterparties to sign “big-boy”
letters. These letters typically ask public-side institutions to acknowledge that there may be information they are not
privy to, and they are agreeing to make the trade in any case. They are, effectively, big boys, and will accept the
risks.

Credit Risk - Overview

Pricing a loan requires arrangers to evaluate the risk inherent in a loan and to gauge investor appetite for that risk.

The principal credit risk factors that banks and institutional investors contend with in buying loans

Default risk
Loss-given-default risk
Among the primary ways that accounts judge these risks are ratings, collateral coverage, seniority, credit statistics,
industry sector trends, management strength, and sponsor. All of these, together, tell a story about the deal.

Descriptions of the major risk factors follow.

Default risk
Default risk is simply the likelihood of a borrower being unable to pay interest or principal on time.

It is based on the issuer’s financial condition, industry segment, and conditions in that industry, as well as
economic variables and intangibles, such as company management.

Default risk will, in most cases, be most visibly expressed by a public rating from Standard & Poor’s Ratings
Services or another ratings agency. These ratings range from ‘AAA’ for the most creditworthy loans to ‘CCC’ for the
least.

The market is roughly divided into two segments:

Investment grade (loans to issuers rated ‘BBB-’ or higher)

Leveraged (borrowers rated ‘BB+’ or lower).
Default risk, of course, varies widely within each of these broad segments.

Since the mid-1990s, public loan ratings have become a de facto requirement for issuers that wish to do business
with a wide group of institutional investors. Unlike banks, which typically have large credit departments and adhere
to internal rating scales, fund managers rely on agency ratings to bracket risk, and to explain the overall risk of their
portfolios to their own investors.

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 As of mid-2011, then, roughly 80% of leveraged loan volume carried a loan rating, up from 45% in 1998. Before 1995
virtually no leveraged loans were rated.

Seniority
Where an instrument ranks in priority of payment is referred to as seniority. Based on this ranking, an issuer will
direct payments with the senior most creditors paid first and the most junior equityholders last. In a typical
structure, senior secured and unsecured creditors will be first in right of payment – though in bankruptcy, secured
instruments typically move the front of the line – followed by subordinate bond holders, junior bondholders, preferred
shareholders and common shareholders. Leveraged loans are typically senior, secured instruments and rank
highest in the capital structure.

Loss-given-default
Loss-given-default risk measures how severe a loss the lender is likely to incur in the event of default.

Investors assess this risk based on the collateral (if any) backing the loan and the amount of other debt and equity
subordinated to the loan. Lenders will also look to covenants to provide a way of coming back to the table early –
that is, before other creditors – and renegotiating the terms of a loan if the issuer fails to meet financial targets.

Investment-grade loans are, in most cases, senior unsecured instruments with loosely drawn covenants that apply
only at incurrence. That is, only if an issuer makes an acquisition or issues debt. As a result, loss-given-default may
be no different from risk incurred by other senior unsecured creditors.

Leveraged loans, in contrast, are usually senior secured instruments that, except for covenant-lite loans, have
maintenance covenants that are measured at the end of each quarter, regardless of the issuer is in compliance with
pre-set financial tests.

Loan holders, therefore, almost always are first in line among pre-petition creditors and, in many cases, are able to
renegotiate with the issuer before the loan becomes severely impaired. It is no surprise, then, that loan investors
historically fare much better than other creditors on a loss-given-default basis.

Calculating loss given default is tricky business. Some practitioners express loss as a nominal percentage of
principal or a percentage of principal plus accrued interest. Others use a present-value calculation, employing an
estimated discount rate – typically the 15-25% demanded by distressed investors.

Credit statistics
Credit statistics are used by investors to help calibrate both default and loss-given-default risk. These statistics
include a broad array of financial data, including credit ratios measuring leverage (debt to capitalization and debt to
EBITDA) and coverage (EBITDA to interest, EBITDA to debt service, operating cash flow to fixed charges). Of
course, the ratios investors use to judge credit risk vary by industry.
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 In addition to looking at trailing and pro forma ratios, investors look at management’s projections, and the
assumptions behind these projections, to see if the issuer’s game plan will allow it to service debt.

There are ratios that are most geared to assessing default risk. These include leverage and coverage.

Then there are ratios that are suited for evaluating loss-given-default risk. These include collateral coverage, or the
value of the collateral underlying the loan, relative to the size of the loan. They also include the ratio of senior
secured loan to junior debt in the capital structure.

Logically, the likely severity of loss-given-default for a loan increases with the size of the loan, as a percentage of
the overall debt structure. After all, if an issuer defaults on $100 million of debt, of which $10 million is in the form of
senior secured loans, the loans are more likely to be fully covered in bankruptcy than if the loan totals $90 million.

Industry segment

Industry segment is a factor because sectors, naturally, go in and out of favor.

For that reason, having a loan in a desirable sector, like telecom in the late 1990s or healthcare in the early 2000s,
can really help a syndication along.

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 Also, loans to issuers in defensive sectors (like consumer products) can be more appealing in a time of economic
uncertainty, whereas cyclical borrowers (like chemicals or autos) can be more appealing during an economic
upswing.

Private equity sponsor

Sponsorship is a factor too.

Needless to say, many leveraged companies are owned by one or more private equity firms. These entities, such as
Kohlberg Kravis & Roberts or Carlyle Group, invest in companies that have leveraged capital structures. To the
extent that the sponsor group has a strong following among loan investors, a loan will be easier to syndicate and,
therefore, can be priced lower.

In contrast, if the sponsor group does not have a loyal set of relationship lenders, the deal may need to be priced
higher to clear the market.

Among banks, investment factors may include whether the bank is party to the sponsor’s equity fund. Among
institutional investors, weight is given to an individual deal sponsor’s track record in fixing its own impaired deals by
stepping up with additional equity or replacing a management team that is failing.

For reference, here’s some of the largest sponsor-backed leveraged loans from 2013, along with the private equity
firm associated with each deal.

Issuer $Mils Date Sponsor Purpose Industry

Food &
H.J. Heinz Company 11500 03/13 3G Capital Management LBO
Beverage

Hilton Hotels Corp 8600 09/13 Blackstone Group Recap/IPO Gaming & Hotel

Computers &
Dell Inc 8160 09/13 Silver Lake Partners LBO
Electronics

Madison Dearborn
Asurion LLC 3900 02/13 Refinancing Insurance
Partners

Neiman Marcus Group Inc 3750 10/13 Ares Management LBO Retail

Fieldw ood Energy LLC 3625 09/13 Riverstone LBO Oil & Gas

Intelsat S.A. 3600 11/13 BC Partners Refinancing Telecom

Retail Food &

Rite Aid Corp 3320 02/13 Leonard Green Refinancing
Drug

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 Computers &
BMC Softw are Inc 3230 07/13 Bain Capital LBO
Electronics

Madison Dearborn Services &

Nuveen Investments Inc 3061 04/13 Refinancing
Partners Leasing

Ineos Group Ltd 2988 04/13 Ineos Capital Refinancing Chemicals

Biomet Inc 2982 09/13 Blackstone Group Refinancing Healthcare

Bausch & Lomb Inc 2819 04/13 Warburg Pincus Refinancing Healthcare

Caesars Entertainment Inc 2770 09/13 Apollo Management Recap Gaming & Hotel

Freescale Semiconductor Computers &

2730 01/13 Blackstone Group Refinancing
Inc Electronics

Axalta Coating Systems 2700 01/13 Carlyle Group LBO Chemicals

Kohlberg, Kravis & Food &

Del Monte Foods Co 2700 01/13 Refinancing
Roberts Beverage

Madison Dearborn Services &

Nuveen Investments Inc 2561 01/13 Refinancing
Partners Leasing

Neiman Marcus Group Inc 2560 01/13 Texas Pacific Group Refinancing Retail

Syndicating a Loan - by Facility

Most loans are structured and syndicated to accommodate the two primary syndicated lender constituencies:
banks (domestic and foreign) and institutional investors (primarily structured finance vehicles, mutual funds, and
insurance companies). As such, leveraged loans consist of:

Pro rata debt consists of the revolving credit and amortizing term loan (TLa), which are packaged together
and, usually, syndicated to banks. In some loans, however, institutional investors take pieces of the TLa and,
less often, the revolving credit, as a way to secure a larger institutional term loan allocation. Why are these
tranches called “pro rata?” Historically, arrangers syndicated revolving credit and TLa tranches on a pro rata
basis to banks and finance companies.
Institutional debt consists of term loans structured specifically for institutional investors, though there are
also some banks that buy institutional term loans. These tranches include first- and second-lien loans, as
well as pre-funded letters of credit. Traditionally, institutional tranches were referred to as TLbs because they
were bullet payments, and are repaid after the TLa tranches.

Finance companies also play in the leveraged loan market, and buy both pro rata and institutional tranches. With
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 institutional investors playing an ever-larger role, however, by the late 2000s many executions were structured
simply as revolving credit/institutional term loans, with the TLa falling by the wayside.

Pricing a Loan - Primary Market

Pricing loans for the institutional market is a straightforward exercise based on simple risk/return consideration and
market technicals. Pricing a loan for the bank market, however, is more complex. Indeed, banks often invest in
loans for more than just spread income. Rather, banks are driven by the overall profitability of the issuer relationship,
including noncredit revenue sources.

For bank investors

Since the early 1990s almost all large commercial banks have adopted portfolio-management techniques that
measure the returns of loans and other credit products, relative to risk. By doing so, banks have learned that loans
are rarely compelling investments on a stand-alone basis.

Therefore, banks are reluctant to allocate capital to issuers unless the total relationship generates attractive returns
– whether those returns are measured by risk-adjusted return on capital, by return on economic capital, or by some
other metric.

If a bank is going to put a loan on its balance sheet, it takes a hard look not only at the loan’s yield, but at other
sources of revenue from the relationship, including noncredit businesses – like cash-management services and
pension-fund management – and economics from other capital markets activities, like bonds, equities, or M&A
advisory work.

This process has had a breathtaking result on the leveraged loan market, to the point that it is an anachronism to
continue to call it a “bank” loan market.

Of course, there are certain issuers that can generate a bit more bank appetite. As of mid-2011 these included
issuers with a European or even a Midwestern U.S. angle. Naturally, issuers with European operations are able to
better tap banks in their home markets (banks still provide the lion’s share of loans in Europe) and, for Midwestern
issuers, the heartland remains one of the few U.S. regions with a deep bench of local banks.

What this means is that the spread offered to pro rata investors is important. But so too, in most cases, is the
amount of other, fee-driven business a bank can capture by taking a piece of a loan. For this reason issuers are
careful to award pieces of bond- and equity-underwriting engagements and other fee-generating business to banks
that are part of its loan syndicate.

For institutional players

For institutional investors the investment decision process is far more straightforward because, as mentioned above,
they are focused not on a basket of returns but on loan-specific revenue.
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 In pricing loans to institutional investors it’s a matter of the spread of the loan, relative to credit quality and market-
based factors. This second category can be divided into liquidity and market technicals (i.e., supply/demand).

Liquidity is the tricky part but, as in all markets, all else being equal, more liquid instruments command thinner
spreads than less liquid ones.

In the old days – before institutional investors were the dominant investors and banks were less focused on portfolio
management – the size of a loan didn’t much matter. Loans sat on the books of banks and stayed there.

But now that institutional investors and banks put a premium on the ability to package loans and sell them, liquidity
has become important. As a result, smaller executions – generally those of $200 million or less – tend to be priced
at a premium to the larger loans.

Of course, once a loan gets large enough to demand extremely broad distribution the issuer usually must pay a size
premium. The thresholds range widely. During the go-go mid-2000s it was upwards of $10 billion. During more
parsimonious late-2000s a $1 billion credit was considered a stretch.

Market technicals, or supply relative to demand, is a matter of simple economics. If there are many dollars chasing
little product then, naturally, issuers will be able to command lower spreads. If, however, the opposite is true, then
spreads will need to increase for loans to be successfully syndicated.

Mark-to-market
Beginning in 2000 the SEC directed bank loan mutual fund managers to use available price data (bid/ask levels
reported by dealer desks and compiled by mark-to-market services), rather than fair value (estimates based on
whether the loan is likely to repay lenders in whole or part), to determine the value of broadly syndicated loan
portfolios.

In broad terms this policy has made the market more transparent, improved price discovery and, in doing so, made
the market far more efficient and dynamic than it was in the past.

Types of Syndicated Loan Facilities

There are four main types of syndicated loan facilities. Each is detailed below.

Revolving credits (included here are options for swingline loans, multicurrency-borrowing, competitive-bid
options, term-out, and evergreen extensions)
Term loans
A letter of credit (LOC)
Acquisition or equipment line

Revolving credits
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 A revolving credit line allows borrowers to draw down, repay, and reborrow.

An RC acts much like a corporate credit card, except that borrowers are charged an annual fee on unused amounts
(a facility fee).

Revolvers to speculative-grade issuers are sometimes tied to borrowing-base lending formulas. This limits
borrowings to a certain percentage of specified collateral, most often receivables and inventory (see “Asset-based
loan” section below for a full discussion of this topic).

Revolving credits often run for 364 days. These revolving credits – called, not surprisingly, 364-day facilities – are
generally limited to the investment-grade market. The reason for what seems like an odd term is that regulatory
capital guidelines mandate that, after one year of extending credit under a revolving facility, banks must then
increase their capital reserves to take into account the unused amounts.

Therefore, banks can offer issuers 364-day facilities at a lower unused fee than a multiyear revolving credit. There are
a number of options that can be offered within a revolving credit line:

A swingline is a small, overnight borrowing line, typically provided by the agent.

A multicurrency line allows the borrower to borrow in one or more alternative currencies (in most agreements
this option is capped).
A competitive-bid option (CBO) allows borrowers to solicit the best bids from its syndicate group. The agent
will conduct what amounts to an auction to raise funds for the borrower, and the best bids are accepted.
CBOs typically are available only to large, investment-grade borrowers.
A term-out will allow the borrower to convert borrowings into a term loan at a given conversion date. This,
again, is usually a feature of investment-grade loans. Under the option, borrowers may take what is
outstanding under the facility and pay it off according to a predetermined repayment schedule. Often the
spreads ratchet up if the term-out option is exercised.
An evergreen is an option for the borrower – with consent of the syndicate group – to extend the facility each
year, for an additional year. For instance, at the end of each year, a three-year facility would be reset to three
years if the lenders and borrower agree. If the evergreen is not exercised, the agreement would simply run to
term.

Term loans
A term loan is simply an installment loan, such as a loan you’d use to buy a car.

The borrower may draw on the loan during a short commitment period (during which lenders usual chare a ticking
fee, akin to a commitment fee on a revolver), and repay it based on either a scheduled series of repayments or a
one-time lump-sum payment at maturity (bullet payment). There are two principal types of term loans:

An amortizing term loan (“A” term loans, or TLa) is a term loan with a progressive repayment schedule that
typically runs six years or less. These loans are normally syndicated to banks along with revolving credits as
part of a larger syndication.
An institutional term loan (“B” term loans, “C” term loans or “D” term loans) is a term loan facility carved out
for nonbank, institutional accounts. These loans came into broad usage during the mid-1990s as the
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 institutional loan investor base grew. This institutional category includes second-lien loans and covenant-lite
loans.

Letters of credit (LOC)

Letters of credit (LOCs) are guarantees provided by the bank group to pay off debt or obligations if the borrower
cannot.

Acquisition/equipment line
Acquisition/equipment lines (delayed-draw term loans) are credits that may be drawn down for a given period
to purchase specified assets or equipment, or to make acquisitions. The issuer pays a fee during the
commitment period (a ticking fee). The lines are then repaid over a specified period (the term-out period).
Repaid amounts may not be reborrowed.
Bridge loans are loans that are intended to provide short-term financing to provide a “bridge” to an asset sale,
bond offering, stock offering, divestiture, etc. Generally, bridge loans are provided by arrangers as part of an
overall financing package. Typically the issuer will agree to increasing interest rates if the loan is not repaid
as expected. For example, a loan could start at a spread of L+250 and ratchet up 50 basis points every six
months the loan remains outstanding past one year.
Equity bridge loan is a bridge loan provided by arrangers that is expected to be repaid by a secondary equity
commitment to a leveraged buyout. This product is used when a private equity firm wants to close on a deal
that requires, say, $1 billion of equity, of which it ultimately wants to hold half. The arrangers bridge the
additional $500 million, which would be then repaid when other sponsors come into the deal to take the $500
million of additional equity. Needless to say, this is a hot-market product.

Second-Lien Loans
As their name implies, the claims on collateral of second-lien loans are junior to those of first-lien loans. Although
they are really just another type of syndicated loan facility, second-liens are sufficiently complex to warrant detailed
discussion here.

After a brief flirtation with second-lien loans in the mid-1990s, these facilities fell out of favor after the 1998 Russian
debt crisis caused investors to adopt a more cautious tone. But after default rates fell precipitously in 2003
arrangers rolled out second-lien facilities to help finance issuers struggling with liquidity problems.

By 2007 the market had accepted second-lien loans to finance a wide array of transactions, including acquisitions
and recapitalizations. Arrangers tap nontraditional accounts – hedge funds, distressed investors, and high-yield
accounts – as well as traditional CLO and prime fund accounts to finance second-lien loans.

Again, the claims on collateral of second-lien loans are junior to those of first-lien loans. Second-lien loans also
typically have less restrictive covenant packages, in which maintenance covenant levels are set wide of the first-lien
loans. For these reasons, second-lien loans are priced at a premium to first-lien loans. This premium typically starts
at 200 bps when the collateral coverage goes far beyond the claims of both the first- and second-lien loans, to more

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 than 1,000 bps for less generous collateral.

There are, lawyers explain, two main ways in which the collateral of second-lien loans can be documented. Either
the second-lien loan can be part of a single security agreement with first-lien loans, or they can be part of an
altogether separate agreement. In the case of a single agreement, the agreement would apportion the collateral, with
value going first, obviously, to the first-lien claims, and next to the second-lien claims.

Alternatively, there can be two entirely separate agreements. Here’s a brief summary:

In a single security agreement second-lien lenders are in the same creditor class as first-lien lenders from the
standpoint of a bankruptcy, according to lawyers who specialize in these loans. As a result, for adequate
protection to be paid the collateral must cover both the claims of the first- and second-lien lenders. If it does
not the judge may choose to not pay adequate protection or to divide it pro rata among the first- and second-
lien creditors.In addition, the second-lien lenders may have a vote as secured lenders equal to those of the
first-lien lenders. One downside for second-lien lenders is that these facilities are often smaller than the first-
lien loans and, therefore, when a vote comes up, first-lien lenders can out-vote second-lien lenders to promote
their own interests.
In the case of two discrete security agreements, divided by a standstill agreement, the first- and second-lien
lenders are likely to be divided into two creditor classes. As a result, second-lien lenders do not have a voice
in the first-lien creditor committees. As well, first-lien lenders can receive adequate protection payments even
if collateral covers their claims, but does not cover the claims of the second-lien lenders. This may not be the
case if the loans are documented together and the first- and second-lien lenders are deemed a unified class
by the bankruptcy court.

For more information, we suggest Latham & Watkins’ terrific overview and analysis of second-lien loans, from 2004.

Covenant-Lite Loans

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 Covenant-lite loan volume surges when institutional investors have cash to invest, and the resulting
demand for the leveraged loan asset class puts issuers in the drivers seat. That was the case in 2013,
obviously, when cov-lite activity entered a different orbit as companies look ed to refinance out of more
expensive debt.

Like second-lien loans, covenant-lite loans are a particular kind of syndicated loan facility. At the most basic level,
covenant-lite loans are loans that have bond-like financial incurrence covenants, rather than traditional maintenance
covenants that are normally part and parcel of a loan agreement. What’s the difference?

Incurrence covenants generally require that if an issuer takes an action (paying a dividend, making an acquisition,
issuing more debt), it would need to still be in compliance. So, for instance, an issuer that has an incurrence test
that limits its debt to 5x cash flow would only be able to take on more debt if, on a pro forma basis, it was still within
this constraint. If not it would have breached the covenant and be in technical default on the loan. If, on the other
hand, an issuer found itself above this 5x threshold simply because its earnings had deteriorated, it would not violate
the covenant.

Maintenance covenants are far more restrictive. This is because they require an issuer to meet certain financial
tests every quarter, whether or not it takes an action. So, in the case above, had the 5x leverage maximum been a
maintenance rather than incurrence test, the issuer would need to pass it each quarter, and would be in violation if
either its earnings eroded or its debt level increased.

For lenders, clearly, maintenance tests are preferable because it allows them to take action earlier if an issuer
experiences financial distress. What’s more, the lenders may be able to wrest some concessions from an issuer
that is in violation of covenants (a fee, incremental spread, or additional collateral) in exchange for a waiver.

Conversely, issuers prefer incurrence covenants precisely because they are less stringent.
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 Lender Titles
In the formative days of the syndicated loan market (the late 1980s) there was usually one agent that syndicated
each loan. “Lead manager” and “manager” titles were doled out in exchange for large commitments. As league
tables gained influence as a marketing tool, “co-agent” titles were often used in attracting large commitments, or in
cases where these institutions truly had a role in underwriting and syndicating the loan.

During the 1990s the use of league tables – and, consequently, title inflation – exploded. Indeed, the co-agent title
has become largely ceremonial today, routinely awarded for what amounts to no more than large retail
commitments. In most syndications there is one lead arranger. This institution is considered to be on the “left” (a
reference to its position in an old-time tombstone ad). There are also likely to be other banks in the arranger group,
which may also have a hand in underwriting and syndicating a credit. These institutions are said to be on the “right.”

The different titles used by significant participants in the syndications process are administrative agent, syndication
agent, documentation agent, agent, co-agent or managing agent, and lead arranger or book runner:

The administrative agent is the bank that handles all interest and principal payments and monitors the
loan.
The syndication agent is the bank that handles, in purest form, the syndication of the loan. Often, however,
the syndication agent has a less specific role.
The documentation agent is the bank that handles the documents and chooses the law firm.
The agent title is used to indicate the lead bank when there is no other conclusive title available, as is often
the case for smaller loans.
The co-agent or managing agent is largely a meaningless title used mostly as an award for large
commitments.
The lead arranger or book runner title is a league table designation used to indicate the “top dog” in a
syndication.

Secondary Sales
Secondary sales occur after the loan is closed and allocated, when primary market investors are free to trade the
paper. Loan sales are structured as either assignments or participations, with investors usually trading through
dealer desks at the large underwriting banks. Dealer-to-dealer trading is almost always conducted through a “street”
broker.

Assignments
In an assignment, the assignee becomes a direct signatory to the loan and receives interest and principal
payments directly from the administrative agent.

Assignments typically require the consent of the borrower and agent, trhough consent may be withheld only if a
reasonable objection is made. In many loan agreements the issuer loses its right to consent in the event of default.
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 The loan document often sets a minimum assignment amount, usually $5 million, for pro rata commitments. In the
late 1990s, however, administrative agents started to break out specific assignment minimums for institutional
tranches. In most cases, institutional assignment minimums were reduced to $1 million in an effort to boost
liquidity. There were also some cases where assignment fees were reduced or even eliminated for institutional
assignments, but these lower assignment fees remained rare into 2012, and the vast majority was set at the
traditional $3,500.

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

Primary Assignments
The term primary assignment is something of an oxymoron. It applies to primary commitments made by offshore
accounts (principally CLOs and hedge funds). These vehicles, for a variety of reasons, suffer tax consequence from
buying loans in the primary. The agent will therefore hold the loan on its books for some short period after the loan
closes, then sell it to these investors via an assignment. These are called primary assignments and are effectively
primary purchases.

Participations
As the name implies, in a participation agreement, the buyer takes a participating interest in the selling lender’s
commitment.

The lender remains the official holder of the loan, with the participant owning the rights to the amount purchased.
Consents, fees, or minimums are almost never required. The participant has the right to vote only on material
changes in the loan document (rate, term, and collateral). Non-material changes do not require approval of
participants.

A participation can be a riskier way of purchasing a loan because, if the lender becomes insolvent or defaults, the
participant does not have a direct claim on the loan. In this case the participant then becomes a creditor of the
lender, and often must wait for claims to be sorted out to collect on its participation.

Loan Derivatives
Traditionally, accounts bought and sold loans in the cash market through assignments and participations. Aside
from that, there was little synthetic activity outside over-the-counter total rate of return swaps. By 2008, however, the
market for synthetically trading loans was budding.

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 This primer will look at three main types of loan derivatives:

Loan Credit Default Swaps

LCDX
Total Rate of Return Swaps

Loan credit default swaps (LCDS)

Loan credit default swaps (LCDS) are standard derivatives that have secured loans as reference instruments. In
June 2006, the International Settlement and Dealers Association issued a standard trade confirmation for LCDS
contracts.
Like all credit default swaps (CDS), an LCDS is basically an insurance policy. The seller is paid a spread in
exchange for agreeing to buy at par, or a pre-negotiated price, a loan if that loan defaults. LCDS enables participants
to synthetically buy a loan by going short the LCDS or sell the loan by going long the LCDS. Theoretically, then, a
loanholder can hedge a position either directly (by buying LCDS protection on that specific name) or indirectly (by
buying protection on a comparable name or basket of names).

Moreover, unlike the cash markets, which are long-only markets for obvious reasons, the LCDS market provides a
way for investors to short a loan. To do so, the investor would buy protection on a loan that it doesn’t hold. If the loan
subsequently defaults, the buyer of protection should be able to purchase the loan in the secondary market at a
discount and then deliver it at par to the counterparty from which it bought the LCDS contract.

For instance, say an account buys five-year protection for a given loan, for which it pays 250 bps a year. Then, in
year two, the loan goes into default and the market price of the debt falls to 80% of par. The buyer of the protection
can then buy the loan at 80 and deliver it to the counterparty at 100, a 20-point pickup.

Or instead of physical delivery, some buyers of protection may prefer a cash settlement in which the difference
between the current market price and the delivery price is determined by polling dealers or using a third-party pricing
service. Cash settlement could also be employed if there’s not enough paper to physically settle all LCDS contracts
on a particular loan.

LCDX
Introduced in 2007, the LCDX is an index of 100 LCDS obligations that participants can trade. The index provides a
straightforward way for participants to take long or short positions on a broad basket of loans, as well as hedge
exposure to the market.

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

The LCDX is reset every six months, with participants able to trade each vintage of the index that is still active. The
index will be set at an initial spread, based on the reference instruments, and trade on a price basis. According to
the primer posted by Markit, “the two events that would trigger a payout from the buyer (protection seller) of the
index are bankruptcy or failure to pay a scheduled payment on any debt (after a grace period), for any of the
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 constituents of the index.”

Single-name total rate of return swaps (TRS)

The total rate of return swap is the oldest way for participants to purchase loans synthetically. In essence, a TRS
allows an institution to by a loan on margin.

In simple terms, under a TRS program a participant buys from a counterparty, usually a dealer, the income stream
created by a reference asset (in this case a syndicated loan). The participant puts down some percentage as
collateral, say 10%, and borrows the rest from the dealer. Then the participant receives the spread of the loan less
the financial cost. If the reference loan defaults the participant is obligated to buy the facility at par or cash settle the
position based on a mark-to-market price or an auction price.

Here’s how the economics of a TRS work, in simple terms.

A participant buys via TRS a $10 million position in a loan paying L+250. To affect the purchase the participant puts
$1 million in a collateral account and pays L+50 on the balance (meaning leverage of 9:1).
Thus, the participant would receive:

L+250 on the amount in the collateral account of $1 million, plus 200 bps (L+250 minus the borrowing cost of L+50)
on the remaining amount of $9 million.

The resulting income is L+250 * $1 million plus 200 bps * $9 million. Based on the participants’ collateral amount –
or equity contribution – of $1 million, the return is L+2020. If LIBOR is 5% the return is 25.5%.

Of course, this is not a risk-free proposition. If the issuer defaults and the value of the loan goes to 70 cents on the
dollar the participant will lose $3 million. And if the loan does not default, but is marked down for whatever reason –
maybe market spreads widen, it is downgraded, its financial condition deteriorates – the participant stands to lose
the difference between par and the current market price when the TRS expires. Or, in an extreme case, the value
declines below the value in the collateral account, and the participant is hit with a margin call.

TRS Programs
In addition to the type of single-name TRS, another way to invest in loans is via a TRS program in which a dealer
provides financing for a portfolio of loans, rather than a single reference asset.

The products are similar in that an investor would establish a collateral account equal to some percent of the overall
TRS program and borrow the balance from a dealer. The program typically requires managers to adhere to
diversification guidelines as well as weighted average maturity maximums as well as weighted average rating
minimums.

Like with a single-name TRS, an investor makes money by the carry between the cost of the line and the spread of
the assets. As well, any price appreciation bolsters the returns. Of course, if loans loss value, the investor’s losses

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 would be magnified by the leverage of the vehicle. As well, if collateral value declines below a predetermined level,
the investor could face a margin call, or in the worst-case scenario, the TRS could be unwound.

TRS programs were widely used prior to the 2008 credit contraction. Since then, they have figured far less
prominently into the loan landscape as investors across the capital markets shy away from leveraged, mark-to-
market product.

Pricing Terms/Rates
Most loans are floating-rate instruments that are periodically reset to a spread over a base rate, typically LIBOR. In
most cases, borrowers can lock in a given rate for one month to one year.

Syndication pricing options include Prime, as well as LIBOR, CDs, and other fixed-rate options:

Prime is a floating-rate option. Borrowed funds are priced at a spread over the reference bank’s Prime lending
rate. The rate is reset daily, and borrowings may be repaid at any time without penalty. This is typically an
overnight option, because the Prime option is more costly to the borrower than LIBOR or CDs.
The LIBOR (or Eurodollar) option is so called because, with this option, the interest on borrowings is fixed for
a period of one month to one year. The corresponding LIBOR rate is used to set pricing. Borrowings cannot
be prepaid without penalty.
The CD option works precisely like the LIBOR option, except that the base rate is certificates of deposit, sold
by a bank to institutional investors.
Other fixed-rate options are less common but work like the LIBOR and CD options. These include federal
funds (the overnight rate, which is set by the Federal Reserve, at which banks charge each other on overnight
loans) and cost of funds (the bank’s own funding rate).

Spread (margin)
Borrower pays a specified spread over the base rate to borrow under loan agreements. The spread is typically
expressed in basis points. Further, spreads on many loans are tied to performance grids. In this case, the spread
adjusts based on one or more financial criteria. Ratings are typical in investment-grade loans. Financial ratios for
leveraged loans. Media and communications loans are invariably tied o the borrower’s debt-to-cash-flow ratio.

LIBOR floors
As the name implies, LIBOR floors put a floor under the base rate for loans. For instance, if a loan has a 3% LIBOR
floor and LIBOR falls below this level, the base rate for any resets defaults to 3%.

Fees
Of course, fees are an essential element of the leveraged/syndicated loan process. Prominent fees associated with
syndicated loans:
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 Upfront fee
Commitment fee
Facility fee
Usage Fee
Prepayment fee
Administrative agent fee
Letter of Credit (LOC) fee

Upfront fee
An upfront fee is a fee paid by the issuer at close. It is often tiered, with the lead arranger receiving a larger amount
in consideration for structuring and/or underwriting the loan. Co-underwriters will receive a lower fee, and then
investors in the general syndicate will likely have fees tied to their commitment.

Most often, fees are paid on a lender’s final allocation. For example, a loan has two fee tiers: 100 bps (or 1%) for
$25 million commitments and 50 bps for $15 million commitments. A lender committing to the $25 million tier will be
paid on its final allocation rather than on commitment, which means that, in this example, if the loan is
oversubscribed, lenders committing $25 million would be allocated $20 million and receive a fee of $200,000 (or 1%
of $20 million).

Sometimes upfront fees will be structured as a percentage of final allocation plus a flat fee. This happens most often
for larger fee tiers, to encourage potential lenders to step up for larger commitments. The flat fee is paid regardless
of the lender’s final allocation.
Fees are usually paid to banks, mutual funds, and other non-offshore investors at close. CLOs and other offshore
vehicles are typically brought in after the loan closes as a “primary” assignment, and they simply buy the loan at a
discount equal to the fee offered in the primary assignment, for tax purposes.

Commitment fee
A commitment fee is a fee paid to lenders on undrawn amounts under a revolving credit or a term loan prior to
draw-down. On term loans, this fee is usually referred to as a “ticking” fee.

Facility fee
A facility fee is paid on a facility’s entire committed amount, regardless of usage.

A facility fee is often charged instead of a commitment fee on revolving credits to investment-grade borrowers,
because these facilities typically have competitive bid options that allow a borrower to solicit the best bid from its
syndicate group for a given borrowing. The lenders that do not lend under the CBO are still paid for their
commitment.

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 Usage fee
A usage fee is a fee paid when the utilization of a revolving credit is above, or more often, falls below a certain
minimum.

Preypayment fee
A prepayment fee is a feature generally associated with institutional term loans.

Typical prepayment fees will be set on a sliding scale. For instance: 2% in year one and 1% in year two. The fee
may be applied to all repayments under a loan loan including from asset sales and excess cash flow (a “hard” fee)
or specifically to discretionary payments made from a refinancing or out of cash on hand (a “soft” fee).

Administrative fee
An administrative agent fee is the annual fee paid to administer the loan (including to distribute interest payments
to the syndication group, to update lender lists, and to manage borrowings).

For secured loans (particularly those backed by receivables and inventory) the agent often collects a collateral
monitoring fee, to ensure that the promised collateral is in place.

Letter of credit (LOC)

A letter of credit fee (LOC) can be any one of several types.

The most common – a fee for standby or financial LOCs – guarantees that lenders will support various corporate
activities. Because these LOCs are considered “borrowed funds” under capital guidelines, the fee is typically the
same as the LIBOR margin.

Fees for commercial LOCs (those supporting inventory or trade) are usually lower, because in these cases actual
collateral is submitted.

The LOC is usually issued by a fronting bank (usually the agent) and syndicated to the lender group on a pro rata
basis. The group receives the LOC fee on their respective shares while the fronting bank receives an issuing (or
fronting, or facing) fee for issuing and administering the LOC. This fee is almost always 12.5 bps to 25 bps (0.125%
to 0.25%) of the LOC commitment.

Original-Issue Discounts
This is yet another term imported from the bond market.

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 The original-issue discount (OID), or the discount from par at which the loan is offered for sale to investors, is used
in the new issue market as a spread enhancement. If a loan is issued at 99 cents on the dollar to pay par, the OID
is said to be 100 bps, or 1 point.

OID vs Upfront Fees

So, what’s the difference between an OID and an upfront fee? After all, in both cases the lender effectively pays less
than par for a loan.

From the perspective of the lender, actually, there is no practical difference. From an accounting perspective, an OID
and a fee may be recognized, and potentially taxed, differently.

Voting Rights
Amendments or changes to a loan agreement must be approved by a certain percentage of lenders. Most loan
agreements have three levels of approval: required-lender level, full vote, and supermajority:

The “required-lenders” level, usually just a simple majority, is used for approval of non-material amendments
and waivers or changes affecting one facility within a deal.
A full vote of all lenders, including participants, is required to approve material changes such as RATS rights
(rate, amortization, term, and security; or collateral), but as described below, there are occasions when
changes in amortization and collateral may be approved by a lower percentage of lenders (a supermajority).
A supermajority is typically 67-80% of lenders. It sometimes is required for certain material changes, such as
changes in term loan repayments and release of collateral.

Covenants
Loan agreements have a series of restrictions that dictate, to varying degrees, how borrowers can operate and carry
themselves financially.

For instance, one covenant may require the borrower to maintain its existing fiscal-year end. Another may prohibit it
from taking on new debt. Most agreements have financial compliance covenants, stipulating perhaps that a borrower
must maintain a prescribed level of performance, which, if not maintained, gives banks the right to terminate the
agreement or push the borrower into default.

The size of the covenant package increases in proportion to a borrower’s financial risk. Agreements to investment-
grade companies are usually thin and simple. Agreements to leveraged borrowers are more restrictive.

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

Affirmative covenants
Affirmative covenants state what action the borrower must take to be in compliance with the loan.

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 These covenants are usually boilerplate, and require a borrower to pay the bank interest and fees, for instance, or to
provide audited financial statements, maintain insurance, pay taxes, and so forth.

Negative covenants
Negative covenants limit the borrower’s activities in some way, such as undertaking new investments.

Negative covenants, which are highly structured and customized to a borrower’s specific condition, can limit the
type and amount of acquisitions and investments, new debt issuance, liens, asset sales, and guarantees.

Financial covenants
Financial covenants enforce minimum financial performance measures against the borrower, such: The company
must maintain a higher level of current assets than of current liabilities.

Broadly speaking, there are two types of financial convenants: maintenance and incurrence.

Under maintenance covenants, issuers must pass agreed-to tests of financial performance such as minimum levels
of cash flow coverage and maximum levels of leverage. If an issuer fails to achieve these levels, lenders have the
right to accelerate the loan. In most cases, though, lenders will pass on this draconian option and instead grant a
waiver in return for some combination of a fee and/or spread increase; a repayment or a structuring concenssion
such as additional collateral or seniority.

An inccurence covenant is tested only if an issuer takes an action, such as issuing debt or making an acquisition.
If, on a pro forma basis, the issuer fails the test then it is not allowed to proceed without permission of the lenders.

Historically, maintenance tests were associated with leveraged loans and incurrence tests with investment-grade
loans and bonds. More recently, the evolution of covenant-lite loans (see above) has blurred the line.

In a traditional loan agreement, as a borrower’s risk increases, financial covenants become more tightly wound and
extensive. In general, there are five types of financial covenants–coverage, leverage, current ratio, tangible net worth,
and maximum capital expenditures:

A coverage covenant requires the borrower to maintain a minimum level of cash flow or earnings, relative to
specified expenses, most often interest, debt service (interest and repayments), and fixed charges (debt
service, capital expenditures, and/or rent).
A leverage covenant sets a maximum level of debt, relative to either equity or cash flow, with total-debt-to-
EBITDA level being the most common. In some cases operating cash flow is used as the divisor. Moreover,
some agreements test leverage on the basis of net debt (total less cash and equivalents) or senior debt.
A current-ratio covenant requires that the borrower maintain a minimum ratio of current assets (cash,
marketable securities, accounts receivable, and inventories) to current liabilities (accounts payable, short-
term debt of less than one year), but sometimes a “quick ratio,” in which inventories are excluded from the
numerator, is substituted.

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 A tangible-net-worth (TNW) covenant requires that the borrower have a minimum level of TNW (net worth
less intangible assets, such as goodwill, intellectual assets, excess value paid for acquired companies),
often with a build-up provision, which increases the minimum by a percentage of net income or equity
issuance.
A maximum-capital-expenditures covenant requires that the borrower limit capital expenditures
(purchases of property, plant, and equipment) to a certain amount, which may be increased by some
percentage of cash flow or equity issuance, but often allowing the borrower to carry forward unused amounts
from one year to the next.

Mandatory Prepayments
Leveraged loans usually require a borrower to prepay with proceeds of excess cash flow, asset sales, debt
issuance, or equity issuance.

Excess cash flow is typically defined as cash flow after all cash expenses, required dividends, debt
repayments, capital expenditures, and changes in working capital. The typical percentage required is 50-
75%.
Asset sales are defined as net proceeds of asset sales, normally excluding receivables or inventories. The
typical percentage required is 100%.
Debt issuance is defined as net proceeds from debt issuance. The typical percentage required is 100%.
Equity issuance is defined as the net proceeds of equity issuance. The typical percentage required is 25% to
50%.
Often, repayments from excess cash flow and equity issuance are waived if the issuer meets a preset financial
hurdle, most often structured as a debt/EBITDA test.

Collateral
In the leveraged market, collateral usually includes all the tangible and intangible assets of the borrower and, in
some cases, specific assets that back a loan.

Virtually all leveraged loans and some of the more shaky investment-grade credits are backed by pledges of
collateral.

In the asset-based market, for instance, that typically takes the form of inventories and receivables, with the
maximum amount of the loan that the issuer may draw down capped by a formula based off of these assets. The
common rule is that an issuer can borrow against 50% of inventory and 80% of receivables. There are loans backed
by certain equipment, real estate, and other property as well.

In the leveraged market there are some loans that are backed by capital stock of operating units. In this structure
the assets of the issuer tend to be at the operating-company level and are unencumbered by liens, but the holding
company pledges the stock of the operating companies to the lenders. This effectively gives lenders control of these
subsidiaries and their assets if the company defaults.

The risk to lenders in this situation, simply put, is that a bankruptcy court collapses the holding company with the
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 operating companies and effectively renders the stock worthless. In these cases – this happened on a few
occasions to lenders to retail companies in the early 1990s – loan holders become unsecured lenders of the
company and are put back on the same level with other senior unsecured creditors.

Subsidiary guarantees
Those not collateral in the strict sense of the word, most leveraged loans are backed by the guarantees of
subsidiaries so that if an issuer goes into bankruptcy all of its units are on the hook to repay the loan. This is often
the case, too, for unsecured investment-grade loans.

Negative pledge
This is also not a literal form of collateral, but most issuers agree not to pledge any assets to new lenders to ensure
that the interest of the loanholders are protected.

Springing liens
Some loans have provisions stipulating that borrowers sitting on the cusp of investment-grade and speculative-grade
must either attach collateral or release it if the issuer’s rating changes.

A ‘BBB’ or ‘BBB-’ issuer may be able to convince lenders to provide unsecured financing, but lenders may demand
springing liens in the event the issuer’s credit quality deteriorates.

Often, an issuer’s rating being lowered to ‘BB+’ or exceeding a predetermined leverage level will trigger this
provision. Likewise, lenders may demand collateral from a strong, speculative-grade issuer, but will offer to release
under certain circumstances (if the issuer attains an investment-grade rating, for instance).

Change-of-control
Invariably, one of the events of default in a credit agreement is a change of issuer control.

For both investment-grade and leveraged issuers, an event of default in a credit agreement will be triggered by a
merger, an acquisition of the issuer, some substantial purchase of the issuer’s equity by a third party, or a change
in the majority of the board of directors.

For sponsor-backed leveraged issuers, the sponsor’s lowering its stake below a preset amount can also trip this
clause.

Equity cures

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 These provision allow issuers to fix a covenant violation – exceeding the maximum leverage test for instance – by
making an equity contribution.

These provisions are generally found in private equity backed deals. The equity cure is a right, not an obligation.
Therefore, a private equity firm will want these provisions, which, if they think it’s worth it, allows them to cure a
violation without going through an amendment process, during which lenders will often ask for wider spreads and/or
fees, in exchange for waiving the violation, even with an infusion of new equity.

Some agreements don’t limit the number of equity cures, while others cap the number to, say, one per year or two
over the life of the loan. It’s a negotiated point, however, so there is no rule of thumb.

Asset-based lending
Most of the information above refers to “cash flow” loans, loans that may be secured by collateral, but are repaid by
cash flow.

Asset-based lending is a distinct segment of the loan market. These loans are secured by specific assets and
usually are governed by a borrowing formula (or a “borrowing base”). The most common type of asset-based loans
are receivables and/or inventory lines. These are revolving credits that have a maximum borrowing limit, perhaps
$100 million, but also have a cap based on the value of an issuer’s pledged receivables and inventories.

Usually the receivables are pledged and the issuer may borrow against 80%, give or take. Inventories are also often
pledged to secure borrowings. However, because they are obviously less liquid than receivables, lenders are less
generous in their formula. Indeed, the borrowing base for inventories is typically in the 50-65% range. In addition, the
borrowing base may be further divided into subcategories – for instance, 50% of work-in-process inventory and 65%
of finished goods inventory.

In many receivables-based facilities issuers are required to place receivables in a “lock box.” That means that the
bank lends against the receivable, takes possession of it, and then collects it to pay down the loan.

In addition, asset-based lending is often done based on specific equipment, real estate, car fleets, and an unlimited
number of other assets.

Bifurcated collateral
Most often, bifurcated collateral refers to cases where the issuer divides collateral pledge between asset-based
loans and funded term loans.

The way this works, typically, is that asset-based loans are secured by current assets like accounts receivables
and inventories, while term loans are secured by fixed assets like property, plant, and equipment. Current assets
are considered to be a superior form of collateral because they are more easily converted to cash.

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 Subsidiary guarantees
Though not collateral in the strict sense of the word, most leveraged loans are backed by the guarantees of
subsidiaries, so that if an issuer goes into bankruptcy all of its units are on the hook to repay the loan. This is often
the case, too, for unsecured investment-grade loans.

Negative pledge
This is also not a literal form of collateral, but most issuers agree not to pledge any assets to new lenders to ensure
that the interest of the loanholders are protected.

Spread Calculation
Calculating loan yields or spreads is not straightforward.

Unlike most bonds, which have long no-call periods and high-call premiums, most loans are prepayable at any time,
typically without prepayment fees. And even in cases where prepayment fees apply they are 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 little more than
a theoretical calculation.

This is because an issuer’s behavior is unpredictable. It may repay a loan early because a more compelling financial
opportunity presents itself or because the issuer is acquired, or because it is making an acquisition and needs a
new financing. Traders and investors will often speak of loan spreads, therefore, as a spread to a theoretical call.

Loans had a 15-month average life between 1997 and 2004. So, if you buy a loan with a spread of 250 bps at a price
of 101, you might assume your spread-to-expected-life as the 250 bps less the amortized 100 bps premium, or
LIBOR+170. Conversely, if you bought the same loan at 99, the spread-to-expected life would be LIBOR+330. Of
course, if there’s a LIBOR floor, the minimum would apply.

Default/Restructuring
There are two primary types of loan defaults: technical defaults, and the much more serious payment defaults.

Technical defaults occur when the issuer violates a provision of the loan agreement. For instance, if an issuer
doesn’t meet a financial covenant test or fails to provide lenders with financial information or some other violation that
doesn’t involve payments.

When this occurs, the lenders can accelerate the loan and force the issuer into bankruptcy. That’s the most
extreme measure. In most cases, the issuer and lenders can agree on an amendment that waives the violation in
exchange for a fee, spread increase, and/or tighter terms.

Payment defaults are a more serious matter. As the name implies, this type of default occurs when a company
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 misses either an interest or principal payment. There is often a pre-set period of time, say 30 days, during which an
issuer can cure a default (the “cure period”). After that, the lenders can choose to either provide a forbearance
agreement that gives the issuer some breathing room or take appropriate action, up to and including accelerating, or
calling, the loan.

If the lenders accelerate, the company will generally declare bankruptcy and restructure debt via Chapter 11. If the
company is not worth saving, however, because its primary business has cratered, then the issuer and lenders may
agree to a Chapter 7 liquidation, under which the assets of the business are sold and the proceeds dispensed to the
creditors.

Debtor-in-possession loans
Debtor-in-possession (DIP) loans are made to bankrupt entities. These loans constitute super-priority claims in the
bankruptcy distribution scheme, and thus sit ahead of all prepretition claims. Many DIPs are further secured by
priming liens on the debtor’s collateral.

Traditionally, prepetition lenders provided DIP loans as a way to keep a company viable during the bankruptcy
process and therefore protect their claims. In the early 1990s a broad market for third-party DIP loans emerged.
These non-prepetition lenders were attracted to the market by the relatively safety of most DIPs, based on their
super-priority status, and relatively wide margins. This was the case again the early 2000s default cycle.

In the late 2000s default cycle, however, the landscape shifted because of more dire economic conditions. As a
result, liquidity was in far shorter supply, constraining availability of traditional third-party DIPs. Likewise, with the
severe economic conditions eating away at debtors’ collateral – not to mention reducing enterprise values –
prepetition lenders were more wary of relying solely on the super-priority status of DIPs, and were more likely to ask
for priming liens to secure facilities.

The refusal of prepetition lenders to consent to such priming, combined with the expense and uncertainty involved in
a priming fight in bankruptcy court, greatly reduced third-party participation in the DIP market. With liquidity in short
supply, new innovations in DIP lending cropped up aimed at bringing nontraditional lenders into the market. These
include:

Junior DIPs. These facilities are typically provided by bond holders or other unsecured debtors as part of a
loan-to-own strategy. In these transactions the providers receive much or all of the post-petition equity
interest as an incentive to provide the DIP loans.
Roll-up DIPs. In some bankruptcies – LyondellBasell and Spectrum Brands are two 2009 examples – DIP
providers were given the opportunity to roll up prepetition claims into junior DIPs that rank ahead of other
prepetition secured lenders. This sweetener was particularly compelling for lenders that had bought
prepetition paper at distressed prices, and were able to realize a gain by rolling it into the junior DIPs.

Junior and roll-up DIPs are suited to challenging markets during which liquidity is scarce. During more liquid times,
issuers can usual secure less costly financing in the form of traditional DIPs from prepetition lenders and/or third-
party lenders.

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 Exit loans
These are loans that finance an issuer’s emergence from bankruptcy. Typically the loans are prenegotiated, and are
part of the company’s reorganization plan.

Sub-par buybacks
Sub-par loan buybacks are another technique that grew out of the bear market, that began in 2007. Performing
paper fell to a price not seen before in the loan market – with many names trading south of 70. This created an
opportunity for issuers with the financial wherewithal and the covenant room to repurchase loans via a tender, or in
the open market, at prices below par.

Sub-par buybacks have deep roots in the bond market. Loans didn’t suffer the price declines before 2007 to make
such tenders attractive, however. In fact, most loan documents do not provide for a buyback. Instead, issuers
typically need obtain lender approval via a 50.1% amendment.

Distressed exchanges
This is a negotiated tender in which classholders will swap existing paper for a new series of bonds that typically
have a lower principal amount and, often, a lower yield. In exchange the bondholders might receive stepped-up
treatment, going from subordinated to senior, say, or from unsecured to second-lien.

Standard & Poor’s consider these programs a default and, in fact, the holders are agreeing to take a principal
haircut in order to allow the company to remain solvent and improve their ultimate recovery prospects.

This technique is used frequently in the bond market but rarely for first-lien loans. One good example was courtesy
Harrah’s Entertainment. In 2009 the gaming company issued $3.6 billion of 10% second-priority senior secured
notes due 2018 for about $5.4 billion of bonds due between 2010 and 2018.

Default rate

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 The leveraged loan default rate reached historical lows in late 2011 and
early 2012 before rising slightly. The huge spik e in 2009-10 followed the
Lehman Bank ruptcy in 2008 and subsequent economic meltdown, when
the credit mark ets were all but closed.

The Default Rate is calculated by either number of loans or principal amount. The formula is similar.

For default rate by number of loans: the number of loans that default over a given 12-month period divided by the
number of loans outstanding at the beginning of that period.

For default rate by principal amount: the amount of loans that default over a 12-month period divided by the total
amount outstanding at the beginning of the period.

Standard & Poor’s defines a default for the purposes of calculating default rates as a loan that is either (1) rated ’D’
by Standard & Poor’s, (2) to an issuer that has filed for bankruptcy, or (3) in payment default on interest or principal.

Amend-to-Extend
An amend-to-extend transaction allows an issuer to push out part of its loan maturities through an amendment,
rather than a full-out refinancing.

Amend-to-extend transactions came into widespread use in 2009 as borrowers struggled to push out maturities in
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 the face of difficult lending conditions that made refinancing prohibitively expensive.

Amend-to-extend transactions have two phases, as the name implies.

The first is an amendment in which at least 50.1% of the bank group approves the issuer’s ability to roll some or all
existing loans into longer-dated paper. Typically the amendment sets a range for the amount that can be tendered
via the new facility, as well as the spread at which the longer-dated paper will pay interest.

The new debt is pari passu with the existing loan. But because it matures later and, thus, is structurally
subordinated, it carries a higher rate and, in some cases, more attractive terms. Because issuers with big debt
loads are expected to tackle debt maturities over time, amid varying market conditions, in some cases accounts
insist on most-favored-nation protection. Under such protection the spread of the loan would increase if the issuer in
question prints a loan at a wider margin.

The second phase is the conversion, in which lenders can exchange existing loans for new loans. In the end, the
issuer is left with two tranches: (1) the legacy paper at the initial spread and maturity and (2) the new longer-dated
facility at a wider spread. The innovation here: amend-to-extend allows an issuer to term-out loans without actually
refinancing into a new credit (which, obviously would require marking the entire loan to market, entailing higher
spreads, a new OID, and stricter covenants).

Download the Primer

LCD’sLoan Market Primer is in available in PDF format. (Though it does not include the eye-popping charts and
graphs displayed above. It does, however, feature an overview from S&P Capital IQ on rating leveraged loans, as well
as criteria guidelines for recovery ratings on speculative-grade debt.) Enjoy.

Guide To US Loan Market

Author, Copyright
Steven Miller
Copyright © 2014 by Standard & Poor’s Financial Services LLC (S&P) a subsidiary of The McGraw-Hill Companies,
Inc. All rights reserved.

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 Privacy Notice/Cookies Disclaimer Contact Copyright © 2014 by Standard & Poor’s Financial Services LLC (S&P),
a subsidiary of The McGraw -Hill Companies, Inc.

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