In the wake of the market crisis, fewer syndicated loans are being issued, terms are tighter, prices are up and non-bank investors have virtually left the market, reports Joanne Hart.

The syndicated loan market has been variously described as dead, dormant, in migration, in hibernation or in transition. Some observers suggest it is virtually closed; others say it remains active. Some say banks have cash at their disposal; others say they are hugely constrained.

But there is one undisputed fact: the market has changed dramatically since last year. Beforehand, the biggest challenge lenders faced was gaining access to loans. Collateralised loan obligations and other funds were buying into a vast number of deals and many banks found it almost impossible to get in on the action, at least in the quantities they wanted. The talk was all about excess liquidity; borrowers were in the ascendant and ‘negative flex’ was a common occurrence where the terms of a loan became tighter during syndication because demand was so strong.

Fast forward a few months and the environment is very different. Volumes were at least 30% lower in the final quarter of 2007 than in the same period the previous year and the trend has continued into 2008. Prices are higher across the board and the terms on which banks are prepared to lend are substantially more onerous.

Margins rising

“Margins have risen by about 50 basis points (bp) on average and covenant-lite deals no longer exist,” says one banker.

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Ian Fitzgerald, head of loan syndicate at Lloyds TSB, points to the €7.2bn deal launched earlier this year for high- quality borrower Lafarge. The loan was issued to help finance the acquisition of Egyptian Orascom Cement by the French building materials group and has several tranches. The five-year tranche carries a margin of 72.5bp over Euribor. “In 2006, Lafarge was paying a spread of 22.5bp,” says Mr Fitzgerald.

The story is similar in the corporate market. “On the investment grade side, big deals are still being done but prices have gone up. Circumstances are tough and relationships are key,” says Philip Snell, partner at Slaughter and May.

“Prices are higher than they were six months ago and available capacity is generally lower as the investor base has narrowed. Large transactions are getting done but the focus is on key relationship banks rather than on retail investors,” says David Bassett, global head of loan markets at Royal Bank of Scotland.

Investor base narrowing

The investor base has narrowed because institutional buyers are almost entirely absent. “Last year, non-bank investors, such as insurers, hedge funds and collateralised loan funds made up 70% of some deals. That meant there were hundreds of investors in the market. Now there are just banks,” says Mr Fitzgerald.

Market flex has also become a key area of focus for both lenders and borrowers alike. The flip side of reverse flex – market flex – refers to arrangers increasing the pricing and sometimes changing the structure and terms of deals to assist with syndication.

“Last year, before the credit crunch, reverse flex was particularly common. Arranger banks would commonly reduce pricing if a deal was very oversubscribed – as deals often were – and arranging banks were rewarded for this with a share of the cost saving. Now the world has changed. Arranging banks are extremely focused on market flex so the circumstances in which market flex can be exercised tend to be broader and limits on market flex are more difficult for borrowers to secure,” says Mr Snell.

Not surprisingly, borrowers are distrustful of market flex and ensure that there is clarity about the circumstances under which such changes are allowed.

“Some banks are even trying to divorce market flex from any reference to the successful syndication of the deal,” says Mr Snell.

This is a significant shift. Market flex provisions used to be drafted on the basis that changes could only be made to achieve a sell down of the arranging banks’ commitments to below a pre-agreed level. Now, arranging banks are pushing for much greater flexibility and they are putting pressure on borrowers to give them ancillary business in return for underwriting transactions.

First refusals

“This was always common in the leveraged market but it has become more of a feature of the investment grade market too. Some banks will try to include clauses in the original loan documentation, giving them the right of first refusal or the right to match,” says Mr Snell.

The right of first refusal or the right to match refers to banks being able either to refuse other business or match proposals put forward by rival lenders. And the underlying point is that there has been a fundamental shift in the loan syndication market. Last year, the borrowers called the shots. This year, it is the turn of the lenders.

The roots of the problem are not hard to understand. Something between €40bn and €75bn of loan paper is in the system, underwritten but not syndicated. This means that many banks have far more debt on their balance sheets than they expected or feel comfortable with. The debt is not distressed but it does constrain lenders’ ability to carry on lending.

“Deals are priced to sell,” says one banker. “In the past, even large deals would be underwritten by two or three lead banks. Now six, eight or even 10 banks will underwrite at the top,” says Mr Bassett.

Soft syndication

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Steven Victorin, managing director of global fixed income credit markets at Citigroup, agrees. “Last year, it was not uncommon to see between one and four bookrunners leading a transaction. Under current market conditions involving large market-making transactions, it is not uncommon to see as many as six to eight bookrunners, depending on the size of the underwriting, credit profile and overall complexity of the financing.”

Some market participants believe there has been an increase in so-called soft syndication. Definitions of this vary but most accept that it revolves around trying to de-risk large transactions as much as possible by enlisting support as early in the process as possible. Most bankers are reluctant to talk about this but they do admit that more lead banks are sounding out potential co-underwriters or sub-underwriters before formally launching a transaction.

The situation in the investment grade market is tough but things are far more difficult in the leveraged market where most of the underwritten but unsyndicated paper comes from. The lack of confidence in this sector is graphically illustrated by the secondary market, where leveraged loans are trading at between 90% and 91% of par value, down from 102% last summer.

“It used to be the case that if a deal was trading at between 95% and 100% it was stressed, and if it traded between 90% and 95% it was distressed. Now there does not seem to be any distinction,” says Chris Baines, managing director of leveraged capital markets at Société Générale.

Mr Baines suggests that cash is available for the right deals in the right sectors at the right price. “There are three deals in the market right now. Deals tend to be €500m or less and they are characterised by fairly large mezzanine or subordinated tranches. A number of mezzanine funds were struggling to invest last year because the collateralised loan obligations (CLOs) entered the market. Someone else was eating their lunch,” he says.

The CLOs have had their fill of that particular meal for now and the mezzanine funds can gorge to their heart’s content. Across the leveraged arena, however, the emphasis is on generous pricing, designed to whet lenders’ appetite. The spread on eight-year bullet loans has risen from about 200bp to nearer 300bp; seven-year amortising paper is about 50bp more expensive and mezzanine finance, which used to carry a spread of about 800bp, is now priced at some 1000bp (10%) over Libor. In addition, banks are insisting that any leveraged deal includes substantially more equity than it did last summer.

Less debt, more equity

“Deals are being done with less debt and more equity and covenants are being put in place to protect the lenders and control borrowers’ behaviour. They are being that told there are certain things they can do and certain things they can’t,” says Mr Baines. “And everyone is looking for resilient sectors too, such as telecoms, food and healthcare.”

Some private equity firms are boasting that they can virtually bypass the European and US banking market, taking capital instead from sovereign wealth funds and emerging market lenders. The $3.2bn deal for Turkish supermarket Mygros is an example of this. Backed by private equity firm BC Partners, the debt was provided by Turkish banks.

A new breed

“New lenders are cropping up all over the place,” says Mr Snell. There are several examples of this trend but western lenders suggest it would be premature to overemphasise the importance of this new breed of lender.

“They do not tend to have a natural deposit base of dollars or euros so they need to raise capital in the interbank market. This means their cost of funds is high so it can be a real stretch for them to lend large sums,” says Mr Bassett. He believes that banks do still have an appetite for deals, provided they are properly structured, sensibly priced and in the right sector. He is not alone in holding this opinion. Most lenders concur that the market is open but there is much more due diligence and terms are tighter. The overhang of unsyndicated paper implies too that the current situation will persist, at least until the end of the year.

“The market is going back to basics,” says Mr Baines.

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