We have not done an overview in quite some time and needed a post specific to Wall Street. This will elaborate a bit on our hedge fund posts and provide an overview for those that are interested in Investment Banking (You will work closely with Leverage Finance at some point in your career). As with our many other overviews, please feel free to add any additional color. These posts generally rank extremely high with page views and low with comments as many of you Wall Street guys are introverted! Overview below:
2) Corporate Debt Securities
3) Purposes of Debt Instruments
4) Lending Side of Leveraged Finance
5) Credit Analysis
6) Investment Considerations
Unlike the equity market, the credit universe captures a huge variety of security-types.
Why? It encompasses (pretty much) every other sort of financing. The size and complexity is also magnitudes larger than the equity market (roughly speaking the US bond market is 3x the size of the equity market!!!). As such, we’re focusing on perhaps the most significant portion of the credit markets to institutional (i.e., HF / PE) investors: the leveraged finance market (LevFin).
We are focusing on LevFinfirst for the following key reasons:
Depth Instead of Breadth: We could give an overview of the entire credit market at a much higher level, or we could explain part of it really well. We prefer more quality and of course *actionable and useful* information.
Single Markets Make Descriptions Easier: Fundamental credit analysis is best introduced within the vacuum of a single market segment and a limited number of security-types
Cross Sectional Leverage: As noted above, LevFin is useful to the largest cross-section of our Wall Street focused readership. Almost all front office Wall Street careers are guaranteed to involve at least some exposure to and interaction with LevFin in one form or another. Better to learn the basics now so you don’t have to deal with it later.
Corporate Debt Securities
As many of you know, corporations have three basic ways of securing financing: 1) debt, 2) equity, and 3) hybrid securities. We’re only concerned with credit for now, so we’re going to ignore equities, hybrids and other more complex securities.
Corporate Debt Securities (In rough order of seniority)…
Revolving Credit Lines (Revolvers / Short-Term Financing): Simplistically a corporate credit card issued to a company by a bank. Companies are allowed to draw on and repay revolvers as they please. They are usually secured by a Company’s cash flow, meaning they always have to be 100% repaid before any other non-mandatory debt prepayment. As a result, revolvers are the cheapest form of debt financing.
You will find many of these instruments outlined in SEC filings. Simple example? Companies access the revolving credit facility when there is a short term swing in cash flows. They access the facility for the temporary operating purpose and repay the debt.
Ford is a great example (Page 67 of 10-K filing), emphasis is ours.
“We target to have an average ongoing Automotive gross cash balance of about $20 billion. We expect to have periods when we will be above or below this amount due to (i) future cash flow expectations such as for pension contributions, debt maturities, capital investments, or restructuring requirements, (ii) short-term timing differences, and (iii) changes in the global economic environment. In addition, we also target to maintain a revolving credit facility for our Automotive business of about $10 billion to protect against exogenous shocks.”
Other types of short-term / senior-most financing can include: 1) Swingline Loans, 2) Bridge Loans, 3) Commercial Paper, 4) Letters of credit (LOCs)
Loans (Term Loans / Amortizing Loans): Exactly what they sound like! Loans issued to corporations by banks (which in turn usually syndicate the loan to other banks and institutional investors so as not to keep too much risk on their own balance sheets). They require full payback over periods of anywhere from roughly 3-9 years. These loans usually include restrictive covenants as well since they are ranked second in overall seniority.
Unlike Revolvers (cash flow), Loans are secured by a lien (claim, or first right) on the value of a company’s assets in bankruptcy.
Here is an overview of the various types of term loans:
Term Loan A (TLA / Amortizing Term Loan / Senior Secured: This is the most senior Loan type. Secured by a priority lien on the Company’s assets. Amortized evenly. Syndicated to banks. Lower interest rates. Maturities <=6 Years
Institutional Term Loan (TLB / Term Loan B/C/D / Senior Unsecured): Junior to TLAs. Either unsecured, or secured by a lien that is typically junior to that of the TLA (in bankruptcy, they only get right to corporate assets once the TLA lenders have been repaid first). Amortize partially with bullet repayment schedule. Syndicated to both banks and institutional investors. Higher interest rates. Maturities range is roughly 3-9 years. There are two major types of TLBs worth mentioning:
2nd Lien Loan: Specifically refers to TLBs with a junior claim (2nd lien) on corporate assets and
Covenant-Light Loans (Covi-lite): Loans that have more relaxed, bond-like financial covenants rather than maintenance covenants that are typical with loans. Usually issued in “seller’s markets”, as companies can get away with more relaxed covenants when investors have excess cash to invest.
Bonds: Even the masses are familiar with this one. About as vanilla as debt securities come. The lender purchases a bond from the borrower in exchange for periodic fixed interest (coupon) payments (hence the term “fixed income”) principal repayment at maturity.
Broadly, there are two types:
Investment Grade: Bonds issues by companies considered investment grade (BBB- or higher)
High Yield (HY Bonds / Leveraged Bonds / Subordinated Notes / Junk Bonds): Bonds issued by companies rated BB+ and lower. Carry much higher interest rates than Investment Grade Bonds
Mezzanine Financing (Mezz): Here we won’t go into too much detail as we’re knocking on the hybrid securities arena. But here are two basic bullets on the topic:
Hybrid-like debt financing, also called “in between” debt which ranks above equity but below other debt in a company’s capital structure
Typically high-yield subordinated debt coupled with equity warrants (“equity kicker”)
Leveraged Finance: Within the context of the credit market, “Leveraged Finance” involves any debt financing in which a company is financing with more debt than what is considered normal for that company or industry (overleveraging itself) relative to earnings and cash flow. This is certainly a vague line to draw.
What’s more than normal? There’s no set answer. But. Some rules of thumb are based on interest rate spread cut-offs (anything > LIBOR+125-150bps), ratings (anything BB+ or lower), and leverage ratios (Net Debt / EBITDA) relative to industry comps. Typical LevFin issuers include sponsors, fallen angels, company’s exiting bankruptcy and startups that need seed capital.
If you work in a specific sector (A Detailed Look at Financial Institutions Group; Overview of the Consumer Sector; Overview of the Healthcare Sector; Overview of the Oil and Gas Sector; A Detailed Look at Technology Media and Telecom (TMT)... also find Part 2 here) You will find various rules of thumb to add to your definition of “over leveraged”.
In Short: There are several types of debt/loans and the seniority is as follows: 1) Revolving Credit, 2) Term Loans – followed by B’s C’s and various levels of security, 3) Bonds, 4) Mezzanine Financing and 5) Leverage Finance.
What is more telling than interest rate cutoffs or leverage benchmarking? What is the company *using* leveraged financing for?
Overleveraging is a risky and expensive proposition, so it is typically used for specific projects in which the borrower feels the potential upside from the project is high enough to justify the increased cost of capital. This increased leverage generally comes with restrictive covenants particularly in an aggressive leveraged finance investment. Examples of such project include:
LBOs: The business model of Private Equity. The increased leverage is justified by the increased returns on equity possible once the debt is paid down. The simplest example… even for your “Average Joe” is the purchase of a fixer upper home. He puts down a minimal down payment (over leverage) then tries to fix the asset and sell it for a profit (or generate higher than expected cash flow to more than offset the monthly payments).
If you want a basic overview of a real estate LBO/private equity investment we have one here and if you’d like to look at company specific ones… You’ll have to wait! Generally for a company there is ~10-20% equity and ~80-90% debt, heavily leveraged and you’re looking for a 20% annual ROI (yes the typical definition is 90% debt and 10% equity but we’re expanding the range to encompass more transactions)
M&A / Capital Expenditures: If a company identifies an attractive enough acquisition target or capital investment opportunity, they can justify the leverage based on the synergies and growth opportunities they think a potential investment will provide them.
Re-capitalizations: Equity holders will leverage the Company in order to use the proceeds for a dividend, stock repurchase, equity infusion, or any other transaction that will significantly impact a Company’s debt / equity ratio. Recaps are used when the company’s current capital mix is equity-heavy enough to justify allowing equity holder to liquidate of portion of their stake
Refinancing: Investment grade issues will use Refis to take advantage of periods of low interest rates in order to swap their existing debt out for *new*… Cheaper debt. Companies that use LevFin to refinance, are likely facing a maturity wall, cash flow shortage, or upcoming default event.
Refinancing using the LevFin market is somewhat of a “last resort”. But. Lacking other options, companies prefer expensive debt that’s matures 7 years from now over cheaper debt that matures tomorrow that they don’t know if they can repay.
In Short: Leveraged Finance is expensive debt that’s usually tied to a specific purpose. It is crucial to understand what the financing is being used for as the reasons for the financing will determine what investors are interested in the debt instruments.
Lending Side of Leveraged Finance (Lenders / Investors)
Leveraged Finance includes three of primary security-types: Institutional Term Loans, High Yield Bonds and Mezzanine Financing. These are typically the only debt securities with high enough yields to attract institutional investors. As such, they are the focus of a majority of institutional credit analysis. This brings us to the other side of the LevFin market: who the investors (or lenders) are.
In contrast to the low-risk Investment Grade debt market (largely funded directly by banks themselves), lenders in the LevFin market are typically institutional investors seeking to generate a higher risk-adjusted return.
Besides banks and finance companies, they include:
1) Hedge Funds: Debt focus; 2) Niche Private Equity Shops: Specifically, Mezzanine funds, 3) Traditional Institutional Investors: Pensions, Endowments, Insurers etc.
And finally…. The most infamous example…
4) Collateralized Debt Obligations (CDOs): The perpetrators of the 2008 Financial Crisis (partial joke for the intense finance readers). A CDO is essentially a corporate entity that is set up in order to buy a slug of debt securities and pool them together. CDO investors then buy stakes (liens) in that entity, which gives them a right to the cash flows from the debt purchased. The CDO is cut into slices (tranches) based on seniority, and investors pick which tranche they want to invest in based on their risk-return preferences.
The debt payments are then paid out to investors in a waterfall fashion, with those who bought the more expensive senior tranches being paid before those who bought the cheaper and higher yielding junior tranches.
Finally, to give you an idea about sizing: the HY Bond market is ~$1.4Tn, the Leveraged Loan market is ~$625Bn, and the Mezzanine Finance market is ~$500Bn. So all in, LevFin is about a $2.5Tn market!!! There is a lot of money out there!!!
In Short: When you start looking at “over leveraged” investments you begin talking to more and more risk loving investors. Or as they like to call themselves “sophisticated investors” (please tell us you got that joke!). The market is huge at $2.5Tn and you will certainly deal with the LevFin market at some point during your career.
Whether you are investing in equity or credit, you are evaluating whether or not a given company is worthy of an investment (stating the obvious we know). That is, if you give XYZ Corp. some of your money now, is XYZ likely to give you your money (and more) back in the future. The biggest risk in both cases is that you are not paid any of your money back.
Alternatively? You are not paid the “appropriate” amount of money back for the amount of risk you took on.
The difference is in the potential upsides? For equity investors, upside is unlimited. For credit investors, the upside is contractually limited.
Credit investors are guaranteed their upside, so their biggest focus is on the risk of not getting paid back. Since their returns are capped (fixed income), they spend a lot more time caring about the nature of the actual security that they are investing in. Where does it fall within a given Company’s capital structure? Do they believe the Company will be able to afford their interest payments? Will this lead to an eventual return of principal? They aren’t nearly as focused on earnings or the income statement as a whole. instead. They focus much more on the balance sheet and cash-flow statement.
While credit analysts end up covering the same companies as the equity analysts… They spend almost all of their time on different things.
Credit analysts also find themselves working on unique and complicated situations that the equity analysts often avoid. This includes restructuring, asset sales and joint ventures. It requires hours of reading through bank covenants and other financial documents which most equity analysts don’t have the time to do. In order to predict cash flow, you still have to be able to predict revenue, so you do spend a decent amount of time on revenue and costs as well.
In Short: Credit investors have much less upside relative to equity investors. They are looking to secure a defined return and want to mitigate risk to hit their specific benchmarks. Therefore, a credit analyst would look at a security in a different light relative to an equity analyst.
Given that credit investors will look at investments in a different fashion… Below is an outline of some of the key takeaways:
Default Risk: The likelihood of a borrower’s being unable to pay interest or principal on time. Based on the issuer’s financial condition, industry segment, conditions in that industry and economic variables/intangibles (company management as an example). Default risk will, in most cases, be most visibly expressed by a company’s public credit rating from S&P, Moody’s and the like.
Loss-given-default Risk: Severity of loss. How much will the lender lose in the event of a 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.
Industry Sector: 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.
Sponsorship: If a sponsor has a good track record, a loan will be easier to syndicate and 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.
Liquidity: All else being equal, more liquid instruments command thinner spreads than less liquid ones.
Market Technicals: If there are a lot of dollars chasing little product. Then… issuers will be able to command lower spreads. If the opposite is true? Then spreads will need to increase for loans to clear the market.
In Short: Credit analysts focus more on *downside* risk. Why? Well the upside is already capped at X% return so that is already set in stone. What is not set in stone? The downside of a default and overall payment risks.
Since this post is heavily tailored to Wall Street specific individuals you probably read the entire post. That said here are the main takeaways in bulleted form as requested:
– You will likely work with the Leveraged Finance team at some point in your career. That said if you’re interviewing for one you now have an overview. Two birds. One stone
– The LevFin market is huge at $2.5Tn
– Several types of debt/loans and the seniority is as follows: 1) Revolving Credit, 2) Term Loans – followed by B’s C’s and various levels of security, 3) Bonds, 4) Mezzanine Financing and 5) Leverage Finance
– It is crucial to understand what the financing is being used for as the reasons for the financing will determine what investors are interested in the debt instruments
– When you start looking at “over leveraged” investments you begin talking to more and more risk loving investors or “sophisticated investors”
– Credit investors have much less upside relative to equity investors. They are looking to secure a defined return and want to mitigate risk to hit their specific benchmarks
– Credit analysts focus more on *downside* risk. Why? Well the upside is already capped at X% return so that is already set in stone. What is not set in stone? The downside of a default and overall payment risks
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Updated for 2017 and beyond.