That worrying wall of debt

The leveraged loan market got accustomed to big numbers over the past decade. There's $3.6 trillion, the amount of leveraged loans made since 2000, according to Thomson Reuters' Loan Pricing Corp. There's 735-fold, the amount of growth between 2003 and 2007 in the volume of collateralized loan obligations -- the funds that helped fuel the loan market's surge after the tech and telecom bust of 2001. And there's $375 billion, the amount of bank debt used to fund leveraged buyouts completed between 2005 and 2007.

But right now, the leveraged loan market is fixated on one number: $430 billion, the amount in leveraged loans due to mature between 2012 and 2014. Despite the big numbers of the past, this might be simply too big. Indeed, the $430 billion figure is already worrying lenders, borrowers and loan-market investors alike as they struggle with the possibility that a large portion of those loans will neither be repaid nor refinanced, raising the specter of a wave of defaults among the debt-fueled LBO borrowers of 2005 through 2007.

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-- See related story: The future and other problems --

"People are in a panic about it right now," says one lawyer who specializes in corporate finance. "There's not enough capacity to refinance this."

Is the panic justified?

Standing where we are today, it certainly seems as though the looming maturities will break upon an already fragile market, causing further damage and potentially extending the crisis. But just how serious a threat the maturities pose is an open question. Markets are dynamic, ever-evolving systems, and it's virtually certain the conditions that exist today will have changed substantially, even fundamentally, tomorrow. As Alexander Gendzier, capital markets lawyer at Jones Day, says, "2012 is a couple of lifetimes from where we are today."

The problem, in perspective: According to Standard & Poor's Leveraged Commentary & Data unit, about $10.8 billion worth of loans will mature in 2010. In 2011, the total more than doubles, to $26.5 billion, and almost triples in 2012, when it reaches $73.6 billion.

Given that the Loan Syndications and Trading Association estimates that average yearly issuance of leveraged loans totaled $107 billion between 1998 and 2005 (and ignoring for now the fact that the market for risky loans today is frozen and few expect it to regain anything like its recent size when it does thaw), those numbers could be deemed manageable. But in 2013 and 2014, the scale of the problem reveals itself as the volume of maturing loans surges to $152.5 billion, then surges again to $203.1 billion, before falling back to $27.7 billion in 2015.

The $430 billion making up the bulge that begins in 2012 largely consists of debt owed by some of the largest and highest-profile borrowers of the past several years. Private equity firms such as Apollo Management LP, Bain Capital LLC, Blackstone Group LP, Kohlberg Kravis Roberts & Co. and THL Investment Capital Corp. placed billions of senior debt on the balance sheets of companies such as Clear Channel Communications Inc., First Data Corp. and Freescale Semiconductor Inc. to finance their megabuyouts.

There was some concern even then of the amount of debt being piled on to balance sheets. For example, KKR's financing plan for its purchase of credit- and debit-card processor First Data initially met resistance in the summer of 2007 as investors struggled with the company having an Ebitda-to-­interest-payments ratio of 1.2 times, meaning KKR had barely enough cash flow to cover interest on its debt. (The deal was eventually financed, but only after KKR agreed to add some covenants, though very loose ones, to the loan agreement.) Still, the availability of cheap credit served as powerful encouragement for financial sponsors to load more debt onto the balance sheets of portfolio companies.

LCD's data shows this quite clearly. Total equity in leveraged buyouts between 1999 and the first quarter of 2009 dropped from 35.72% to 32.91%. That decline in equity came with an increase in bank debt, which jumped from 47.88% in 1999 to 53.31% in 2007.

As one executive at a private equity firm describes it, the availability of so much cheap debt profoundly affected how sponsors did business because it encouraged them to change their focus. "The PE firms were not investing in specific industries," he says. "They were investing in the capital markets."

This strategy was predicated on faith that loans could be continually refinanced, that exit options in the form of the equity markets or mergers and acquisitions fueled by more financing would be easily available and lead to profits that justified the outsized risk the sponsors were taking. There was also the belief that an ever-expanding economy would allow companies to keep increasing their Ebitda and pay down debt. The strategy had more than a few similarities with the one used by people who borrowed in increasing amounts to finance home purchases and hoped for either a quick flip or continually rising prices that would make debt more manageable.

Seen in that light, the $430 billion maturity bulge represents the bill from the lending surge coming due. But issuers and lenders have clearly been chastened by the crisis atmosphere of the past six months and are not passively waiting for the tidal wave to break upon them. Many are working aggressively to whittle away their debts. Some are using the relatively open high-yield bond markets to refinance some loans or getting bank lenders to amend and extend agreements to push out the maturities and delay the day of reckoning. "You do have evidence in place of how much of [the outstanding loans] will be reasonably refinanced," says a leveraged finance banker.

As LCD notes, the stock of outstanding leveraged finance paper -- including both leveraged loans and high-yield bonds -- has dropped from its peak of $1.15 trillion in October to $1.11 trillion as of April. This was the largest decline since 1997, although in percentage terms the 3.1% decline in outstanding paper was smaller than the 3.4% decline between December 2001 and April 2002.

Much of that decline has been in the high-yield bond market -- where LCD estimates that $372.5 billion will come due between 2012 and 2016 -- either through debt exchanges or through debt buybacks. In terms of exchanges, companies such as TPG Capital and Apollo-owned Harrah's Entertainment Inc. and Blackstone portfolio company Freescale persuaded debtholders to exchange some debt for a lesser amount that carries higher interest or has more seniority, helping to push out the maturity dates.

In the loan market, buybacks have been more popular. Companies such as Ford Motor Co. and Apollo's Berry Plastics Corp. have gained approval to buy back their loans in the secondary market, which in today's climate is a cheaper option than repaying them at par. This has allowed companies to retire about $2.8 billion of loans, according to LCD.

Borrowers have also been taking advantage of a revival in the high-yield-bond markets to repay some of their loans by issuing bonds. The LSTA's vice president of research, Meredith Coffey, says that about $11 billion has been refinanced in this way. Chief among the companies that took this tack is HCA Inc., the hospital operator that KKR, Bain Capital and Merrill Lynch Global Private Equity bought for $33 billion in November 2006.

The sponsors had loaded about $12 billion of bank debt onto HCA's books, but used the resurgent bond market to pay that down by about $1.5 billion.

And, most recently, companies are looking to extend maturities in a bid to make their debt loads more manageable. Blackstone portfolio company Graham Packaging Co. LP did this in May, when it extended $1.1 billion of a term loan to April 2014, from October 2011.

But these strategies aren't exactly free rides, and much uncertainty still surrounds the loan market outlook. "Capital has a tendency to find its way to places that need it," says one leveraged finance banker. "But that doesn't mean it won't cost a lot more."

Refinancing loans for bonds, for example, is an expensive proposition, costing HCA an extra $85 million a year in interest payments, according to LCD. The ability to afford higher interest rates is very much an issue, even with lower interest rates overall, because the struggling economy has put pressure on company balance sheets.

According to LCD, average borrowing costs for leveraged loan issuers fell roughly 8% between the first quarter of 2008 and the first quarter of 2009. Ebitda numbers, however, fell even more during that time period, down 15% on the year, which pushed the ratio of Ebitda to cash interest to 3.1 times, from 3.5 times a year earlier. This suggests companies have little room to take on increased interest expense, even in the face of looming maturities that they might not be able to pay.

Other strategies, such as debt buybacks, also pose problems. In particular, ratings agencies view debt buybacks as a sign of distress and often downgrade companies that choose the route. This is what happened to troubled radio company Emmis Communications Corp. when it announced it was buying back term loans at about 45 cents on the dollar in April. Both Standard & Poor's and Moody's Investors Service reacted by lowering the company's ratings, signaling high default risk.

Graham Packaging, in exchange for its extension, had to agree to increase the price of its loan from LIBOR plus 225 basis points to LIBOR plus 425 with a 2.5% floor.

Then, there is also the difficult problem of rejuvenating loan market demand.

According to Dave Preston, a structured products analyst at Wachovia Capital Markets LLC, the surge in the loan market between 2003 and 2007 was prompted by a concurrent surge in the creation of collateralized loan obligations -- structured funds similar to the collateralized debt obligations that bought mortgage-backed securities -- that invested primarily in leveraged loans. Preston estimates the yearly volume of CLO creation jumped from $52 million in 1997 to $85.9 billion in 2007, with the vehicles responsible for about 66% of loan demand at the height of the credit boom.

But that demand will not return. Preston says existing CLOs, which are still returning money to investors, will themselves hit the end of their reinvestment periods between 2011 and 2014, meaning they won't be able to use cash in their vehicles to buy new loans.

And there's little expectation that new CLO creation will be sufficient to replace that lost demand from existing vehicles. The primary investors in the triple-A tranches of the CLOs were foreign banks, the now discredited structured investment vehicles and the monoline insurers, which doesn't exactly bode well for a resumption of investment in these structures.

"As CLOs purchased approximately two-thirds of loans from 2003-2007, these loans may face difficulty refinancing without a CLO market," Preston says. "Just as mortgage defaults rose and recoveries fell due to option ARM borrowers with limited refinancing opportunities, loan cumulative losses could spike if the market is not revived by 2012-2014."

Which brings us to the nuclear option of debt reduction: bankruptcies. S&P estimates that default rates in the loan market hit 8.03% in April and could double as the recession continues. This may, in fact, be the most effective method of reducing maturities. LCD estimated on May 12 that about 15 bankrupt leveraged loan issuers will reduce secured debt by 41%, from $24.6 billion to $14.6 billion.

LSTA suggests that if defaulted loans are taken into account with the other options issuers are using, the loan-maturity bulge could shrink by 40%.

"This is never a good option," says the LSTA's Coffey, adding that bankruptcy is an uncertain process that could inflict broader economic pain by increasing layoffs, not to mention destroy returns for many private equity investors.

But, as one debt markets banker puts it, companies that default because of onerous debt, as opposed to a flawed business model, such as the one that brought down Apollo portfolio company Linens 'n Things Inc., could still emerge as healthier companies on the other side. This may hurt private equity firms and shrink the loan market, but these could be good things in the end.

"It's clear we won't be turning the spigots back on," says the banker, referring to both the loan market and the private equity industry that fed off it. "But the name of the game right now is survival."

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