Shortly before Christmas, a seemingly unimportant release hit the leveraged buyout news wires. The arrangers, made up of Deutsche Bank, Goldman Sachs, Allied Irish Banks, Bank of Ireland and Barclays Capital, of the €2.4bn loan facility provided to Valentia Telecommunications in 2001 to help fund its acquisition of Eircom, Ireland's incumbent fixed line telecommunications group, had at last been made free to trade in the secondary loan market.
Perhaps this news was of no great surprise to market watchers. After all, the deal was originally launched post-September 11 into a market that was already suffering from a measure of indigestion courtesy of one too many telecommunications sector deals. The initial sub-underwriting phase of the loan had transmuted into a take-and-hold one and further distribution plans had been cancelled. The fees paid at this stage had to be flexed and the arranging group, we were told, was left long. Surely the opening of a secondary phase, permitting a loan to be traded without restriction in the market, was simply a much-delayed next step for the lending group to reduce their exposure, enabling them, finally, to deploy the resources they'd committed somewhere else? In principle yes, but the actual details may be a little more involved, and the reasoning that little bit subtler.
The timing of the announcement, coming close to most financial institutions' financial year-ends, is significant in this respect. Reducing exposure levels at this time of year in order to manage the year-end balance sheet position is not especially new. Indeed, it was widely reported at the end of 2001 that this issue was one of the reasons that led to the shift from sub-underwriting to take-and-hold for this very facility. As the initial effort was launched towards the end of the year, with the retail phase planned for early 2002, the banks invited to participate were nervous about holding underwriting positions over a year-end in such an uncertain market.
However, this practice is becoming more common also because more and more banks adopt mark-to-market practices for their loan books. In essence, this practice requires financial institutions to value their loan portfolios periodically, and in particular, to reflect any loans valued below par at that reduced level on their balance sheets. For quite some time loans held as ?inventory? – that is, held as a trading asset or pending distribution through the syndication process – have been required to be valued based on market information. However, the retained exposure from such facilities has historically been held at par in the absence of specific write-offs or provisions. This is no longer the case and as a result banks and other loan investors, particularly in Europe, have an awkward problem to deal with. What exactly is the market price of a loan asset, especially something as illiquid as a leveraged loan?
In the case of the Valentia transaction, it may be that tightening internal controls not only put pressure on loan portfolio managers' position limits (especially if the arrangers were long) with respect to the facility, but also the veracity of its carrying value too. At the time the retail phase was cancelled, the arrangers reported that they had achieved around 75 per cent of their targeted sell-down levels. This may of course have simply been bravura on their part in the face of failure, but if we take it at face value, why then the pressure to reduce exposure levels now? Significantly, in order to entice new investors into the transaction, the arrangers also announced that the pricing had been flexed once again with the margins on each tranche increased by 50bp. Conveniently, this would also increase the price at which the loan would trade in the market, reducing any fall in the reported value of the loan from the arrangers' standpoint. Thus the ?problem? can be fixed in two ways through the ability to trade the loan: balance sheet exposures are reduced (assuming there are takers for the asset at the new pricing level), and the value of the remaining positions is both more transparent and closer to par.
PEI has discussed valuation and transparency issues in the context of private equity transactions on a number of occasions. As the above example illustrates, this is a wide-ranging theme not simply restricted to the equity players but, increasingly, includes the providers of debt too. Looking ahead, something as simple as the date may affect underwriting LBO debt facilities, and therefore sponsors will effectively need to get deals done prior to banks' annual cut-off point. Though in the past only an issue in times of unsettled markets, with the implementation phase of the new capital regime for banks fast approaching and the number of active large underwriters shrinking, this could well become a major factor going forward.