Monday, December 22, 2014

The $800 Billion Leveraged Loan Blacklist?

There's a Blacklist in the $800 Billion U.S. Loan Market and It's Not Illegal (h/t, Johnny Quigley):
What do Highland Capital Management, Fortress Investment Group LLC (FIG) and Cerberus Capital Management have in common? The firms, which manage some $110 billion among them, are on a list that says they can never invest in a $155 million loan that’s trading in U.S. markets.

RBS Holding Co., the owner of direct marketer Quadriga Art, banned the three firms and seven others last year from buying parts of the loan, according to two people with knowledge of the matter who asked not to be named because the decision was private. They were deemed, the people said, to be too demanding in debt restructurings, a fate that executives at RBS -- which has no relationship to the Scottish bank -- considered as Quadriga’s business faltered.

Unlike any other market in the U.S., the blacklist rules in leveraged loans. No regulator polices trading in the $800 billion market. Here, borrowers -- and the investors who control them -- choose who gets into the club. It would be as if Apple Inc. (AAPL) got to decide who could buy its stock.

“I really can’t think of a good example of another market where you really are selling to a lot of people but you still retain the right to keep some people out,” said Elisabeth de Fontenay, a professor at Duke University School of Law in Durham, North Carolina, and a former corporate lawyer.


While banks managing stock and bond deals can pick which investors are allotted securities in public offerings, anyone with enough money can buy the assets once they start trading in the market. Not so with loans. The lists prohibiting investors can last until the debt matures.

Booming Market

The practice poses risks to a market whose size has quadrupled from about $200 billion over the last decade as plunging interest rates fueled investor demand for securities that offer extra yield. Blacklisting reduces the number of potential buyers, which in turn makes the loans difficult to trade, and can exclude the savvier investors who are better able to fight for creditor rights in a default. 


“These types of limitations are tremendously detrimental” to the market’s quantity and quality of buyers and sellers, said Greg Margolies, a senior partner at Los Angeles-based Ares Management LP (ARES), which manages about $80 billion in assets including speculative-grade debt and real estate. “Ares will not invest in a name where secondary liquidity can dry up immediately because an issuer has decided to blacklist a number of market participants.”

Blacklist Defined

The Merriam-Webster Dictionary defines blacklist as “a list of persons who are disapproved of or are to be punished or boycotted.” In the loan market, there are three things that can warrant punishment: having a reputation for being a tough negotiator in debt restructurings, like Highland and the other firms in the RBS deal; having an affiliation with a borrower’s competitor; or simply being disliked.

“We protect the rights of our investors,” Jim Dondero, president of Highland, said in an e-mailed statement. “Sometimes we must pursue the ‘bad acts’ of management teams or sponsors. It stuns us that some managers are passive and never protect their investors.”

Mark Schulhof, chief executive officer of RBS, declined to comment. Gordon Runte, a spokesman for Fortress, and Peter Duda, a spokesman for Cerberus at Weber Shandwick, declined to comment.

Illiquid Assets

The lack of liquidity in speculative-grade debt has drawn warnings from regulators, including the Financial Stability Board and the U.S. Securities and Exchange Commission, as individual investors poured money into mutual funds and exchange-traded funds. The concern is that it’s become too easy to get into a market for people who don’t understand how tough it may be to cash out when sentiment sours.  

Trading is slow even in a bull market.

It took 20 days on average to complete a loan trade in the three months ending in June, according to data compiled by the New York-based Loan Syndications & Trading Association. That’s almost seven times as long as the three-day average in the corporate bond market.

Yet for all of the concern expressed by U.S. policy makers, none of them oversee the loan market. Its unregulated status traces back to securities laws that were drafted in the 1930s, when company loans were mainly private transactions between one bank and one borrower. These days, though, the debt is mostly sliced into pieces worth several million dollars and distributed to investors.

The SEC’s authority in this market is limited to loans that meet the legal definition of a security, which “depends on the facts, circumstances and economic terms of the loan or loan tranche,” according to spokesman John Nester. “The SEC is focused on the oversight of liquidity management in mutual funds and ETFs, and will continue to vigorously pursue violations of the securities laws within its jurisdiction,” Nester said in an e-mailed statement.

Bad Blood

Blacklisting is rampant. And growing.

Data gathered by Xtract Research show that 77 percent of all loan deals in the third quarter included provisions giving borrowers the ability to block individual lenders, up from 51 percent at the end of last year. The lists can often be updated to add new investors whenever a borrower wants.

The most common explanation given for excluding potential buyers is that they have an affiliation with rivals of the borrower. There’s private information that lenders get access to -- things like financial projections -- that the borrower doesn’t want them to see.

Robert Blank, head of leveraged-loan research at Xtract in Westport, Connecticut, calls those circumstances the most “reasonable” for justifying the blacklist.
Apollo-Highland

Jonathan Kitei, head of U.S. loan sales and collateralized-loan obligation origination at Barclays Plc (BCS), said, though, that he’s seen personal animosity shape lists.

“Often times you see a sponsor put an investor on a blacklist because one partner at the firm doesn’t like the investor,” said Kitei, who is based in New York. “There are great inconsistencies in the use of blacklists.”

Leon Black’s Apollo Global Management LLC has blocked Highland from buying several loans of its takeover targets, according to a person with direct knowledge of the matter. There’s a history of feuding between the two firms: Highland sought in 2006 to stop a merger between Apollo-backed SkyTerra Communications and Motient Corp., triggering a series of court battles.

Highland, a Dallas-based money manager, was banned from deals including loans taken out by Caesars Entertainment Corp. (CZR), the casino operator partly owned by Apollo, according to the person, who asked not to be identified because the matter is private.

Charles Zehren, a spokesman for New York-based Apollo at Rubenstein Associates Inc., declined to comment.

‘Shindler’s List’

Blacklisting dates back to at least the late 1990s, when Nextel Communications Inc.’s then chief financial officer Steve Shindler penalized lenders who didn’t participate in the company’s new credit facility by banning them from buying the debt in the secondary market, according to industry newsletter Bank Letter.

It became known as “Shindler’s List,” reflecting Wall Street’s penchant for tasteless puns that twist history. The phrase is a reference to German businessman Oskar Schindler’s list of Jews to be saved from transportation to concentration camp Auschwitz during World War II, the subject of the Oscar-winning film of that name in 1993.

To this day, traders still use the name when talking about blacklists. Shindler, who is now chief executive officer of NII Holdings Inc., the bankrupt mobile-phone company that uses the Nextel brand in Latin America, declined to comment.
‘Disqualified Institutions’

“It’s anti-American,” Lee Shaiman, a senior portfolio manager with Blackstone Group LP (BX)’s credit unit GSO Capital Partners in New York, told the LSTA’s annual conference Oct. 23 when asked about the practice. “It’s anti-competitive.”

Some investors find out that they have been barred when they try to complete a trade and are turned away by broker-dealers. Others never know. Most lists are kept privately by the banks that arrange the deals.

Occasionally, they’re included in public credit agreements, like the blacklist orchestrated this year by a Goldman Sachs Group Inc.-controlled company named Interline Brands Inc. An addendum to a March 19 regulatory filing for the deal listed two names as “Disqualified Institutions” that couldn’t buy the loans: hedge funds Bulldog Investors and QVT Financial.

Andrea Raphael, a spokeswoman for Goldman Sachs, said the bank didn’t select the names on the list. Lev Cela, a spokesman for Interline, didn’t respond to e-mails and telephone calls seeking comment. A QVT representative declined to comment.

Phil Goldstein, the co-founder of Bulldog in Saddle Brook, New Jersey, was unaware for months that he had been banned. “It kind of irks you that there’s somebody saying you’re not good enough to do this or we don’t want you for that,” he said.

The whole thing is perplexing to Goldstein.

His fund, he said, doesn’t even invest in loans.
Welcome to the Wild West of credit markets, the unregulated, ever expanding U.S. leveraged loan market.

Back in July, Fed Chair Janet Yellen warned she sees signs of asset price bubbles forming in some markets such as those for leveraged loans and lower-rated corporate debt:
“We’re seeing a deterioration in lending standards, and we are attentive to risks that can develop in this environment” of low interest rates, Yellen said today in semi-annual testimony to the Senate Banking Committee.  
And in October, the Fed said it was stepping up its oversight of high-risk leveraged loans, shifting to a deal-by-deal review after its previous industry-wide guidelines were largely ignored by banks.

However, if the Fed sees a deterioration in lending standards and risks developing in the leveraged loan market, it didn't discuss them in its most recent deliberations where it basically committed itself to keeping rates low for considerable time longer despite the linguistic nuances in its text.

Financial Advisor reports the U.S. Treasury is also warning leveraged loans may be systemically risky:
Excesses in the buying of bank leveraged loans by asset managers from banks may be systemically risky, the Treasury Department’s Office of Financial Research said in its annual report Tuesday.

As banks moved to shrink their leveraged loan holdings to reduce risk and comply with the Volcker Rule, asset managers and pension funds have stepped in to buy.

The agency noted asset managers are purchasing an increasing share of leveraged loans on behalf of investors in hedge funds, high-yield bond mutual funds, and collateralized loan obligations.

“The growing role of asset management products in funding leveraged lending adds urgency to discussions about structural vulnerabilities, such as redemption, fire sale and maturity transformation risks in credit funds, and whether and to what extent they can contribute to financial stability risks,” the report said.

OFR added continuing concentrations of money market fund assets with a few large asset managers may require more intense monitoring of potential cash reallocation.
Increased scrutiny is impacting the leveraged loan market. Leveraged Loan Funds Seen Plunging 40% After Record Year:
Wall Street dealers are bracing for a steep drop in issuance of collateralized loan obligations after a record amount of the debt was raised this year, threatening to boost borrowing costs for the neediest companies.

Rules designed to limit risk-taking may mean CLO sales will be at least 41 percent less than the unprecedented $119.2 billion issued so far in 2014, according to the most pessimistic forecast by JPMorgan Chase & Co. (JPM:US) At least three other leveraged-loan underwriters are also projecting a decline even though the regulations won’t go into effect until at least 2016.

CLOs helped finance some of the biggest leveraged buyouts in history, and the outlook for a drop in issuance comes as prices in the more than $800 billion market for high-yield, high-risk loans are already near a two-year low. A BC Partners-led group of investors agreed to buy pet-store chain PetSmart Inc. for about $8.3 billion, the largest LBO for a U.S. company this year.

“The net result of the CLO market shrinking is that there will be less capital available for the leveraged-loan market and as a result borrowing costs will go up,” John Fraser, managing partner at 3i Debt Management U.S., said in a telephone interview. The U.S. debt-investment arm of the London-based buyout firm 3i Group Plc oversees $13.3 billion.
CLO Forecasts

Morgan Stanley predicts CLO issuance will fall to $75 billion to $85 billion in 2015, while Wells Fargo & Co. (WFC:US) sees a drop to $90 billion, according to research reports. Deutsche Bank AG says there may be $80 billion to $90 billion raised next year, according to a Dec. 10 report. JPMorgan expects CLO issuance of $70 billion to $80 billion, according to a Nov. 26 report.

CLO sales surpassed the previous 2006 high of $94 billion in October, according to JPMorgan. The growth has been a boon to lending with $485.8 billion of institutional loans issued in the U.S. this year, following the record $701.7 billion in all of 2013, Bloomberg data show. The debt is typically sold to non-bank lenders such as CLOs, mutual funds and hedge funds.

CLOs controlled 63 percent of the leveraged-loan market in the second quarter, according to the New York-based Loan Syndications & Trading Association. The funds purchase the speculative-grade debt and package it into securities of varying risk and return, typically from a AAA rating down to B.
Loan Prices

An investing arm of Zurich-based Credit Suisse Group AG (CSGN) issued a $685.8 million CLO this month, data compiled by Bloomberg show. The deal includes a $413.2 million portion rated AAA that pays interest at 1.48 percentage points more than the London interbank offered rate.

A reduction in CLOs would come when loan prices are falling as other buyers flee. Prices fell to 94.5 cents on the dollar today, the least since August 2012, according to the Standard & Poor’s/LSTA U.S. Leveraged Loan 100 Index. Investors pulled $1.05 billion from U.S. mutual and exchange-traded funds that buy leveraged loans in the week ended Dec. 10, a record 22nd straight week of withdrawals totaling more than $14 billion, according to Lipper.

The drop in prices may bode ill for Citgroup Inc., Nomura Holdings Inc., Jefferies Group LLC, Barclays Plc and Deutsche Bank, which, according to a company statement, have underwritten debt to back the buyout of Phoenix-based PetSmart.
LBO Loan

The financing for the deal announced Dec. 14 may be marketed to other lenders next year, according to a person with knowledge of the transaction, who asked not to be identified because the information is private.

The average yield for all loans rose to 6.01 percent in December from 5.84 percent in November, according to S&P’s Capital IQ Leveraged Commentary & Data.

New restrictions on CLOs are aimed at limiting excesses in the leveraged-loan market, where regulators have warned of froth. Investors piled into the debt in their search for yield as the Federal Reserve kept interest rates close to zero.

While the impending regulation hasn’t curtailed CLO formation in 2014, the cost to raise the biggest portions of the funds rose in November to an almost three-year high, according to Wells Fargo. The risk-retention rule, released on Oct. 21, is intended to make sure CLO managers are on the hook for at least a portion of their deals. It’s part of the 2010 Dodd-Frank Act enacted in response to the credit crisis that was fueled in part by securitized debt, particularly in the mortgage market.
What are the key takeaways for pension funds? While some firms defend the practice of blacklisting for competitive reasons, the more pressing issue is this market is growing by leaps and bounds and liquidity -- or lack of liquidity -- can come back to haunt investors.

More importantly, as the market grows, there are increasing systemic risks that can contribute to another financial meltdown. I worry about this now more than ever as there are delays and push back on banking regulatory reforms.

Does this sound familiar? Well, it should because it all happened in 2008 with toxic CDOs and CDS except the leveraged loan market isn't as big and doesn't pose systemic risk -- yet.

But as the hunt for yield keeps pushing funds back into CLOs, expect the exponential growth in leveraged loans to continue as more investors keep plowing into these funds ignoring the risks of leveraged loans.

And this isn't just a U.S. problem. Reuters reports that the European high-yield entering unknown territory:
The growth of European high-yield looked unstoppable until just a few months ago, but for the first time in years there is real uncertainty on where the junk bond market is heading.

While January is shaping up to be a busy month for primary activity thanks to a rush of M&A trades, with Altice alone set to issue up to EUR5.7bn equivalent, it is not clear if companies will continue to tap the market for opportunistic refinancings in droves.

"The wild card will be the market backdrop," said Nigel Walder, managing director, high-yield and loan capital markets and syndicate, EMEA at JP Morgan.

"There's a lot of event risk on the horizon, and we could see that impact high-yield next year."

At the start of 2014 the market was fixated on the threat of rising Treasury rates, with geopolitical concerns and credit risk largely ignored. But while rates rises were pushed out further on the horizon, political instability returned with a vengeance in the second half of the year and high-profile defaults such as Phones 4U wrong footed many.

In this fraught environment, whole swathes of the market that previously flourished have now been shut-out.

Greek corporates have tapped the market in droves since the start of 2013, but none has issued euro bonds since July. The same is true of European retailers, which following Phones 4U's demise in September, have seen some of the biggest price collapses in the secondary market.

While these shocks are far from over, as seen in the savage price action on German retailer Takko's bonds last week, it does mean that there is now some real opportunity for credit selection for investors.

"There's a lot of idiosyncratic risk in the retail sector, so you have to tread carefully, but if you're looking for value you can't ignore it," said Peter Aspbury, a high-yield portfolio manager at JP Morgan Asset Management.

"You could miss out on a lot of performance if Christmas trading is strong and lower oil prices start to feed through to consumer spending."

MISSING INGREDIENT

This scope for price appreciation was a missing ingredient in the European high-yield market for a long time.

Most high-yield bonds have embedded call options at set prices, which places a natural cap on how high the cash price of the bonds can rise. Until the sell-off began in earnest in September, the vast majority of European high-yield bonds were trading at their first call prices, which meant the only way they could go was down.

In the volatile conditions in the past few months, bonds without call options have fared better, which are overwhelmingly Double-B rated deals. Aspbury notes that the strong performance of Double-B credits caught many people by surprise.

"But many of the big names are now on the cusp of investment grade, and the vacuum created by these upgrades could create a natural bid for Single-B or Triple-C risk," he added.

"There's a lot of very beaten up names and any inkling of growth could spark a decent rally."

There are already tentative signs that buyers are willing to add risk to their portfolios once again. Siemens Audiology received strong demand for a Triple-C rated LBO bond earlier this month, which then traded up several points on the break.

The deal does also point to a potential threat to high-yield primary supply, however. The bond was downsized by EUR40m to EUR275m, after the loan portion of the deal was upsized by the same amount following incredibly strong demand.

While one of the main trends over the past few years has been loan-to-bond refinancings, the robustness of Europe's burgeoning institutional loan market could start tempting companies back.

For example, BNP Paribas credit strategists expect leveraged loan issuance to surpass European high-yield issuance for the first time since 2007.

Walder at JP Morgan said that investor demand for leveraged loans increased in 2014, and that the loan market is now much more liquid and a competitive alternative for deals.

"The technicals are still very good; there's a healthy new CLO pipeline and investors will have cash from the repayment of several large loans such as Boots and TDF," he said.
I don't want to sound the alarm on leveraged loans but I do want investors to be cognizant of all the risks that come with this unregulated market, especially systemic risk. As global leveraged loan markets balloon, I do worry that a fallout in this market has another 2008 stamped all over it.

Below, leveraged-loan investors can find themselves shut out of purchasing loans due to a blacklist restricting access tothe $800 billion loan market. Bloomberg’s Nabila Ahmed explains how it works and why it’s legal on “Market Makers".

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