Ratings

The two major U.S. automakers, Ford Motor Co. and General Motors Corp. (GM), now both 'B' rated, made their debuts in the leveraged loan market this year. Both deals were very complex, each in its own way. GM started out in June with a $4.48 billion secured revolving facility to which Standard & Poor's assigned a loan rating of 'B+' (one notch up from the 'B' corporate credit rating) and a recovery rating of '1'. GM's deal actually consisted of two separate revolvers, one in the U.S. and the other in Canada. Several months later, GM followed with a second secured loan facility, a $1.5 billion secured term loan. The second facility is secured by all the company's U.S. machinery, equipment, and special tools that aren't already pledged or otherwise encumbered via other credit agreements and bond indentures. This deal too, received a notched-up loan rating and recovery rating of '1', signifying that Standard & Poor's believes both loans would receive full recovery in the event of default.

Ford entered the market later in the year with a $15 billion secured facility, comprising an $8 billion revolver and $7 billion term loan, both pari passu with respect to security. Standard & Poor's assigned a loan rating of 'B' (at the same level as the corporate rating; i.e., not notched) and a recovery rating of '2'. The difference in ratings between the GM and Ford deals does not reflect Standard & Poor's opinion of each company's relative value, but is rather an indication of the different financing choices each made. By choosing to borrow more than twice as much on a secured basis as GM did, Ford increased the loan-to-value ratio, lessening the relative protection provided to its secured lenders.

Both deals required Standard & Poor's analysts to evaluate the security packages from a "discrete asset" perspective as well as from an "enterprise value" one. In general, analysts tend to use discrete asset evaluations when the collateral consists of short-term self-liquidating assets (accounts receivable or inventories), or fungible assets (oil and gas reserves), or when the company's default is expected to be due to a fatal decline of its business model (i.e., no sustainable business to reorganize). The enterprise value approach is used when analysts expect the business to survive default and reorganization and emerge as a viable ongoing venture. In most cases, reorganization maximizes the overall value and increases the chances of repayment for unsecured and other less-protected creditors.

Generally, secured lenders ensure that they will have the benefit of a company's full enterprise value in default by insisting on taking substantially all of the borrower's assets as collateral. If the collateral consists of only certain assets, then even if the bankruptcy court decides to allow the company to reorganize itself in order to maximize its post-bankruptcy value, the secured creditor will likely share in that larger enterprise value only to the extent of the value of the specific assets that were part of its original collateral package. The remaining enterprise value would benefit unsecured creditors.

In both the GM and Ford deals, the secured creditors have carefully crafted collateral packages that were essentially carved out of the remaining assets still available after taking into consideration existing liens and restrictions on secured debt under various bond indentures. Even though it's analytically compelling that both Ford and GM would be reorganized rather than liquidated, if either of them defaulted, in neither case would the secured lenders automatically stand first in line to get their entire loans repaid from the resulting enterprise value. Their priority claim would be limited to what the value of their specific collateral was determined to be.

Therefore, in both cases, Standard & Poor's analysts did a two-step review, first determining what the stand-alone discrete asset value of the specific collateral was, and then evaluating the enterprise value of a reorganized GM and Ford. As mentioned above, in the case of GM, Standard & Poor's determined that both of the two secured loan collateral packages would have adequate value in a post-default scenario, enabling those loan holders to be treated as fully protected and essentially first in line for the enterprise value of the emerged business, however it was harvested and made available to creditors. In the case of Ford, analysts concluded that a review of the discrete value of the assets in the secured loan's borrowing base, as well as a more straightforward enterprise value approach, both suggested a shortfall for secured lenders-resulting in the recovery rating of '2'.

Crown Castle International Corp. presented another case in which Standard & Poor's analysts evaluated it both ways-–discrete asset and enterprise value-–and came up with virtually identical results. From an enterprise value perspective, after paying off securitized debt and other preferred expenses, sufficient value remained to repay secured lenders 59%--resulting in a recovery rating of '3'. When analysts carried out a bottoms-up valuation derived from each of the 12,458 wireless towers that the company owned and/or operated throughout Australia and the U.S., they came up with an identical post-default recovery estimate of 59%. Likewise with CSC Holdings Inc., where Standard & Poor's analysts came up with very similar results (94% vs. 98% recoveries, respectively) when they evaluated the company post-default on an enterprise and orderly liquidation basis.

It isn't surprising that so many deals in 2006 utilized second liens as part of the financing package. What is somewhat unexpected is how highly rated a few of those second liens were, including some of the highest profile transactions. Chart 2 shows that of 317 second-lien loans rated in the past three years, Standard & Poor's has assigned a recovery rating of '1' (100% recovery) to only 10 of them. Four of those 10 are featured in table 1.

The most visible was the HCA Inc. transaction, which, at $22.5 billion, was sure to get a lot of attention, regardless of the rating. This was a complex deal, with subgroupings of security even within the first- and second-lien categories. These included an asset-based loan (ABL) facility; senior secured revolvers and term loans (both U.S. and European); and then two levels of second-lien debt, one cash-pay and the other deferred payment in kind (PIK). Standard & Poor's assigned its '1' recovery rating to all of the HCA credit facility, including its most junior second-lien paper, notching the senior secured loans two notches above the corporate credit rating and the second liens one notch. In arriving at these ratings, Standard & Poor's analysts concluded that if HCA were to default, it would retain a viable business model and, therefore, achieve maximum repayment for creditors through reorganization rather than liquidation. Under that scenario, HCA would emerge from bankruptcy with an enterprise value sufficient to cover all of its senior secured as well as its second-lien lenders, including PIK deferred interest.

 Chart 2

Similar results were achieved with the second-lien loans of Charter Communications Inc., Mark IV Industries Inc., and NXP B.V. In each case, second-lien loan holders, despite their junior claim on the security, were expected to be fully covered in the event of default, even after senior claimants were satisfied. Extremely well covered in some cases, like Charter, where Standard & Poor's concluded that even after paying the first liens in full, second-lien holders would have 300% coverage. In other instances, however, second-lien lenders may have to scramble a bit to be paid in full. In the case of Mark IV, the rating analysis suggests that second-lien holders will receive most of their recovery from the collateral they share with first-lien holders, and then will get back in line as unsecured creditors to collect the remainder. In the NXP deal, the revolving credit facility lenders have prior rights to the security, with the senior secured noteholders (whose investment is six times the size of the revolver) ranking behind them. This is a different proportional split than the typical first-/second-lien deal in the U.S., where the second-lien tranche is generally much smaller than the first and is perceived as far less well secured.

Default and bankruptcy of a company on the scale of GM or Ford would present credit workout challenges and legal issues of historical proportions. But the possibility is far from remote for companies in the 'BB' and 'B' rating categories, based on historical default trends. Standard & Poor's data show that the average 'BB' rated issuer stands about a 12% likelihood of defaulting over any five- to six-year period. That likelihood rises to 35% for 'B' rated borrowers, which suggests that investor interest in recovery potential in the event of default is far from academic.

One critical element in the recovery equation is the jurisdiction in which any potential bankruptcy would be adjudicated. Operating in many jurisdictions can make a company a stronger credit, by diversifying its operating and economic risk and making it less dependent on a single market. But such geographic diversity can challenge a lender, especially one that wants to take a security interest in the company's far-flung business assets. The greater number of countries a company operates in, the more complicated it is to file and perfect a security interest in collateral, and later on in bankruptcy, to actually enforce that security interest. It also runs up administrative and legal costs when more jurisdictions are involved. So, in general, just as geographic extension can enhance a company's default profile and, therefore, boost its corporate credit rating, it may lessen its recovery prospects in the event of default.

A good case of this is Smurfit Kappa Group Ltd.--the high leverage and weak operating cash flows of which are offset to some extent by the company's wide geographical diversification. But that same geographic diversification (operations in 32 countries) that helps the corporate credit rating presents a challenge to the recovery rating. It is difficult, and often not cost-effective, to obtain fully perfected collateral coverage in every jurisdiction, which ends up allowing security to "leak" out to other creditors, impinging on the likely recovery for the primary secured lenders. That was a factor in the Smurfit loan being assigned a recovery rating of '3'.

As mentioned earlier, any investor buying a portfolio of leveraged loans knows that the expected range of defaults is between about 12% (for 'BB's) and 35% (for 'B's) over the typical five- to seven-year term loan. The other main portfolio loss determinant the investor faces is the expected loss or recovery when those loans default. So an investor who buys a portfolio of 'B' loans with average recovery ratings of '3' can expect portfolio losses of between 7.0% and 17.5% over that same period. The investor who buys a portfolio of 'BB' loans with average recovery ratings of '2' can expect more modest portfolio losses of between 0% and 2.4%. Obviously, numerous results are achievable in between by mixing and matching different combinations of corporate credit and recovery ratings.

In a mature, well-developed loan market, these differences would be reflected in the pricing, but it's far from apparent that the current loan market has reached that level of efficiency, especially with the liquidity overhang that seems to damp distinctions in credit and pricing. We hope to investigate and explore whether primary and secondary market pricing reflects the values inherent in Standard & Poor's loan and recovery ratings.

One would expect to see deals like those of ArvinMeritor Inc. 'BB' corporate credit rating) or Idearc Inc. (formerly Verizon Directories Disposition Corp.; 'BB' corporate credit rating), with recovery ratings of '1', clearly distinguished from, for example, those of Owens-Illinois Inc. ('BB-' corporate credit rating) or CSC Holdings Inc. ('BB' corporate credit rating), with recovery ratings of '2'.

With respect to CSC Holdings, it's interesting to note that its subsidiary Rainbow National Services LLC loan presents a significantly more protected profile from a recovery perspective than that of the parent, even providing an estimated $2.5 billion of excess value upstream to CSC creditors, after its own creditors are fully satisfied. Since the Rainbow equity is not pledged upstream to the CSC lenders, the CSC lenders can only participate in it pari passu with other CSC unsecured creditors. If CSC secured lenders had a direct pledge of the Rainbow equity, it would undoubtedly improve the loan's prospects for a higher recovery rating level.

No such glaring credit disparity exists between the secured loans of Intelsat Ltd. ('BB-' corporate credit rating) and its subsidiary Intelsat Corp. (formerly PanAmSat Corp.). No cross guarantees or cross-defaults exist between the two facilities, and it's clearly intended that they stand on their own. Fortunately they each appear to be well supported in terms of security protection, with Intelsat's projected post-default value expected to cover its secured debt many times over, and PanAmSat's to cover its debt comfortably as well. Even though Intelsat is the holding company, it has the better secured deal, earning two notches above the corporate credit rating, with the subsidiary's deal, while also receiving a recovery rating of '1', only getting a single notch up on the loan rating.

This is not intended to be a statistical sampling of the entire leveraged loan market in 2006, but merely a survey of some of the higher profile rated transactions. However, several observations seem clear. The first is that the high level of liquidity in the market has created a forgiving environment for credit generally, which means better structured deals probably have less of a relative advantage over poorly structured ones in the current market than they will at some future point when the credit cycle turns. The second is that recovery ratings, even though Standard & Poor's has been assigning them more than three years, are still a relatively new phenomenon in the leveraged finance arena, and do not yet play the role in pricing and distribution that bond ratings play in the high yield market. This too we believe will change, especially at that future point--whether six months or 36 months from now--when the market again sharpens its sensitivity to credit.

For more about these higher profile recovery ratings, as well as hundreds of other recovery ratings on loans not mentioned in this article, readers are encouraged to review the actual recovery reports on each deal, which are available on Standard & Poor's RatingsDirect. Please feel free to contact the author, Steven Bavaria, at stevenbavaria@standardandpoors.com, for additional information about Standard & Poor's loan and recovery ratings, or for copies of any of the referenced companies' recovery rating reports.

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