Standard & Poor's Ratings Services' recovery ratings on second-lien financings continued to bulge at the low end of the ratings scale in the second half of 2006. Since the end of the first half, a greater percentage of second-lien loans are carrying our lowest recovery rating of '5', meaning lenders can expect a negligible (0%-25%) recovery of principal in case of default. About seven of every 10 second-lien loans Standard & Poor's now rates globally fall into this category.
It should be noted, however, that while this suggests lenders are becoming less likely to see the return of a significant portion of their capital in the event of a borrower's default, the relatively short (five-month) sample may be misleading. And, in fact, the percentage of '5' recovery ratings assigned to second liens is down slightly from 2004.
Viewed historically, second-lien facilities are becoming an increasingly important part of leveraged financing, and the surge in these types of deals has been accompanied by the expansion of Standard & Poor's recovery ratings on them. Since we began assigning the ratings three years ago, the portfolio of all rated loans has approached 1,800 facilities–-and more than 3,000 tranches. As of Nov. 16, we had rated more than 200 second-lien deals globally.
Since the inception of our recovery ratings, a majority of second-lien deals have received a '5'. Still, the recent increase in that number is notable, even as the reasons for comparatively low recovery ratings remain the same. Simply put, second-lien loans rank behind senior tranches in the repayment hierarchy-–thus diminishing expectations for repayment, while increasing the borrower's cost of capital and offering potentially higher returns for lenders to compensate for the greater risk.
A Profile Of The North American Portfolio
As of Nov. 16, 2006, Standard & Poor's had assigned recovery ratings to 1,189 senior secured loans in North America, with a par value of about $612 billion, and 187 second-lien loans, valued at almost $27 billion. Of the latter, we rated nearly all–175, or 94%--at least one notch below the borrower's corporate credit rating, a slight increase from the end of 2006's first half. Of those 187, 132, or just more than 70%, fell into the lowest recovery rating category.
Chart 1
At the same time, with a collective size of about $15.5 billion, those second-lien loans assigned a '5' make up just 58% of the deals falling into the lowest category, when measured by dollar value. This jibes with our belief that lenders generally structure larger transactions to provide greater overall recovery value–-the likely reason for the difference in '3' and '5' recovery ratings assigned on a volume basis versus on a dollar basis. The dollar-value percentage of deals in the lowest category is an increase from the 48% ($10.3 billion of the $21.4 billion of rated second liens) we saw at the end of June. As of Nov. 16, a total of 132 of the 187 rated second-lien deals, or 71%, fell into the '5' category. That's up from 102 of 156, or 65%, at the end of the first half. In other words, 30 of the 31 second-lien loans rated since the end of June have received the lowest recovery rating.
All of this means, of course, that on a dollar basis, holders of 42% of the North American second-lien loans that have been assigned recovery ratings can expect the return of at least 25% of their principal in the event of a default. Nonetheless, holders of the loans that we consider to have a high expectation of full principal recovery make up a very small fraction of the total. In fact, just five second-lien loans in our rated portfolio have been assigned a recovery rating of '1'–and none had received the highest rating of '1+'.
We rated these loans as '1':
Dayco Products LLC: $170 million;
Confidentially rated $350 million loan in the telecommunications sector;
Ply Gem Industries Inc.: $105 million;
The Rhodes Companies LLC: $70 million; and
Ginn-LA CS Borrower LLC: $125 million.
We expect substantial enterprise value at emergence from default to support the first three, and significant real-estate value to support the other two.
A Profile Of The European Portfolio
While all three second-lien deals rated in Europe in the second half received a recovery rating of '5', the lack of a critical mass might cast doubt on the significance of the numbers. Nonetheless, a majority of second-lien deals in Europe fall into the lowest ratings category. As of Nov. 16, a total of 20 of the 32 rated facilities, or 63%, did so. That represents an increase from about 59% (17 of 29) at the end of the first half.
Chart 2
The same holds true when measured on a dollar basis. The 20 European second liens in the '5' category total $9.3 billion, representing 71% of the $13.1 billion rated portfolio. This is a slight increase from about 69% at the end of June. This means that just 29% of the rated second-lien portfolio in Europe has recovery prospects greater than 25%–and no deal has received a recovery rating of '1' or better.
In any case, second liens in Europe make up a greater portion of the universe of rated senior secured debt than in North America, representing more than a quarter of the total number and about 10% on a dollar-value basis-–in contrast to the 16% and 4%, respectively, in North America. Of the 32 second-liens in Europe, 30 are rated at least one notch below the corporate credit rating-–matching the 94% rate in North America.
A Time For Investors To Review Pricing
While pricing on loan originations is driven primarily by supply and demand in the market, we see signs that second-lien pricing may not fully account for lenders' risk. This is true even in the context of assessing risk across a diverse portfolio in which most of the assets are unlikely to default.
Insufficiently strict pricing may be especially troublesome in the face of a potential spike in defaults in second-lien transactions, as expected loss may underestimate realized portfolio loss. On top of that, the limited upside in par loan investing means investors that experience defaults and loss of principal may find that portfolio loss will be difficult to offset unless the portfolio contains a significant number of other second-lien (i.e., high-yielding) loans, or unless the portfolio manager has set aside reserves to cover the loss.
In short, it may be prudent for second-lien investors to review current pricing. An increase in lower rated, higher risk credits has giving rise to the dual prospects for a surge in defaults and the potential for severe losses associated with those defaults.
Factors That Could Support Recovery Prospects
Signs that recovery prospects for second-lien lenders are low have been tempered, if not contradicted, by a number of factors. Among them is the fact that transactions continue to include features that will likely afford lenders stronger negotiating leverage and stronger recovery prospects than would be traditionally allowed with either "silent seconds" or "absolute priority" deals (The following sections characterize these features).
The use of distinct credit agreements on second-lien loans, which now appears to be the norm, shows the improved power of second-lien creditors. If both first- and second-lien tranches are covered by a single credit agreement, the former have greater control over terms, while separate documentation provides a discrete set of covenants and may give second-lien lenders more influence in a borrower's default. (This, naturally, affects recovery prospects for first-lien holders.) In addition, we have seen that almost all discretely documented second-lien tranches include some form of financial covenant, in contrast to deals with combined documentation, which typically contain no specific separate second-lien covenants.
Discretely documented transactions generally allow second-lien lenders to diverge from their first-lien counterparts regarding pre-insolvency covenant management. This independence may make it possible to keep a borrower in default despite the willingness of first-lien lenders to resolve with the borrower the violation of first-lien covenants. Separate covenants may also allow second-lien lenders to extract value–-for example, through enhanced returns associated with default pricing-–under the threat of withholding approval for second-lien covenant waivers or amendments. (This may also affect the borrower's default risk, since separate covenants may in some cases be used to force a borrower to default.)
Standard & Poor's has also noted the increased incidence of limitations to standstill provisions in separately documented transactions-–specifically the shortening of standstill periods. We expect that this will enhance the negotiating leverage of second-lien lenders and increase the chances that their first-lien counterparts will act to preserve recovery value for all lenders.
Further supporting recovery prospects are indications that lenders are increasingly holding both the first- and second-lien tranches of loans, thereby encouraging a negotiated settlement, which may render the diverging recovery prospects somewhat moot. At the same time, lenders should not expect that second-lien debt will afford a static asset-class recovery, either de minimus or 50%. Indeed, second-lien recoveries to date demonstrate substantial variability.
A Mixed Outlook For The Future
The potential that the credit cycle may soon enter a stage in which we see a spike in defaults, especially among second-lien transactions, is worrying, given the low prospects for recovery in such a scenario. Also of concern is the high percentage of second-lien loans carrying a recovery rating of '5' at a time when second-lien facilities are becoming an ever more popular part of leveraged financing.
In default scenarios, returns on second liens are likely to vary substantially, making specific structural and valuation analysis, as opposed to broad asset class assessments, all the more important. In addition, we suspect that the greater returns promised by second liens outside of default may lure investors at the expense of proper valuation. Simply put, lenders may not fully recognize potential losses on such debt.
But the news isn't all bad. Among the factors mitigating signs that second-lien lenders are enduring low recovery prospects is the likelihood that transactions will contain features that give lenders stronger negotiating leverage. Also, the rising popularity of separate credit agreements on second-lien loans gives these lenders greater power in the event of default.
Analytic services provided by Standard & Poor's Ratings Services (Ratings Services) are the result of separate activities designed to preserve the independence and objectivity of ratings opinions. The credit ratings and observations contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Accordingly, any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision. Ratings are based on information received by Ratings Services. Other divisions of Standard & Poor's may have information that is not available to Ratings Services. Standard & Poor's has established policies and procedures to maintain the confidentiality of non-public information received during the ratings process.
Ratings Services receives compensation for its ratings. Such compensation is normally paid either by the issuers of such securities or third parties participating in marketing the securities. While Standard & Poor's reserves the right to disseminate the rating, it receives no payment for doing so, except for subscriptions to its publications. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.
