Theres a pricing revolution taking place in the normally staid and predictable world of investment grade syndicated loans. For too long, these loans have offered lenders only small returns on their capital. The paltry yields on offer, especially for the strongest-rated companies, were instead compensated by the relationships banks cemented with the borrowers which in turn, so the theory went, would translate into treasury business, bond mandates and M&A advisory work.
But since the onset of turmoil in financial markets following Lehman Brothers bankruptcy, that model has ceased to work. Banks are no longer willing, and in many cases are simply unable, to provide large amounts of debt for small returns. Borrowers are being forced to pay up for their loans. "Increasingly, youre going to see lenders becoming relative yield players," says Julian van Kan, global head of loan syndications and trading at BNP Paribas in London. "The old argument about ancillary business has become heavily diluted.
"Its important, but how much relevance will you place on it? For instance, when will the bond market open for you to realise the value of that promise. Thats something thats out of the borrowers hands."
The £11bn loan for EDF, launched in October to back its part takeover of British Energy, exemplified the change in pricing more than any other. The French nuclear energy group, rated Aa1/AA-/AA- and 85% state owned, is one of Europes strongest credits. It is also a regular borrower and has a close set of relationship banks. Despite all this, it launched the deal paying 100bp over Libor for its one year money (stepping up another 10bp after six months) and 120bp for its three year tranche margins among the widest ever seen for a double-A borrower.
But not everyone is satisfied with the new pricing. Many bankers think that it will have to go up further this year. "It could easily increase from the 100bp-200bp range were seeing for solid investment grade credits," says one loans official at a European institution. "Those levels nowhere near compensate for banks funding costs."
The experience of recent jumbo deals lends some credence to this argument. Both the loans for EDF and Spanish utility Gas Natural, two of the biggest in the market after Lehman collapsed, struggled. EDF had only three commitments some six weeks after it launched, while Gas Natural was similarly slow and pricing had to be flexed up in mid-syndication.
Critics of these facilities have ventured pricing as one of their flaws. "A lot of people said that EDFs problem had nothing to do with margins," says a banker at a US house. "But it is this very attitude thats driving the market down. Would EDF have got nowhere if it was priced at 250bp? Its a great credit but 100bp just doesnt cut it when lenders funding costs are taken into account.
"Whats going to happen this year with another EDF-style syndication? Will the underwriters just price it at 150bp and watch it crater? "Banks shortage of capital is obviously a big issue. But its wrong to use that as an excuse for an underpriced deal."
But dont increase the price too muchIndicative of the increased costs borrowers will face this year is the $1bn loan for AngloGold Ashanti, the South African miner. The one year deal, which will be launched sometime in 2009, pays 425bp for the first six months, rising to 5.25% after that. The deal has been praised by some bankers for setting a new standard. The margin compares to one of just 40bp that AngloGold Ashanti, an unrated credit, obtained on its previous facility, a $1.15bn three year revolver that was signed in 2007.
Other bankers, however, insist pricing has reached adequate levels. "We are already getting to the stage where loans start to work on a pure asset basis, which needs to happen," says David Bassett, global head of syndicate at Royal Bank of Scotland in New York. "No one would have thought wed get to this level in the first place. So it would be foolish to say weve reached a ceiling.
"But barring further calamities among the major banks which I think is unlikely pricing wont go up much further. Liquidity is improving.
"Single-A names will probably come with a 150bp-175bp handle [this year]. In the high triple-B space a 175bp-200bp range is likely."
It is clear that once pricing reaches a certain level, capacity becomes a more pertinent issue for banks. The Eu19bn facility for Gas Natural and that for EDF were always going to be hard to sell down, given that the top tickets on the deals were Eu750m and £500m respectively. These are sums that some banks now find too hefty, even if the borrower in question is a core client.
"Pricing needs to be good enough to clear the market," says van Kan. "But pricing wont clinch everything. Its going to be availability of liquidity that gets deals done."
As such, the loan market no longer has the capacity to absorb the bigger jumbo deals. One European banker says that facilities of $45bn, say, are "completely off the table", regardless of the borrower and the margins it is offering.
The Swiss pharmaceutical group Roche exemplifies this. The Aa1/AA-/AA rated company made an offer for Genentech, the US drugs company, in July and hoped to back that with a loan of up to $45bn. But that is no longer possible, according to most loans bankers, even for a borrower as attractive as Roche.
But for those deals that are feasible, pricing will be affected by the cost of capital in other markets, especially the bond market. In the wake of Lehman Brothers falling, the European bond market was shut to corporate borrowers. While it opened towards the end of October, pricing gapped out to the extent that the first triple-B issuer, German retailer Metro, paid 590bp over mid-swaps for a Eu500m five year deal. Even single-A credits were paying about 300bp.
It is unlikely that loan pricing will reach the point where it matches that on bonds. "The loan market is underpriced relative to other debt instruments," says van Kan. "You do, however, have to take into account the senior status of loans. That makes them far better assets than many others."
Even in the less conservative US market, where bankers say there have been discussions about pricing investment grade deals through a borrowers CDS and close to what it would have to pay in the capital markets, no such facilities have been mandated.
However, borrowers have to recognise that no capital market is isolated and that if bond spreads widen this year they will have little choice but to pay more for their loans too.
Uncertainty pervades the new worldThe headline margin will not be the only aspect of pricing adjusted this year. In 2008, as banks costs of funds soared, an alternative to a screen-based interbank rate which margins are typically priced above was sought. EDFs was the first jumbo western European deal to use a group of reference banks instead of screen-based Libor, which many bankers thought had ceased to be an accurate measure of banks funding costs. The method is unlikely to fade away soon.
But while reference rates give banks more assurance that their costs of funds will be met, the group of banks used is crucial. Most loans linked to reference rates have so far used top tier banks, many of whom already provide screen-based Libor rates. Bankers say that this year wider pools of reference banks are needed so that smaller lenders, whose cost of funds are typically higher, are also protected.
For certain facilities, especially commercial paper backstops, pricing linked to credit default swaps will become more common. Last year Nestlé, the Swiss food group, became the first European borrower to price a deal linked to its CDS. CP backstops were historically priced with very small margins due to the fact they were unlikely to be drawn. But the prospect of this, while still unlikely for strong credits, has heightened given the increased volatility in the non-bank CP market.
While CDS-based loans also compensate lenders, the limitations placed on them have been criticised. Nestlé, for example, will pay just 40% of its five year CDS. Even then, this will be restricted to between 10bp and 30bp.
"The revolvers arent meant to be drawn down in many cases and, if they are, then you capture the added value by structuring it like this," says one senior loans banker in London. "But if you cap the pricing, you lose that added value."
Whatever happens with loan pricing this year, it is unlikely to come down. Banks will still be constrained. Funding costs are likely to be high well into the year. And with Europes economy in a severe downturn, banks will be especially cautious about which borrowers they give funding to. Only the strongest credits with high cashflows and ready access to the bond market will be able to secure facilities of, say, Eu10bn or more.
Fears of future financing costs and availability have already begun to hinder companies expansionary ambitions. Last year Xstrata, the Anglo-Swiss miner, dropped plans to take over Lonmin, the UK platinum group. It had lined up a $15bn loan to back the offer, but the need to refinance much of that within a year was deemed too much of a risk. Similarly, Anglo-Australian mining group BHP Billiton decided to call-off its bid for compatriot Rio Tinto, despite having already secured a $55bn acquisition loan.
But while financing costs have become a key consideration in M&A, bankers deny that they are overly prohibitive. "Higher costs will only jeopardise M&A deals that are on the edge of working to begin with," says Bassett, "or where companies are trying to skimp on the amount of equity they want to put into a transaction."
The syndicated loan market was rocked last year. Liquidity was drained and borrowers were forced to agree to take out their loans more quickly than ever via other capital markets. More changes are inevitable in 2009. Of all those, pricing deals will be one of the biggest challenges for arrangers, not least because of continuing volatility and a lack of benchmarks. "There seems to be little consensus on pricing right now," says Jonathan Macdonald, head of global syndicated finance for Europe and Asia Pacific at UBS in London. "The few recent deals weve seen have shown a wide range of levels. Many banks are still trying to figure out their true cost of doing deals in the new world."