The US student loan company, under fire from regulators and government, said on Monday it had accepted a $25bn offer from the so-called Mustang consortium of JC Flowers & Co, Friedman Fleischer & Lowe, JP Morgan and Bank of America.
Flowers and FFL will pay $4.4bn for a combined 50.2% stake, while JP Morgan and Bank of America will each pay $2.2bn for 24.9% apiece.
The two banks will also provide $16.5bn of bridge debt which will be refinanced with high yield bonds.
Both the bridge and refinancing will be secured by guarantee on the assets of the company and thus rank senior to Sallie Mae’s outstanding senior unsecured debt — all $49bn of it.
The existing debt is likely to be downgraded from A2/A/A+ to junk. However, risk of default is minimal since JP Morgan and Bank of America will keep their new joint venture well-supplied with cash for lending and ensure the old debt is repaid at maturity.
News of the deal blindsided the market and sent SLM’s five year credit default swaps bulging out from around 40bp at the beginning of the month to 180bp yesterday. "This came totally out of left-field," said one investor.
The LBO set debt investors scouring their portfolios for other financial services companies that could be bought out. The top suspects were three US firms: retail and small business lender CIT Group, real estate financier iStar and Countrywide, the mortgage company.
Taking Sallie Mae as a blueprint, potential targets would need to have weak management or a depressed share price, minimal capital regulation, assets susceptible to securitisation or asset backed financing, business units that could be split off and sold and the potential for an exit strategy.
"This remains a rare set of circumstances, at least as far as European credits are concerned," observed RBS in a research note published yesterday.
In the US, however, non-bank finance companies are a much more developed sector.
CIT Group’s 5.65% 2017 notes — priced in February at 93bp over Treasuries — had widened already this month amid the subprime shake-out but were changing hands this week at 135bp over. This was despite CIT having a much smaller student lending business and different funding strategies.
"But under today’s new paradigm, we can provide no assurances that CIT won’t be a private equity target," noted GimmeCredit, an independent research provider, in a report published on Monday. "Its $10.6bn market capitalisation is practically bite-sized by the standards of today’s extra value meal-sized LBO deals.
"Fixed income investors have good cause to demand higher spreads, since private equity firms are certainly not going to be looking out for the lowly bondholder," it added.
Sallie Mae’s bonds were certainly hammered in secondary trading this week. Its euro denominated 2012 notes widened from a Z-spread of 55bp last week to 180bp bid yesterday (Thursday).
The 5.5% 2009 dollar floater was trading at 12bp over three month Libor last Wednesday and was seen yesterday in the mid-150s over.
SLM’s 5% 2013 fixed rate bonds widened from the mid-90s over five year Treasuries earlier this month to around 240bp over yesterday.
Fear of legislation
Sallie Mae’s share price has suffered in the last 12 months from fears Congress will restrict its ability to sell high margin products.
The company was founded as a government-sponsored enterprise in 1972 and privatised between 1997 and 2004.
Last Friday (April 13), rumours of a possible buy-out sent SLM’s share price surging to $46.76 from its $40.75 close the night before.
Yesterday (Thursday), Sallie Mae shares were trading at $55.12. That level, still considerably below the $60 a share offer price, suggests many investors believe the deal may yet falter.
All Sallie Mae’s ratings are now on negative watch and its senior bonds are widely expected to be junked. However, the company has consistent earnings and it announced on Wednesday that JP Morgan and Bank of America would give it $30bn of liquidity through asset backed commercial paper conduits. It will not need to issue unsecured debt this year, though it will continue to sell ABS.
SLM’s statement on Monday announcing the takeover said the acquisition facility "has been structured to accommodate repayment of SLM Corp debt and the company anticipates that the debt will be repaid as it matures."
But some analysts were sceptical. At the end of 2006, SLM had $52bn of unencumbered assets (that is, unsecuritised assets) on its balance sheet, against $49bn of senior debt. Those assets will now first be available to back the $16.5bn acquisition financing, leaving a shortfall to back senior debt.
According to RBS, a simplistic calculation said that the best investors could hope for in the event of a winding-up would be 68 cents in the dollar. But that figure gave no recognition to Sallie Mae’s strong cashflows, which are expected to be enough to meet interest payments on the new debt and existing unsecured debt.
"However, we would expect that SLM increases the proportion of operational funding provided by securitisation, as this is a cheap form of financing," said Royal Bank of Scotland. "So there is the prospect of a reducing amount of unencumbered assets and a $16.5bn obligation ranking ahead of unsecured noteholders."
Sallie Mae funds its activities extensively in the asset backed securities market — it raised $32bn that way in 2006. Although securitisations are designed to withstand the insolvency of the assets’ originator and servicer, the details of the structures often depend on the strength or weakness of the servicer.
Raters consider ABS
So if Sallie Mae is junked there may be a knock-on effect for the securitisations if the documentation is not changed. A downgrade to junk would make Sallie Mae one of the biggest junk-rated ABS issuers.
"There is no explicit ratings trigger in the [ABS] transactions," said Barbara Lambotte, a senior analyst at Moody’s in New York. "However, there are two parts of the transactions that may be impacted by the ratings of Sallie Mae. One of the areas is borrower benefits. Currently, Sallie Mae reimburses the [securitisation] trust for borrower benefits.
"Our analysis assumed that Sallie Mae, at A2, would reimburse the trust. If the company were no longer high investment grade, we would need to re-evaluate that assumption.
"The other significant area to consider is what the legal documents allowed with respect to how the cash is managed between the trust and a corporate entity. Some of these provisions may no longer be applicable," added Lambotte.
One investor who did not hold any Sallie Mae debt was crowing this week. "Event risk is something investors must constantly be aware of, irrespective of the sector," the fund manager said.
"Sallie Mae is one of these entities that everybody talks about as having an implied government guarantee," he added. "But an implied guarantee is no guarantee at all. The bonds are clearly going sub. This highlights that investors have to be extremely vigilant."
Joanne O’Connor