M&A Alerts - May 21, 2010

As we prepare for our 5th Annual Middle Market Financing Awards, we went to one of the leading credit experts in the country to discuss and dispel some of the issues surrounding middle market financing. John Brignola is a co-founder of LBC Credit Partners. Over the past nine years, Brignola has been dedicated to the junior debt and special situations markets. Since 1999, Brignola has a successful track record of over $1.5B in transaction experience ranging from M&A activity to complex debt restructurings.

M.A.: What are your general thoughts on the current DIP market and its direction going forward?

J.B.: As a middle market participant, we have not seen many DIP opportunities and the ones we have seen, rather than being realistic lending opportunities, were situations where advisors were seeking terms and pricing levels to determine market clearance. Middle market lenders with distressed borrowers appear to be either restructuring out of court or providing the DIP loans themselves. The financial condition of the borrower, the complexity of the borrower's capital structure and the relative value of the lenders' loan position are key issues that drive the lenders' decision to stay out of court or provide additional capital in a filing process.

Today, the lenders are often choosing to amend and avoid a costly filing when the situation is less complex and all constituents can reach a restructuring accord. When there is an opportunity to provide a DIP loan, it is often difficult to replace the incumbent lenders.

Most DIP providers want to refinance the existing senior debt and provide additional capital with their DIP facilities. In this cycle, DIP providers are challenged by the amount of debt required to accomplish a refinance of the existing lenders and to provide incremental capital. Moreover, the greater the capital structure complexity, the more complicated the DIP opportunity. This market will continue to provide many opportunities for the financial advisors specializing in restructurings.

M.A.: Do you think the originate-to-distribute (OTD) model is good for middle market deals over the long run? Why or why not?

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J.B.: From a middle market participant's perspective, I don't believe OTD represents an effective strategy for a middle market borrower. With an OTD provider, the capital raise will be economically efficient due to the broad syndication, but for the management teams of the borrowers, ongoing credit administration can become unwieldy should the distributor resign as agent or should some of the bank group participants sell their positions.

With an OTD strategy, the capital arrangers' incentives may not be aligned with the syndicate lenders. A distributor is incented with fees and a lender's incentive is interest yield on the loan. It is difficult to maintain an alignment of interests when the agent has sold down all of its loan position.

M.A.: Do you think the truism is true: that the secondary loan market creates a disincentive for senior lenders to monitor their investments? Is this good or bad?

J.B.: I think the notion of senior lenders having a disincentive to monitor their investment based on the ability to sell out of position is erroneous. The underlying motivation is the structure of the senior lender. Generally, traditional banks have established servicing platforms to monitor the loan while hedge funds have created trading platforms to opportunistically trade loans or securities.

If hedge funds without a servicing platform are investors in middle market loans trading in the secondary market, they may sell a loan position based on the borrower's underperformance rather than closely monitor and service a potentially troubled situation.

Other funds that rely on leverage or a structured vehicle such as a collateralized loan obligation may have motives relating to the integrity of their fund leverage facilities such as covenant compliance. This may impel a strategy designed to maintain compliance for these funds. The strategy would include selling assets where the underlying borrower is underperforming rather than holding and servicing these assets which by doing so, could impair the integrity of their leverage facilities.

M.A.: Why has the secondary loan market focused on distressed and leverage loans? Do you ever foresee a day when this might change?

J.B.: This market has grown because of the substantial volume of growth it experienced in 2006 and 2007. CLO issuers and hedge funds were the primary propellants over that period of time. A tremendous amount of liquidity permeated the market and as a result, some credit standards were compromised. Now, after the economic downturn, the expansion of the secondary market as a result of the record new issue volume and aggressively structured transactions, many of the loans have underperformed.

In this weak economic environment, the secondary market is providing more workout or turnaround situations. The broadly syndicated nature of many of these loans further exacerbates the workout process. So not only do we have a loan market that experienced rapid growth in an economic decline, but we also have a loan market with many syndicate participants.

The CLO structures encouraged providers to acquire relatively small participants in syndications. When loans became troubled, many CLO issuers were sellers of these loans. This trading dynamic creates an exigent environment for obtaining amendments which aggravates the restructuring process. So the inventory of loan workouts in the secondary market has grown due to these factors: new volume growth, aggressive loan structuring, the economic downturn and the protracted workout process. Eventually this workout volume will return to historical averages, but for the near-term, the secondary market will present opportunities for consultants and advisors.

M.A.: Thanks John.