Institutional characteristics of HLT loans

The development of the market for HLT loans can be traced to the growth over the past decade in commercial lending transactions to finance mergers and acquisitions, leveraged buyouts, and related transactions.

One measure of the growth in HLTs is that between January 1987 and September 1994, LPC reported that there were 4122 deals, with a combined dollar amount (in new-issue loans) estimated at $593.5 billion.

While HLTs are now a significant portion of outstanding commercial credits, the nature of these loans, the market participants (including borrowers, originating banks and participating investors), and the interest and fee structures are not well documented.

HLT criteria

The criteria for classification of a loan as an HLT were in dispute prior to October 1989, when highly-leverage-transaction guidelines were laid out by the Office of the Comptroller of Currency, the Federal Reserve Board, and the Federal Deposit Insurance Corporation (1989, 1990).

These criteria defined HLT loans as:

all loan financings used for buyouts, acquisitions, recapitalizations;
all loan financings which: (i) double the borrower's liabilities and result in a leverage ratio (total liabilities/total assets) higher than 50%; or (ii) increase the leverage ratio higher than 75%;
all loan financings that are designated as an HLT by the syndication agent;
all loan financing to subsidiaries of HLT companies, even if the subsidiary does not meet the HLT definitions above.

The underlying regulatory guidelines exclude debtor-in-possession ®nancing for businesses in Chapter 11 bankruptcy reorganization. Furthermore, some loans are excluded if they meet certain performance criteria, even if the borrower's leverage ratio continues to exceed 75%.

Due to a review prompted by the recession and a perceived credit crunch during 1991±1992, bank regulators (i.e., the Federal Reserve, the FDIC, and the Comptroller of Currency) phased out the requirement that banks disclose the total amount of loans to highly leveraged companies in their financial statements as of 30 June 1992.

This decision re¯ected regulators' findings that large banks were not overexposed to HLTs and that they posed little threat to either the bank insurance fund or bank capital reserves. There was also a desire to prevent bank examinations from impeding the availability of credit to borrowers.

However, the Securities and Exchange Commission (SEC) has required the continuation of HLT loan exposure disclosures.

Given that the LPC database is constructed from loan information filed with the SEC, the sample reflects the HLT designation required by the SEC which is identical to the reporting requirements of bank regulators.

HLT loan features

High-leverage-transaction loans have traditionally being originated by banks and syndicated to other banks in the secondary market for loans. However, in recent years, these loans have become attractive to a larger class of investors.

The high ex ante interest rates associated with these loans are only one reason for their increased attractiveness, especially, compared to high yield (``junk'') bonds. In Table 1 the key features of HLT loans relative to junk bonds are summarized.

In general, HLT loans have a senior priority position over subordinated bondholders with respect to repayment of interest and principal. Because of their senior position in the capital structure, borrowers usually repay HLT loans ahead of all other debt obligations.

Furthermore, these loans are normally secured by pledges of specific collateral either in the form of assets or the equity of the borrower. HLT bank loans also tend to have shorter maturities, averaging 4.4 years (53 months) compared to an average maturity of 10 years for high yield debt.

There are also important di€erences with respect to pricing conventions and ®nancial covenants between HLT loans and high yield debt.

Loans are usually floating-rate based and typically allow borrowers to select a pricing formula linked to the Prime rate, LIBOR, or a Certificate of Deposit rate (CDs), plus a credit spread. Borrowers are also often free to change the base index on any rollover date (usually semiannually).

Finally, HLT debt (as bank issued private debt) generally has more stringent protective covenants than public debt such as high yield bonds (see Carey et al., 1994).

HLT loan market participants

The growth in leveraged loan transactions may be explained in part by an increasing shift by banks from the origination of loans, as long term investment vehicles, to their origination for distribution to others through loan sales or through participations.

Through these loan sales and participations, originating banks can increase the volume of their lending while simultaneously diversifying firm, interest rate and geographic risks, improving liquidity, and enhancing their ability to comply with capital requirements and lending concentration restrictions.

The most important of the originating banks are US money center and large regional banks, many of whom sell participations to a group of buyers beyond their correspondent banks, including smaller banks, non-bank financial institutions such as General Electric Capital Corporation, foreign banks and investment banks.

More specifically, the major purchasers of loans and loan participations can be classi®ed into two groups: (passive) portfolio investors and active strategic buyers. Portfolio investors include US banks and foreign branches, agencies of foreign banks, insurance firms, pension and mutual funds.

These firms purchase HLT loans in anticipation of earning attractive rates of return on senior debt. Foreign banks and smaller banks invest for product and geographic diversi®cation to overcome the e€ects of restrictions on interstate banking.

Strategic buyers of loans and participations invest in HLT loans with the objective of subsequently owning or obtaining a large controlling position in a borrower or its subsidiary. These investors include vulture funds which specialize in purchasing distressed loans for bargaining in a restructuring deal.

Table 2 provides a listing of the top selling institutions in leveraged loan transactions over the past decade. The LPC database lists the originating lender (and major participants) for 4122 deals.

An institution is classified as a ``lead'' lender if it retains primary administrative, monitoring, and contract enforcement responsibilities. These banks also typically retain the largest stake in the loan. Some banks perform administrative oversight duties, although these are relatively minor, and their share ownership in the loan is smaller, on average, than lead banks.

These banks are generally referred to as loan managers. A third group is referred to as participants, to re¯ect the fact that they do not perform special functions other than being signatories to the original loan agreement.

The top 20 lead banks in Table 2 are ordered by the number of transactions. Citibank was the top originator with 323 HLT deals, with an average deal size of $203.36 million, over half of which was sold in participation agreements with other firms (53.0%).

The bank's share represents about 11.23% of the total amount of HLT loans issued, a figure that is second only to the 11.43% reported by (the since-merged) Manufacturers Hanover Trust (MHT). In 190 of the 4122 deal sample, MHT was the lead bank with the highest average deal size of $356.99 million.

The table also shows that Bank of America retains the largest portion of HLT deals, with an average of 70.9% share per deal. Overall, the top 20 institutions are lead lenders in 2573 (or 62.42%) deals, which in dollar terms represents 66.13% of the HLT outstanding.

Second-tier institu tions (i.e., the next 20 leading ``lead'' firms) accounted for a further 12.70% of the amounts originated.

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