America's Heavily Levered Companies Layer Loans Over Loans

(Bloomberg) -- First the companies tapped the loan market. Not long after that, they came back for more.

Corporations like Bausch Health Cos., a drugmaker, telecom provider Sprint Corp. and Applied Systems Inc., an insurance software provider, borrowed again this month after getting financing in the loan market. Their new loans came by layering more debt onto an existing liability, making that older obligation riskier in the process.

This kind of borrowing, known as using incremental debt, has been rampant this year. Companies have secured around $100 billion of these loans so far in 2018 in the U.S., according to data compiled by Bloomberg. That's the most since at least 2014.

A senior official at the Federal Reserve took the unusual step of expressing concern about incremental loans in a speech last month, noting that proceeds of the borrowings may end up as payouts to private equity owners. In one case, Applied Systems borrowed so much using incremental and regular loans that its private equity owners were able to completely recoup their original investments in the company.

Incremental lending has grown so much in part because investors agreed to allow it in the first place. For much of the year, money managers were so eager to make loans that they would consent to just about any terms, including allowing companies to add on more loans. The growth of incremental debt underscores how permissive lending markets have become, and why so many money managers and rulemakers are watching corporate borrowings warily now.

“Lenders have been providing what feels like unlimited capacity to borrowers to incur additional loans,” said Vince Pisano, a senior analyst at Xtract Research. “A lot of the extra debt is paid out to private equity owners as dividends, so at some point you should be investing in those firms and not the loans.”

Lenders have agreed to a wide range of looser terms as U.S. leveraged loans have grown into a more than $1 trillion market, eclipsing junk bonds. Those weaker protections for investors could be painful during the next credit downturn: Moody's Investors Service projects that investors will recover just 61 cents on the dollar when first-lien term loans go bad whenever the market turns, well below the historical average rate of 77 cents.

Valuations are relatively high in the loan market, so it makes sense to be "highly selective," Guggenheim's Scott Minerd wrote in an outlook piece this month. The money manager has been broadly reducing corporate credit exposure to the lowest level since the financial crisis.

Incremental debt is issued under the same terms and documentation as a prior loan. It can make a company riskier for lenders not just by saddling the borrower with more debt, but also by changing the priority of debt repayments. A company, for example, might get an incremental loan that is first in line to be repaid if a company fails, and use the proceeds to refinance a loan that is second in line.

Debt Buffer

With that refinancing, a company ends up with more debt that's first in line, reducing recoveries for everyone at the level known as the first lien, and fewer lenders to absorb losses when things go wrong. The crowded first lien is a problem for lenders who have agreed to receive less interest in exchange for taking what they thought would be less risk, said George Goudelias, of Seix Investment Advisors.

“One of the main reasons you're taking less interest in the first-lien is because you're first in line to get paid and there's a debt buffer behind you,” Goudelias said.

When Bausch Health, formerly known as Valeant, borrowed $1.5 billion in the loan market in an incremental deal in November, it said it was using proceeds to buy back unsecured notes. A spokeswoman for Bausch declined to comment. Ring Container Technologies, a maker of containers and packaging, borrowed $65 million earlier this month, in an add-on to its existing $475 million deal. Proceeds will pay down the second lien.

Ring Container didn't immediately respond to requests for comment, while a spokesman for Bank of America Corp., which led the loan offering, declined to comment. Sprint, which priced a $1.1 billion incremental-loan deal this week, also declined to comment. The telecom company said it was using proceeds for general corporate purposes.

Dividends Increase

Applied Systems is using a $210 million incremental loan to pay its private equity owners $200 million, a third dividend. Hellman & Friedman bought the Illinois-based firm in 2014 in a deal including an investment from JMI Equity.

When combined with two previous debt funded dividends of $390 million in October 2017 and $171 million in the year before, the owners will have recouped their entire initial investment in the firm in two years, according to people familiar with the deals, who asked not to be identified discussing a private matter. Applied Systems didn't immediately respond to requests for comment. Representatives for Hellman & Friedman and JMI declined to comment.

Applied Systems is one of an increasing number of firms using incremental loans for dividends, according to Bloomberg data. This use of proceeds accounted for more than 17 percent of all incremental loans in 2018, up from 15 percent in 2017 and the highest since 2016, the data show. That's the highest since at least 2015 in dollar terms, at about $17 billion.

Some incremental debt deals have even sought to add a piece of debt that matures ahead of the term loan, effectively subordinating borrowings that would otherwise rank equally in the repayment order, according to Chris Mawn, head of the corporate loan business at investment manager CarVal Investors.

“First in time is first in line as they say,” Mawn said.

--With assistance from Lara Wieczezynski.

To contact the reporters on this story: Sally Bakewell in New York at sbakewell1@bloomberg.net;Kelsey Butler in New York at kbutler55@bloomberg.net

To contact the editors responsible for this story: Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Dan Wilchins