LeveragedLoan Primer

What is a Leveraged Loan?

A leveraged loan is a co mmercial loan provided by a group of lenders. It is first structured, arranged, and admin istered by o ne
or several co mmercial or investment banks, known as arrangers. It is then sold, (or syndicated) to other banks or institutional
investors.

Defining "leveraged"

Just what qualifies as a leveraged loan is a discussion of long standing.

Some participants use a spread cut-off. For examp le, any loan with a spread of at least LIBOR+125, or maybe LIBOR+150,
would qualify as “leveraged.”

Others use rating criteria: any loan rated BB+ or lower would qualify.

But what of loans that are not rated?

At LCD we have developed a more co mp lex defin ition. We include a loan in the leveraged universe if:

it is rated BB+ or lower or

it is not rated or rated ‘BBB-‘ or higher but has

(1) a spread of LIBOR +125 or h igher and

(2) is secured by a first or second lien

Under this definit ion, a loan rated BB+ that has a spread of LIBOR+75 would qualify as leveraged, but a nonrated loan with
the same spread would not.

It is hardly a perfect defin ition, but one that LCD thinks best captures the spirit of loan market participants when they talk
about “leveraged loans.”

Leveraged Loan Purposes

For the most part, issuers undertake leveraged loans for four reasons:

 To support an M&A-related transaction

 To back a recap italizat ion of a co mpany’s balance sheet
 To refinance debt
 To fund general corporate purposes or project finance

M&A/ LBOs

M&A is the lifeblood of leveraged finance. There are the three primary types of acquisition loans:

1) Leveraged buyouts (LBOs)

Most LBOs are backed by a private equity firm, which funds the transaction with a significant amount of debt in the form of
leveraged loans, mezzanine finance, high-yield bonds and/or seller notes. Debt as a share of total sources of funding for the
LBO can range fro m 50% to upwards of 75%. The nature of the transaction will determine how h ighly it is leveraged. Issuers
with large, stable cash flows usually are ab le to support higher leverage. Similarly, issuers in defensive, less -cyclical sectors
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are given more latitude than those in cyclical industry segments. Finally , the reputation of the private equity backer (sponsor)
also plays a role, as does market liquidity (the amount of institutional investor cash available). Stronger markets usually a llow
for higher leverage; in weaker markets lenders want to keep leverage in check.

Obviously, LBO activity depends on how active the M&A market is. During the most -recent M&A boom cycle, in 2006-07,
transaction volume of LBOs and leveraged loans backing them hit record highs as banks scrambled to originate these deals –
usually earning hefty fees – while institutional investors clamored to invest in these credits. After the Lehman bankruptcy in
2008 and subsequent economic free-fall, of course, the M&A/LBO loan markets all but disappeared. They began to recover
in 2011, with more cautious deals, picking up noticeably in 2013. And during the first half of 2014 LBO loan volume (below)
totaled $53 billion, for a pace that would make this year the busiest since 2007 (when there was an astronomical $190 billion
in LBO loans).

There are three main types of LBO deals:

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 Public -to-private (P2P) – also called go-private deals – in which the private equity firm purchases a publicly traded
company via a tender offer. In some P2P deals a stub portion of the equity continues to trade on an exchange. In
others the company is bought outright
 Sponsor-to-sponsor (S2S) deals, where one private equity firm sells a portfolio property to another
 Non-core acquisitions, in wh ich a corporate issuer sells a division to a private equity firm.

2) Platform acquisitions

Transactions in which private-equity-backed issuers buys a business that they judge will be accret ive by either creat ing cost
savings and/or generating expansion synergies.

3) Strategic acquisitions

These are similar to a p latform acquisit ions but are executed by an issuer that is not owned by a private equity firm.

Recapi talizations

Recapi talizations
A leveraged loan backing a recapitalization results in changes in the composition of an entity’s balance sheet mix between
debt and equity either by (1) issuing debt to pay a dividend or repurchase stock or (2) selling new equity, in so me cases to
repay debt.

Some co mmon examp les:

 Di vi dend. Dividend financing is straightforward. A co mpany takes on debt and uses proceeds to pay a dividend to
shareholders. Activity here tends to track market conditions. Bu ll markets inspire more dividend deals as issuers tap
excess liquidity to pay out equity holders. In weaker markets activity slows as lenders tighten the reins, and usually
look skeptically upon transactions that weaken an issuer’s balance sheet.
 Stock repurchase. In this form of recap deal a co mpany uses debt proceeds to repurchase stock. The effect on the
balance sheet is the same as a dividend, with the mix shift ing toward debt.
 Equi ty infusion. These transactions typically are seen in d istressed situations. In some cases, the private equity
owners agree to make an equity infusion in the co mpany, in exchange for a new debt package. In others, a new
investor steps in to provide fresh capital. Either way, the deal strengthens the company’s balance sheet.
 IPO (reverse LBO). An issuer lists – or, in the case of a P2P LBO, relists – on an exchange. As part of such a
deleveraging the company might revamp its loans or bonds at more favorable terms.

Refi/ GCP/Build-outs

Refinancing
Simp ly put, this entails a new loan or bonds issue to refinance existing debt.

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The torrent of institutional investor cash into the leveraged loan market over the past few years has led to a surge in
recreational refinancing – aka re-pricings – as issuers took advantage of ever-hungry investors. After a dizzying 2013 this
activity slowed in 2014, however, as the loan market began to turn (cash actually started exiting loan funds).

General corporate purposes

These deals support working capi tal, general operati ons and other business -as-usual purposes.

Build-outs
Build-out financing supports a particular p roject, such as a utility plant, a land development deal, a casino or an energy
pipeline.

Market background

Starting with the large leveraged buyout (LBO) loans of the mid-1980s, the leveraged/syndicated loan market has become the
dominant way for corporate borrowers (issuers) to tap banks and other institutional capital providers for loans. The reason is
simp le: Syndicated loans are less expensive and more efficient to administer than traditional b ilateral – one co mpany, one
lender – credit lines.

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The U.S. leveraged loan market is following up a record $605 billion in “new money” deals in 2013 with an impressive
2014. Through the first half of this year there has been $351 billion in issuance. Both numbers are a far cry fro m the dark
days of 2008-09, of course, immediately after the collapse of Lehman Brothers and meltdown of the financial markets.

Arrangers serve the time-honored investment-banking role of raising investor dollars for an issuer in need of capital. The
issuer pays the arranger a fee for this service and, naturally, this fee increases with the comp lexity and riskiness of the loan.

As a result, the most profitable loans are those to leveraged borrowers – those whose credit ratings are speculative grade
(traditionally double-B plus and lower), and who are paying spreads (premiu ms above LIBOR or another base rate) sufficient
to attract the interest of nonbank term loan investors, (that spread typically will be LIBOR+200 or higher, though this
threshold rises and falls, depending on market conditions).

By contrast, large, h igh-quality, investment-grade companies – those rated triple-B minus and higher – usually forego
leveraged loans and pay little or no fee for a plain-vanilla loan, typically an unsecured revolving credit instrument that is used
to provide support for short-term co mmercial paper borro wings or for working capital (as opposed to a fully d rawn loan used
to fund an acquisition of another company).

In many cases, moreover, these highly rated borrowers will effect ively syndicate a loan t hemselves, using the arranger simp ly
to craft documents and administer the process.

For a leveraged loan, the story is very different for the arranger. And by different we mean mo re lucrative.

A new leveraged loan can carry an arranger fee of 1% to 5% of the total loan co mmit ment, depending on

1. The complexity o f the transaction

2. How strong market conditions are at the time
3. Whether the loan is underwritten

Merger and acquisition (M&A) and recapitalizat ion loans will likely carry h igh fees, as will bankruptcy exit financings and
restructuring deals. Seasoned leveraged issuers, in contrast, pay lower fees for re-financings and add-on transactions.

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Because investment-grade loans are infrequently drawn down and, therefore, offer drastically lower yields, the ancillary
business that banks hope to see is as important as the credit product in arranging such deals, especially because many
acquisition-related financings for investment-grade companies are large, in relat ion to the pool of potential investors, which
would consist solely of banks.

How are Loans Syndicated?

Once the loan issuer (borrower) picks an arranging bank or banks and settles on a structure of the deal, the syndications
process moves to the next phase. The “retail” market for a syndicated loan consists of banks and, in the case of leveraged
transactions, finance companies and institutional investors such as mutual funds, structured finance vehicles and hedge funds
(more on that in section 5).

Before formally offering a loan to these retail accounts, arrangers will often read the market by informally polling select
investors to gauge appetite for the credit.

Based on these discussions, the arranger will launch the credit at a spread and fee it believes will “clear” the market.

Until 1998, this would have been all there is to it. Once the pricing was set, it was set, except in the most extreme cases. If the
loan were undersubscribed – if investor interest in the loan was less than the amount arrangers were looking to syndicate –
the arrangers could very well be left above their desired hold level.

As of 1998, however, the leveraged issuers, arrangers and investors adopted a “market flex” model, wh ich figures heavily in
how the sector operates today. Market Flex is detailed in the following section.

Market Flex

After the Russian debt crisis roiled the market in 1998, arrangers adopted “market -flex” language. Market flex allows
arrangers to change the pricing of the loan based on investor demand —in some cases within a predetermined range—as well
as shift amounts between various tranches of a loan, as a standard feature of loan co mmit ment letters.

Market-flex language, in a single stroke, pushed the loan syndication process, at least in the leveraged arena, across the
Rubicon to a full-fledged capital markets exercise.

Initially, arrangers invoked flex language to make loans more attractive to investors by hiking the spread or lowering the
price. Th is was logical after the volatility introduced by the Russian debt debacle. Over time, however, market-flex became a
tool either to increase or decrease pricing of a loan, based on investor demand.

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After seeing an about-face earlier in 2014 – deals were flexed in favor of investors – issuers regained the upper hand in the
second quarter, as roughly 40% of loans brought to market had either their interest rate or upfront fee trimmed during
syndication. The issuer-friendly moves came even as institutional investors were withdrawing significant amounts of cash
from the leveraged loan asset class (of course, there was roughly $60 billion of net inflows over the previous 18 months).

Because of market flex, a loan syndication today functions as a “book-building” exercise, in bond-market parlance.

A loan is orig inally launched to market at a target spread or, as was increasingly co mmon by the late 2000s, with a range of
spreads, referred to as “price talk”(i.e., a target spread of, say, 250-275 basis points over LIBOR). Investors then will make
commit ments that in many cases are tiered by the spread.

For examp le, an account may put in for $25 million at LIBOR+275 or $15 million at LIBOR+250. At the end of the process,
the arranger will tally the commit ments, then make a call as to where to price, or “print,” the paper.

Following the examp le above, if the loan is oversubscribed at LIBOR+250, the arranger may slice the spread further.
Conversely, if it is undersubscribed, even at LIBOR+275, then the arranger may be forced to raise the spread to bring more
money to the table.

Types of Syndications

There are three main types of leveraged loan syndications:

 An underwritten deal
 A best-efforts syndication
 A club deal

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Underwritten Deal

In an underwritten deal the arrangers guarantee the entire amount committed, then syndicate the loan.

If the arrangers cannot get investors to fully subscribe the loan, they are forced to absorb the difference, which they may later
try to sell sell. This is achievable, in most cases, if market conditions – or the credit’s fundamentals – improve. If not, the
arranger may be fo rced to sell at a d iscount and, potentially, even take a loss on the paper (known as “selling through fees”).
Or the arranger may just be left above its desired hold level of the cred it.

So, why do arrangers underwrite loans? Two ma in reasons

 Offering an underwritten loan can be a co mpetitive tool to win mandates.

 Underwritten loans usually require more lucrat ive fees because the agent is on the hook if potential lenders balk.
Of course, with flex-language now common, underwrit ing a deal does not carry the same risk it once did, when the
pricing was set in stone prior to syndication.

Best-Efforts

In a “best-efforts” syndication the arranger group commits to underwrite less than the entire amount of the loan, leaving the
credit to the vicissitudes of the market. If the loan is undersubscribed, the credit may not close, or may need major surgery –
such as an increase in pricing or addit ional equity fro m a private equity sponsor – to clear the market.

Traditionally, best-efforts syndications were used for riskier borrowers or for comp lex transactions.

Club Deal

A “club deal” is a s maller loan (usually $25 million to $100 million, but as high as $150 million) that is pre -marketed to a
group of relationship lenders.

The arranger is generally a first among equals, and each lender gets a full cut, o r nearly a fu ll cut, of the fees.

The Bank Book (IM)

Before awarding a mandate, an issuer might solicit b ids fro m arrangers. The banks will outline their syndication strategy and
qualifications, as well as their v iew on the way the loan will p rice in market.

Once the mandate is awarded, the syndication process starts.

The arranger will prepare an informat ion memo (IM) describing the terms of the transactions. The IM typically will include
an executive summary, investment considerations, a list of terms and conditions, an industry overview, and a financial model.
Because loans are not securities, this will be a confidential offering made only to qualified banks and accredited investors.

If the issuer is speculative grade and seeking capital fro m non-bank investors, the arranger will often prepare a “public”
version of the IM. This version will be stripped of all confidential material, such as financial p rojections fro m management,
so that it can be viewed by accounts that operate on the public side of the wall, or that want to preserve their ability to buy
bonds, stock or other public securities of the particular issuer (see the Public Versus Private section below).

Naturally, investors that view materially nonpublic informat ion of a co mpany are disqualified fro m buying the company’s
public securities for so me period of time.

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As the IM is being prepared the syndicate desk will solicit in formal feedback fro m potential investors regarding potential
appetite for the deal, and at what price they are willing to invest. Once this intelligence has been gathered the agent will
formally market the deal to potential investors.

Arrangers will distribute most IMs —along with other information related to the loan, pre- and post-closing – to investors
through digital p latforms. Leading vendors in this space are Intralinks, Syntrak and Debt Do main.

Bank book - Components

The IM typically contain the follo wing sections:

 Executi ve summary: A description of the issuer, an overview of the transaction and rationale, sources and uses, and
key statistics on the financials
 Investment considerati ons: Basically, management’s sales “pitch” for the deal
 Terms and condi tions: A preliminary term sheet describing the pricing, structure, collateral, covenants, and other
terms of the cred it (covenants are usually negotiated in detail after the arranger receives investor feedback)
 Industry overview: A description of the co mpany’s industry and competitive position relative to its industry peers
 Financi al model: A detailed model of the issuer’s historical, pro forma, and projected financials, including
management’s high, lo w, and base case for the issuer

The bank meeting

Most new acquisition-related loans kick off at a bank meet ing, where potential lenders hear management and the private
equity/sponsor group (if there is one) describe what the terms of the loan are and what transaction it backs. Understandably,
bank meetings are more often than not conducted via a Webex or conference call, although some issuers still p refer old -
fashioned, in-person gatherings.

Whatever the format, management uses the bank meeting to provide its vision for the transaction and, most important, tell
why and how the lenders will be repaid on or ahead of schedule. In addit ion, investors will be briefed regarding the multip le
exit strategies, including second ways out via asset sales. (If it is a s mall deal or a refinancing instea d of a formal meeting,
there may be a series of calls. or one-on-one meetings with potential investors.)

Once the loan is closed, the final terms are then documented in detailed credit and security agreements. Subsequently, liens
are perfected and collateral is attached.

Loans, by their nature, are flexib le docu ments that can be revised and amended fro m time to time. These amend ments require
different levels of approval (see Voting Rights section). Amend ments can range fro m something as simple as a covenant
waiver to as complex as a change in the collateral package, or allo wing the issuer to stretch out its payments or make an
acquisition.

Leveraged Loan Investor Market

There are three primary investor consistencies for leveraged loans:

 Banks
 Finance co mpanies
 Institutional investors

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Institutional investors can comprise different, distinct, important investor segments, such as CLOs (collateralized loan
obligations) and mutual funds.

Each segment is detailed below.

Banks

A bank investor can be a commercial bank, a savings and loan institution, or a securities firm that usually provides
investment-grade loans. These are typically large revolving cred its that back commercial paper or general corporate purposes.
In some cases they support acquisitions.

For leveraged loans, banks typically provide unfunded revolving credits, letters of credit (LOCs) and – less and less, these
days – amort izing term loans, under a syndicated loan agreement.

Finance companies

Finance co mpanies have consistently represented less than 10% of the leveraged loan market, and tend to play in smaller
deals – $25 million to $200 million.

These investors often seek asset-based loans that carry wide spreads. These deals often require time-intensive collateral
monitoring.

Instituti onal investors

Institutional investors in the loan market usually are structured vehicles known as collateralized loan obligations (CLOs) an d
loan participation mutual funds (known as “Prime funds” because they were originally p itched to investors as a money
market-like fund that would appro ximate the Prime rate).

In addition, hedge funds, high-yield bond funds, pension funds, insurance companies, and other proprietary investors do
participate opportunistically in loans focusing usually on wide-marg in (or “high-octane”) paper.

CLOs

CLOs are special-purpose vehicles set up to hold and manage pools of leveraged loans.

The special-purpose vehicle is financed with several tranches of debt (typically a ‘AAA’ rated tranche, a ‘AA’ tranche, a
‘BBB’ tranche, and a mezzanine tranche) that have rights to the collateral and payment stream, in descending order. In
addition, there is an equity tranche, but the equity tranche usually is not rated.

CLOs are created as arbitrage vehicles that generate equity returns via leverage, by issuing debt 10 to 11 t imes their equity
contribution.

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There’s wrong, and then there’s those who declared the structured finance market dead, for good, after the financial market
meltdown of 2008-09. Despite some rare institutional investor withdrawals from loan funds, the search for yield helped
prompt CLO issuance during 2014’s second quarter to an unprecedented $38.33 billion.

There are also market-value CLOs that are less leveraged – typically 3 to 5 times. These vehicles allow managers greater
flexib ility than more tightly structured arbitrage deals.

CLOs are usually rated by two of the three major ratings agencies and impose a series of covenant tests on collateral
managers, including minimu m rating, industry diversification, and maximu m defau lt basket.

Loan mutual funds

Loan mutual funds are how retail investors can access the loan market. They are mutual funds that invest in leveraged loans.
These funds – originally known as Prime funds, because they offered investors the chance to earn the Prime interest rate that
banks charge on commercial loans – were first introduced in the late 1980s.

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Investors retreated from the loan market in 2014′s second quarter, the first time they’ve done that in recent memory. The
assets under management of loan mutual funds contracted by $2.6 billion in June, or 1.52%, to a six -month low of $169.9
billion, according to Lipper and fund filings. It was the largest monthly outflow by dollar amount since August 2011, when a
record $5.5 billion was withdrawn.

Today there are three main categories of funds:

 Daily-access funds : These are tradit ional open-end mutual fund products into which investors can buy or redeem
shares each day at the fund’s net asset value.
 Continuously offered closed-end funds : These were the first loan mutual fund products. Investors can buy into
these funds each day at the fund’s net ass et value (NA V). Redempt ions, however, are made v ia monthly or quarterly
tenders, rather than each day, as with the open-end funds described above. To make sure they can meet redemptions,
many of these funds, as well as daily access funds, set up lines of credit to cover withdrawals above and beyond cash
reserves.
 Exchange-traded closed-end funds (ETF): These funds, which have skyrocketed in popularity over the past few
years, trade on a stock exchange. Typically the funds are capitalized by an in itial public offering. Thereafter,
investors can buy and sell shares, but may not redeem them. The manager can also expand the fund via rights
offerings. Usually they are able to do so only when the fund is trading at a premiu m to NA V, however – a provision
that is typical of closed-end funds regardless of the asset class.

In March 2011, Invesco introduced the first index-based exchange traded fund, PowerShares Sen ior Loan Portfo lio (BKLN),
which is based on the S&P/LSTA Loan 100 Index. By the second quarter of 2013 B KLN had topped $4.53 billion in assets
under management.

Some ETFs related to the loan market:

 PowerShares Exchange-Traded Fund Trust II ($BKLN)

 iShares iBo xx $ High Yid Corp Bond ($HYG)
 SPDR Barclays Capital High Yield Bnd ($JNK)

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Public vs. Pri vate Markets

In the old days, a bright red line separated public and private informat ion in the loan market. Leveraged loans were strictly on
the private side of the line, and any information transmitted between the issuer and the lender group remained confidential.

In the late 1980s that line began to blur as a result of two market innovations.

The first was a more active secondary trading market, which sprung up to support (1) the entry of non -bank investors into the
market (investors such as insurance companies and loan mutual funds) and (2) to help banks sell rap idly expanding portfolios
of distressed and highly leveraged loans that they no longer wanted to hold.

This meant that parties that were insiders on loans might now exchange con fidential information with traders and potential
investors who were not (or not yet) a party to the loan.

The second innovation that weakened the public/private div ide was trade journalis m focusing on the loan market.

Despite these two factors, the public versus private line was well understood, and rarely was controversial, for at least a
decade.

This changed in the early 2000s as a result of:

 The proliferation of loan rat ings which, by their nature, provide public exposure for loan deals
 The explosive growth of non-bank investors groups, which included a growing number of institutions that operated
on the public side of the wall, including a growing number of mutual funds, hedge funds, and even CLO boutiques
 The growth of the credit default swaps market, in wh ich insiders like banks often sold or bought protection fro m
institutions that were not privy to inside informat ion
 Again, a more aggressive effort by the press to report on the loan market

Background - Public vs pri vate

Some background is in order. The vast majority of loans are unamb iguously private financing arrangements between issuers
and lenders. Even for issuers with public equity or debt, and which file with the SEC, the credit agreement becomes public
only when it is filed – months after closing, usually – as an exh ibit to an annual report (10-K), a quarterly report (10-Q), a
current report (8-K), or some other document (pro xy statement, securities registration, etc.).

Beyond the credit agreement there is a raft of ongoing correspondence between issuers and lenders that is made under
confidentiality agreements, including quarterly or monthly financial disclosures, covenant compliance informat ion,
amend ment and waiver requests, and financial project ions, as well as plans for acquisitions or dispo sitions. Much of this
informat ion may be material to the financial health of the issuer, and may be out of the public domain until the issuer
formally issues a press release, or files an 8-K or so me other document with the SEC.

Today's changing market

In recent years there was growing concern among issuers, lenders, and regulators that migration of once -private information
into public hands might breach confidentiality agreements between lenders and issuers. More important, it could lead to
illegal trading. How has the market contended with these issues?

 Traders. To insulate themselves fro m v iolat ing regulations, some dealers and buyside firms have set up their
trading desks on the public side of the wall. Consequently, traders, salespeople, and analysts do not receive private
informat ion even if so mewhere else in the institution the private data are availab le. Th is is the same technique that

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investment banks have used fro m time immemo rial to separate their private investment banking activit ies fro m their
public trading and sales activities.
 Underwriters. As mentioned above, in most primary syndications, arrangers will prepare a public version of
informat ion memoranda that is scrubbed of private information (such as projections). These IMs will be distributed
to accounts that are on the public side of the wall. As well, underwriters will ask public accounts to attend a public
version of the bank meet ing, and will d istribute to these accounts only scrubbed financial informat ion.
 Buyside accounts. On the buyside there are firms that operate on either side of the public-private divide.

Accounts that operate on the private side receive all confidential materials and agree not to trade in public securities of t he
issuers in question. These groups are often part of wider investment co mplexes that do have public funds and portfolios but,
via Chinese walls, are sealed fro m these parts of the firms.

There are also accounts that are public. These firms take only public IMs and public materials and, therefore, retain the o ption
to trade in the public securities markets even when an issuer for which they own a loan is involved. This can be tricky to pu ll
off in practice because, in the case of an amend ment, the lender could be called on to approve or decline in the absence o f any
real information. To contend with this issue the account could either designate one person who is on the private side of the
wall to sign off on amend ments or empower its trustee, or the loan arranger to do so. But it’s a co mplex proposition.

 Vendors. Vendors of loan data, news, and prices also face many challenges in managing the flo w of public and
private information. In general, the vendors operate under the freedom of the press provision of the U.S.
Constitution’s First Amendment and report on information in a way that anyone can simultaneously receive it (for a
price, of course). Therefore, the info rmation is essentially made public in a way that doesn’t deliberately
disadvantage any party, whether it’s a news story discussing the progress of an amend ment or an acquisition, or a
price change reported by a mark-to-market service. Th is, of course, doesn’t deal with the underlying issue: That
someone who is a party to confidential informat ion is making it available v ia the press or pricing services, t o a
broader audience.

Another way in which part icipants deal with the public-versus-private issue is to ask counterparties to sign “big-boy” letters.
These letters typically ask public-side institutions to acknowledge that there may be information they are not privy to, and
they are agreeing to make the trade in any case. They are, effectively, big boys, and will accept the risks.

Credit Risk - Overview

Pricing a loan requires arrangers to evaluate the risk inherent in a loan and to gauge investor appetite for that risk.

The principal credit risk factors that banks and institutional investors contend with in buying loans

 Default risk
 Loss-given-default risk

Among the primary ways that accounts judge these risks are ratings, collateral coverage, seniority, credit statistics, industry
sector trends, management strength, and sponsor. All of these, together, tell a story about the deal.

Descriptions of the major risk factors follow.

Default risk

Default risk is simp ly the likelihood of a borrower being unable to pay interest or principal on time.

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It is based on the issuer’s financial condition, industry segment, and conditions in that industry, as well as economic varia bles
and intangibles, such as company management.

Default risk will, in most cases, be most visibly expressed by a public rating fro m Standard & Poor’s Ratings Services or
another ratings agency. These ratings range from ‘AAA’ for the most creditwo rthy loans to ‘CCC’ fo r the least.

The market is roughly divided into two segments:

 Investment grade (loans to issuers rated ‘BBB-’ or higher)

 Leveraged (borro wers rated ‘BB+’ or lower).

Default risk, of course, varies widely within each of these broad segments.

Since the mid-1990s, public loan ratings have become a de facto requirement for issuers that wish to do business with a wide
group of institutional investors. Unlike banks, which typically have large credit depart ments and adhere to internal rating
scales, fund managers rely on agency ratings to bracket risk, and to exp lain the overall risk o f their portfolios to their own
investors.

As of mid-2011, then, roughly 80% o f leveraged loan volume carried a loan rating, up fro m 45% in 1998. Befo re 1995
virtually no leveraged loans were rated.

Seniority

Where an instrument ranks in priority of pay ment is referred to as seniority. Based on this ranking, an issuer will direct
payments with the senior most creditors paid first and the most junior equityholders last. In a typical structure, senior sec ured
and unsecured creditors will be first in right of payment – though in bankruptcy, secured instruments typically move the front
of the line – followed by subordinate bond holders, junior bondholders, preferred shareholders and common shareholders.
Leveraged loans are typically senior, secured instruments and rank highest in the capital structure.

Loss-given-default

Loss-given-default risk measures how severe a loss the lender is likely to incur in the event of default.

Investors assess this risk based on the collateral (if any) backing the loan and the amount o f other debt and equity
subordinated to the loan. Lenders will also look to covenants to provide a way of co ming back to the table early – that is,
before other creditors – and renegotiating the terms of a loan if the issuer fails to meet financial targets .

Investment-grade loans are, in most cases, senior unsecured instruments with loosely drawn covenants that apply only at
incurrence. That is, only if an issuer makes an acquisition or issues debt. As a result, loss -given-default may be no different
fro m risk incurred by other senior unsecured creditors.

Leveraged loans, in contrast, are usually senior secured instruments that, except fo r covenant -lite loans, have maintenance
covenants that are measured at the end of each quarter, regardless of the issuer is in co mpliance with pre-set financial tests.

Loan holders, therefore, almost always are first in line among pre-petit ion creditors and, in many cases, are able to
renegotiate with the issuer before the loan becomes severely impaired. It is no surprise, th en, that loan investors historically
fare much better than other creditors on a loss -given-default basis.

Calculating loss given default is tricky business. Some practitioners express loss as a nominal percentage of principal or a
percentage of principal p lus accrued interest. Others use a present-value calculation, emp loying an estimated discount rate –
typically the 15-25% demanded by distressed investors.
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Credit statistics

Cred it statistics are used by investors to help calibrate both default and loss -given-default risk. These statistics include a
broad array of financial data, including credit ratios measuring leverage (debt to capitalization and debt to EBITDA) and
coverage (EBITDA to interest, EBITDA to debt service, operating cash flow to fixed charg es). Of course, the ratios investors
use to judge credit risk vary by industry.

In addition to looking at trailing and pro forma rat ios, investors look at management’s projections, and the assumptions
behind these projections, to see if the issuer’s game plan will allow it to service debt.

There are rat ios that are most geared to assessing default risk. These include leverage and coverage.

Then there are ratios that are suited for evaluating loss -given-default risk. These include collateral coverage, or the value of
the collateral underlying the loan, relative to the size of the loan. They also include the ratio of senior secured loan to junior
debt in the capital structure.

Logically, the likely severity of loss -given-default for a loan increases with the s ize of the loan, as a percentage of the overall
debt structure. After all, if an issuer defaults on $100 million of debt, of wh ich $10 million is in the form of senior secured
loans, the loans are more likely to be fully covered in bankruptcy than if the loan totals $90 million.

Industry segment

Industry segment is a factor because sectors, naturally, go in and out of favor.

For that reason, having a loan in a desirable sector, like telecom in the late 1990s or healthcare in the early 2000s, can re ally
help a syndication along.

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Also, loans to issuers in defensive sectors (like consumer products) can be more appealing in a time of economic uncertainty,
whereas cyclical borrowers (like chemicals or autos) can be more appealing during an economic upswing.

Private equity sponsor

Sponsorship is a factor too.

Needless to say, many leveraged co mpanies are owned by one or more private equity firms. These entities, such as Kohlberg
Kravis & Roberts or Carlyle Group, invest in companies that have leveraged capital structures. To the extent that the sponsor
group has a strong following among loan investors, a loan will be easier to syndic ate and, therefore, can be priced lower.

In contrast, if the sponsor group does not have a loyal set of relat ionship lenders, the deal may need to be priced higher to
clear the market.

Among banks, investment factors may include whether the bank is party t o the sponsor’s equity fund. Among institutional
investors, weight is given to an individual deal sponsor’s track record in fixing its own impaired deals by stepping up with
additional equity or rep lacing a management team that is failing.

For reference, here’s some of the largest sponsor-backed leveraged loans in 2014 (through April), along with the private
equity firm associated with each deal. You can click through to the deal specifics for each transaction.

Issuer $Bils Launch Purpose Sponsor

Avago Technologies 5.10 April Acquisition Silver Lake Partners

Aramark Corp 3.55 Feb Refinancing Thomas H. Lee

Neiman Marcus Group 2.94 March Refinancing Ares Management

Gates Global 2.94 June LBO Blackstone

Advantage Sales 2.82 June LBO Apax

IMS Health 2.74 Feb Refinancing Texas Pacific Group

Freescale Semiconductor 2.72 Feb Refinancing Blackstone Group

Ortho-Clinical Diagnostics 2.52 April LBO Carlyle Group

Ineos Group 2.52 Feb Refinancing Ineos Capital

LightSquared 2.50 Jan Exit Financing Fortress Investment Group

IMG Worldwide 2.45 Feb LBO Silver Lake Partners

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West Corp 2.37 Jan Refinancing Thomas H. Lee

La Quinta Properties 2.35 Feb Recap/IPO Blackstone Group

Vantiv 2.31 May M&A Silver Lake

MultiPlan 2.27 March LBO Partners Group

Kinetic Concepts 2.26 Jan Refinancing Apax Partners

Asurion 2.25 Feb Recap/Dividend Madison Dearborn Partners

Syndicating a Loan - by Facility

Most loans are structured and syndicated to accommodate the two primary syndicated lender constituencies: banks (domestic
and foreign) and institutional investors (primarily structured finance vehicles, mutual funds, and insurance companies). As
such, leveraged loans consist of:

 Pro rata debt consists of the revolving credit and amort izing term loan (TLa), which are packaged toge ther and,
usually, syndicated to banks . In some loans, however, institutional investors take pieces of the TLa and, less often,
the revolving credit, as a way to secure a larger institutional term loan allocation. Why are these tranches called “pro
rata?” Historically, arrangers syndicated revolving credit and TLa t ranches on a pro rata basis to banks and finance
companies.
 Instituti onal debt consists of term loans structured specifically for institutional investors, though there are also
some banks that buy institutional term loans. These tranches include first- and second-lien loans, as well as pre-
funded letters of credit. Trad itionally, institutional tranches were referred to as TLbs because they were bullet
payments, and are repaid after the TLa tranches.

Finance co mpanies also play in the leveraged loan market, and buy both pro rata and institutional tranches. With institutiona l
investors playing an ever-larger role, however, by the late 2000s many executions were structured simp ly as revolving
credit/institutional term loans, with the TLa falling by the wayside.

Pricing a Loan - Primary Market

Pricing loans for the institutional market is a straightforward exercise based on simple risk/return consideration and market
technicals. Pricing a loan for the bank market, however, is more co mp lex. Indeed, banks often invest in loans for more than
just spread income. Rather, banks are driven by the overall profitability of the issuer relationship, including noncredit rev enue
sources.

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For bank investors

Since the early 1990s almost all large co mmercial banks have adopted portfolio -management techniques that measure the
returns of loans and other credit products, relative to risk. By doing so, banks have learned that loans are rarely co mpellin g
investments on a stand-alone basis.

Therefore, banks are reluctant to allocate capital to issuers unless the total relationship generates attractive returns – whether
those returns are measured by risk-adjusted return on capital, by return on economic capital, or by some o ther metric.

If a bank is going to put a loan on its balance sheet, it takes a hard look not only at the loan’s yield, but at other sources of
revenue from the relationship, including noncredit businesses – like cash-management services and pension-fund
management – and economics fro m other capital markets activities, like bonds, equities, or M&A advisory work.

This process has had a breathtaking result on the leveraged loan market, to the point that it is an anachronism to continue t o
call it a “bank” loan market.

Of course, there are certain issuers that can generate a bit more bank appetite. As of mid -2011 these included issuers with a
European or even a Mid western U.S. angle. Naturally, issuers with European operations are able to better tap banks in the ir
home markets (banks still provide the lion’s share of loans in Europe) and, for M idwestern issuers, the heartland remains one
of the few U.S. regions with a deep bench of local banks.

What this means is that the spread offered to pro rata investors is important. But so too, in most cases, is the amount of other,
fee-driven business a bank can capture by taking a piece of a loan. Fo r this reason issuers are careful to award pieces of bond -
and equity-underwriting engagements and other fee-generating business to banks that are part of its loan syndicate.

For institutional pl ayers

For institutional investors the investment decision process is far more straightforward because, as mentioned above, they are
focused not on a basket of returns but on loan-specific revenue.

In pricing loans to institutional investors it’s a matter o f the spread of the loan, relat ive to credit quality and market -based
factors. This second category can be divided into liqui dity and market technicals (i.e., suppl y/ demand).

Liquidity is the tricky part but, as in all markets, all else being equal, mo re liquid instruments command thinner spreads than
less liquid ones.

In the old days – before institutional investors were the dominant investors and banks were less focused on portfolio
management – the size of a loan didn’t much matter. Loans sat on the books of banks and stayed there.

But now that institutional investors and banks put a premiu m on the ability to package loans and sell them, liquid ity has
become important. As a result, smaller executions – generally those of $200 million or less – tend to be priced at a premiu m
to the larger loans.

Of course, once a loan gets large enough to demand extremely broad distribution the issuer usually must pay a size premiu m.
The thresholds range widely. During the go-go mid -2000s it was upwards of $10 billion. During more parsimon ious late-
2000s a $1 b illion credit was considered a stretch.

Market technicals, or supply relat ive to demand, is a matter of simp le econo mics. If there are many dollars chasing little
product then, naturally, issuers will be able to co mmand lo wer spreads. If, however, the opposite is true, then spreads will
need to increase for loans to be successfully syndicated.

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Mark-to-market

Beginning in 2000 the SEC directed bank loan mutual fund managers to use available price data (bid/ask levels reported by
dealer desks and compiled by mark-to-market services), rather than fair value (estimates based on whether the loan is likely
to repay lenders in whole or part), to determine the value of broadly syndicated loan portfolios.

In broad terms this policy has made the market more transparent, improved price discovery and, in doing so, made the market
far mo re efficient and dynamic than it was in the past.

Types of Syndicated Loan Facilities

There are four main types of syndicated loan facilities. Each is detailed below.

 Revolving cred its (included here are options for swing line loans, mu lticurrency -borrowing, co mpetit ive-bid options,
term-out, and evergreen extensions)
 Term loans
 A letter of credit (LOC)
 Acquisition or equipment line

Revol ving credi ts

A revolving credit line allows borrowers to draw down, repay, and reborrow.

An RC acts much like a corporate cred it card, except that borrowers are charged an annual fee on unused amou nts (a facility
fee).

Revolvers to speculative-grade issuers are sometimes tied to borrowing-base lending formu las. This limits borrowings to a
certain percentage of specified collateral, most often receivables and inventory (see “Asset -based loan” section below for a
full discussion of this topic).

Revolving cred its often run for 364 days . These revolving credits – called, not surprisingly, 364-day facilit ies – are generally
limited to the investment-grade market. The reason for what seems like an odd term is that regulatory capital guidelines
mandate that, after one year of extending credit under a revolv ing facility, banks must then increase their capital reserves to
take into account the unused amounts.

Therefore, banks can offer issuers 364-day facilities at a lower unused fee than a mu ltiyear revolving cred it. There are a
number of options that can be offered with in a revolv ing credit line:

 A swingline is a small, overnight borrowing line, typically provided by the agent.

 A mu lticurrency line allows the borrower to borro w in one or more alternative currencies (in most agreements this
option is capped).
 A competitive-b id option (CBO) allows borro wers to solicit the best bids from its syndicate group. The agent will
conduct what amounts to an auction to raise funds for the borrower, and the best bids are accepted. CBOs typically
are available only to large, investment-grade borrowers.
 A term-out will allow the borrower to convert borrowings into a term loan at a given conversion date. This, again, is
usually a feature of investment-grade loans. Under the option, borrowers may take what is outstanding under the
facility and pay it off according to a predetermined repayment schedule. Often the spreads ratchet up if the term-out
option is exercised.

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 An evergreen is an option for the borrower – with consent of the syndicate group – to extend the facility each year,
for an additional year. For instance, at the end of each year, a three-year facility would be reset to three years if the
lenders and borrower agree. If the evergreen is not exercised, the agreement would simply run to term.

Term l oans

A term loan is simply an installment loan, such as a loan you’d use to buy a car.

The borrower may draw on the loan during a short commit ment period (during which lenders usual chare a ticking fee, akin
to a commit ment fee on a revolver), and repay it based on either a scheduled series of repayments or a one -time lu mp-su m
payment at maturity (bullet pay ment). There are two principal types of term loans:

 An amortizing term loan (“A” term loans, or TLa) is a term loan with a progressive repayment schedule that
typically runs six years or less. These loans are normally syndicated to banks along with revolving credits as part of
a larger syndication.
 An institutional term loan (“B” term l oans, “C” term loans or “ D” term loans) is a term loan facility carved out
for nonbank, institutional accounts. These loans came into broad usage during the mid -1990s as the institutional loan
investor base grew. This institutional category includes second-lien loans and covenant-lite loans.

Letters of credit (LOC)

Letters of credit (LOCs) are guarantees provided by the bank group to pay off debt or obligations if the borrower cannot.

Acquisition/equi pment line

 Acquisition/equi pment lines (delayed-draw term loans) are credits that may be drawn down for a given period to
purchase specified assets or equipment, or to make acquisit ions. The issuer pays a fee during the commit ment period
(a ticking fee). The lines are then repaid over a specified period (the term-out period). Repaid amounts may not be
reborrowed.
 Bridge loans are loans that are intended to provide short-term financing to provide a “bridge” to an asset sale, bond
offering, stock offering, divestiture, etc. Generally, bridge loans are provided by arrangers as part of an overall
financing package. Typically the issuer will agree to increasing interest rates if the loan is not repaid as expected.
For examp le, a loan could start at a spread of L+250 and ratchet up 50 basis points every six months the loan
remains outstanding past one year.
 Equi ty bri dge l oan is a bridge loan provided by arrangers that is expected to be repaid by a secondary equity
commit ment to a leveraged buyout. This product is used when a private equity firm wants to close on a deal that
requires, say, $1 billion of equity, o f wh ich it ultimately wants to hold half. The arrangers bridge the additional $500
million, which would be then repaid when other sponsors come into the deal to take the $500 million of addit ional
equity. Needless to say, this is a hot-market product.

Second-Lien Loans

As their name imp lies, the claims on collateral of second-lien loans are junior to those of first-lien loans. Although they are
really just another type of syndicated loan facility, second-liens are sufficiently co mp lex to warrant detailed discussion here.

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After a brief flirtation with second-lien loans in the mid-1990s, these facilities fell out of favor after the 1998 Russian debt
crisis caused investors to adopt a more cautious tone. But after default rates fell precipitously in 2003 arrangers rolled out
second-lien facilit ies to help finance issuers struggling with liquid ity problems.

By 2007 the market had accepted second-lien loans to finance a wide array of transactions, including acquisitions and
recapitalizations. Arrangers tap nontraditional accounts – hedge funds, distressed investors, and high-yield accounts – as well
as traditional CLO and prime fund accounts to finance second -lien loans.

Again, the claims on collateral of second-lien loans are junior to those of first-lien loans. Second-lien loans also typically
have less restrictive covenant packages, in which maintenance covenant levels are set wide of the first -lien loans. For these
reasons, second-lien loans are priced at a p remiu m to first-lien loans. This premiu m typically starts at 200 bps when the
collateral coverage goes far beyond the claims of both the first- and second-lien loans, to mo re than 1,000 bps for less
generous collateral.

There are, lawyers explain, two main ways in which the collateral of second -lien loans can be documented. Either the
second-lien loan can be part of a single security agreement with first-lien loans, or they can be part of an altogether separate
agreement. In the case of a single agreement, the agreement would apportion the collateral, with value going first, obviously,
to the first-lien claims, and next to the second-lien claims.

Alternatively, there can be two entirely separate agreements. Here’s a brief su mmary :

 In a single security agreement second-lien lenders are in the same creditor class as first-lien lenders fro m the
standpoint of a bankruptcy, according to lawyers who specialize in these loans. As a result, for adequate protection
to be paid the collateral must cover both the claims of the first- and second-lien lenders. If it does not the judge may
choose to not pay adequate protection or to divide it pro rata among the first - and second-lien creditors. In addition,
the second-lien lenders may have a vote as secured lenders equal to those of the first-lien lenders. One downside for
second-lien lenders is that these facilit ies are often smaller than the first-lien loans and, therefore, when a vote
comes up, first-lien lenders can out-vote second-lien lenders to promote their own interests.
 In the case of two discrete security agreements, divided by a standstill agreement, the first - and second-lien lenders
are likely to be div ided into two creditor classes. As a result, second -lien lenders do not have a voice in the first-lien
creditor co mmittees. As well, first-lien lenders can receive adequate protection payments even if collateral covers
their claims, but does not cover the claims of the second-lien lenders. This may not be the case if the loans are
documented together and the first- and second-lien lenders are deemed a unified class by the bankruptcy court.

For more info rmation, we suggest Latham & Watkins’ terrific overvie w and analysis of second-lien loans, fro m 2004.

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Covenant-Lite Loans

Covenant-lite loan volume surges when institutional investors have cash to invest, and the resulting demand for the leveraged
loan asset class puts issuers in the drivers seat. That was the case during much of 2014, when covenant-lite activity
comprised as much as 60% of new-issue volume.

Like second-lien loans, covenant-lite loans are a particu lar kind of syndicated loan facility. At the most basic level, covenant-
lite loans are loans that have bond-like financial incurrence covenants, rather than traditional maintenance covenants that are
normally part and parcel of a loan agreement. What’s the difference?

Incurrence covenants generally require that if an issuer takes an action (paying a dividend, making an acquisition, issuing
more debt), it would need to still be in co mp liance. So, for instance, an issuer that has an incurrence test that limits its debt to
5x cash flow would only be able to take on more debt if, on a pro forma basis, it was still within this constraint. If not it
would have breached the covenant and be in technical default on the loan. If, on the other hand, an issuer found itself above
this 5x threshold simply because its earnings had deteriorated, it wo uld not violate the covenant.

Maintenance covenants are far more restrictive. This is because they require an issuer to meet certain financial tests every
quarter, whether or not it takes an action. So, in the case above, had the 5x leverage maximu m been a maintenance rather than
incurrence test, the issuer would need to pass it each quarter, and would be in vio lation if either its earnings eroded or it s debt
level increased.

For lenders, clearly, maintenance tests are preferab le because it allo ws them to t ake action earlier if an issuer experiences
financial distress. What’s more, the lenders may be ab le to wrest some concessions from an issuer that is in violation of
covenants (a fee, incremental spread, or additional co llateral) in exchange for a waiver.

Conversely, issuers prefer incurrence covenants precisely because they are less stringent.

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Free-and-Clear Incremental Tranches

These are carve-outs in covenant-lite loans that allow borro wers to issue debt without triggering incurrence financial tests.
For instance, a leverage test may say that an issuer cannot take on new debt if, on a pro forma basis, total debt to EBITDA
would be 4x or more – but the test only kicks in once the issuer incurs more than, say, $100 million of new debt. That
effectively g ives the borrower the ability to issue up to $100 million of new debt at a market clearing rate whether or not
leverage exceeds 4x. Lenders, in most cases, have most-favored-nations (MFN) protection that resets the yield of the existing
loan to the rate of the new loan to make sure it remains on market. In rare cases, however, this protection is limited to a
certain period of t ime by what is known as an MFN sunset. In other cases, the rate adjustment is capped, to perhaps 50 bps.

Free-and-clear tranches are an innovation that grew out of the proliferation of covenant-lite loans since 2013. Lenders expect
the use of these provisions to ebb and flow with the strength of market conditions.

Lender Titles

In the formative days of the syndicated loan market (the late 1980s) there was usually one agent that syndicated each loan.
“Lead manager” and “manager” tit les were doled out in exchange for large co mmit ments. As league tables gained influence
as a marketing tool, “co-agent” titles were often used in attracting large co mmit ments, or in cases where these institutions
truly had a role in underwrit ing and syndicating the loan.

During the 1990s the use of league tables – and, consequently, title inflat ion – exploded. Indeed, the co-agent title has
become largely ceremon ial today, routinely awarded for what amounts to no more than large retail co mmit ments. In most
syndications there is one lead arranger. This institution is considered to be on the “left” (a reference to its position in a n old-
time to mbstone ad). There are also likely to be other banks in the arranger group, which may also have a hand in
underwrit ing and syndicating a credit. These institutions are said to be on the “right.”

The different titles used by significant participants in the syndications process are admin istrative agent, syndication agent,
documentation agent, agent, co-agent or managing agent, and lead arranger or book runner:

 The administrati ve agent is the bank that handles all interest and principal pay ments and monitors the loan.
 The syndication agent is the bank that handles, in purest form, the syndication of the loan. Often, however, the
syndication agent has a less specific role.
 The documentation agent is the bank that handles the documents and chooses the law firm.
 The agent title is used to indicate the lead bank when there is no other conclusive title available, as is often the case
for smaller loans.
 The co-agent or managing agent is largely a mean ingless title used mostly as an award for large co mmit ments.
 The lead arranger or book runner tit le is a league table designation used to indicate the “top dog” in a syndication.

Secondary Sales

Secondary sales occur after the loan is closed and allocated, when primary market investors are free to trade the paper. Loan
sales are structured as either assignments or participations, with investors usually trading through dealer desks at the large
underwrit ing banks. Dealer-to-dealer trading is almost always conducted through a “street” broker.

Assignments

In an assignment, the assignee becomes a direct signatory to the loan and receives interest and principal pay ments directly
fro m the ad ministrative agent.
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Assignments typically require the consent of the borrower and agent, though consent may be withheld only if a reasonable
objection is made. In many loan agreements the issuer loses its right to consent in the event of default.

The loan document often sets a minimu m assignment amount, usually $5 million, for pro rata co mmit ments. In the late
1990s, however, ad ministrative agents started to break out specific assignment min imu ms for institutional tranches. In most
cases, institutional assignment min imu ms were reduced to $1 million in an effort to boost liquidity. There were also some
cases where assignment fees were reduced or even eliminated for institutional assignments, but these lower assignment fees
remained rare into 2012, and the vast majority was set at the traditional $3,500.

One market convention that became firmly establis hed in the late 1990s was assignment-fee waivers by arrangers for trades
crossed through its secondary trading desk. This was a way to encourage investors to trade with the arranger rather than with
another dealer. This is a significant incentive to trade with the arranger – or a deterrent to not trade elsewhere, depending on
your perspective – because a $3,500 fee amounts to between 7 bps to 35 bps of a $1 million to $5 million trade.

Primary Assignments

The term pri mary assignment is something of an o xy mo ron. It applies to primary co mmit ments made by offshore accounts
(principally CLOs and hedge funds). These vehicles, for a variety of reasons, suffer tax consequence from buying loans in the
primary. The agent will therefore hold the loan on its books for some short period after the loan closes, then sell it to these
investors via an assignment. These are called primary assignments and are effectively p rimary purchases.

Partici pations

As the name implies, in a participation agreement, the buyer takes a participating interest in the selling lender’s commit ment.

The lender remains the official holder of the loan, with the participant owning the rights to the amount purchased. Consents,
fees, or minimu ms are almost never required. The participant has the righ t to vote only on material changes in the loan
document (rate, term, and collateral). Non-material changes do not require approval of participants.

A participation can be a riskier way of purchasing a loan because, if the lender beco mes insolvent or defaults, the participant
does not have a direct claim on the loan. In this case the participant then becomes a creditor of the lender, and often must wait
for claims to be sorted out to collect on its participation.

Loan Deri vati ves

Traditionally, accounts bought and sold loans in the cash market through assignments and participations. Aside fro m that,
there was litt le synthetic activity outside over-the-counter total rate of return swaps. By 2008, however, the market for
synthetically trading loans was budding.

This primer will look at three main types of loan derivatives:

 Loan Credit Defau lt Swaps

 LCDX
 Total Rate of Return Swaps

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Loan credit default s waps (LCDS)

Loan credit default s waps (LCDS) are standard derivatives that have secured loans as reference ins truments. In June 2006,
the International Settlement and Dealers Association issued a standard trade confirmat ion for LCDS contracts.
Like all credit default swaps (CDS), an LCDS is basically an insurance policy. The seller is paid a spread in exchange for
agreeing to buy at par, or a pre-negotiated price, a loan if that loan defaults. LCDS enables participants to synthetically buy a
loan by going short the LCDS or sell the loan by going long the LCDS. Theoretically, then, a loanholder can hedge a position
either directly (by buying LCDS protection on that specific name) or indirect ly (by buying protection on a comparable name
or basket of names).

Moreover, unlike the cash markets, wh ich are long-only markets for obvious reasons, the LCDS market p rovides a way for
investors to short a loan. To do so, the investor would buy protection on a loan that it doesn’t hold. If the loan subsequent ly
defaults, the buyer of protection should be able to purchase the loan in the secondary market at a d iscount and then deliver it
at par to the counterparty from wh ich it bought the LCDS contract.

For instance, say an account buys five-year protection for a given loan, for which it pays 250 bps a year. Then, in year two,
the loan goes into default and the market price of the debt falls to 80% of par. The buyer of the protection can then buy the
loan at 80 and deliver it to the counterparty at 100, a 20-point p ickup.

Or instead of physical delivery, some buyers of protection may prefer a cash settlement in which the difference b etween the
current market price and the delivery price is determined by polling dealers or using a third -party pricing service. Cash
settlement could also be emp loyed if there’s not enough paper to physically settle all LCDS contracts on a particular loan.

LCDX

Introduced in 2007, the LCDX is an index of 100 LCDS obligations that participants can trade. The index provides a
straightforward way for participants to take long or short positions on a broad basket of loans, as well as hedge exposure to
the market.

Markit Group administers the LCDX, a product of CDS Index Co., a firm set up by a group of dealers. Like LCDS, the
LCDX Index is an over-the-counter product.

The LCDX is reset every six months, with participants able to trade each vintage of the in dex that is still active. The index
will be set at an init ial spread, based on the reference instruments, and trade on a price basis. According to the primer posted
by Markit, “the two events that would trigger a payout fro m the buyer (protection seller) of the index are bankruptcy or
failure to pay a scheduled payment on any debt (after a grace period), for an y of the constituents of the index.”

Single-name total rate of return s waps (TRS)

The total rate of return s wap is the oldest way for part icipants to purchase loans synthetically. In essence, a TRS allows an
institution to by a loan on margin.

In simple terms, under a TRS p rogram a part icipant buys from a counterparty, usually a dealer, the inco me stream created by
a reference asset (in this case a syndicated loan). The participant puts down some percentage as collateral, say 10%, and
borrows the rest from the dealer. Then the participant receives the spread of the loan less the financial cost. If the reference
loan defaults the participant is obligated to buy the facility at par or cash settle the position based on a mark -to-market price
or an auction price.

Here’s how the economics of a TRS work, in simple terms.

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A participant buys via TRS a $10 million position in a loan paying L+250. To affect the purchase the participant puts $1
million in a collateral account and pays L+50 on the balance (meaning leverage of 9:1).
Thus, the participant would receive:

L+250 on the amount in the collateral account of $1 million, plus 200 bps (L+250 minus the borrowing cost of L+50) on the
remaining amount of $9 million.

The resulting income is L+250 * $1 million plus 200 bps * $9 million. Based on the participants’ collateral amount – or
equity contribution – of $1 million, the return is L+2020. If LIBOR is 5% the return is 25.5%.

Of course, this is not a risk-free proposition. If the issuer defaults and the value of the loan goes to 70 cents on the dollar the
participant will lose $3 million. And if the loan does not default, but is marked down for whatever reason – maybe market
spreads widen, it is downgraded, its financial condition deteriorates – the participant stands to lose the difference between par
and the current market price when the TRS expires. Or, in an ext reme case, the value declines below the value in the
collateral account, and the participant is hit with a marg in call.

TRS Programs

In addition to the type of single-name TRS, another way to invest in loans is via a TRS program in which a dealer provides
financing for a portfolio of loans, rather than a single reference asset.

The products are similar in that an investor would establish a collateral account equal to some percent of the overall TRS
program and borrow the balance fro m a dealer. The program typically requires managers to adhere to diversification
guidelines as well as weighted average maturity maximu ms as well as weighted average rating min imu ms .

Like with a single-name TRS, an investor makes money by the carry between the cost of the line and the spread of the assets.
As well, any price appreciation bolsters the returns. Of course, if loans loss value, the investor’s losses would be magnifie d
by the leverage of the vehicle. As well, if co llateral value declines below a predetermined level, the investor could face a
margin call, or in the wo rst-case scenario, the TRS could be unwound.

TRS programs were widely used prior to the 2008 credit contraction. Since then, they have figured far less prominently into
the loan landscape as investors across the capital markets shy away fro m leveraged, mark -to-market product.

Pricing Terms/Rates

Most loans are floating-rate instruments that are periodically res et to a spread over a base rate, typically LIBOR. In most
cases, borrowers can lock in a g iven rate for one month to one year.

Syndication pricing options include Prime, as well as LIBOR, CDs, and other fixed -rate options:

 Prime is a floating-rate option. Borrowed funds are priced at a spread over the reference bank’s Prime lending rate.
The rate is reset daily, and borro wings may be repaid at any time without penalty. This is typically an overnight
option, because the Prime option is more costly to the borrower than LIBOR or CDs.
 The LIBOR (or Eu rodollar) option is so called because, with this option, the interest on borrowings is fixed for a
period of one month to one year. The corresponding LIBOR rate is used to set pricing. Bo rrowings cannot be
prepaid without penalty.
 The CD option works precisely like the LIBOR option, except that the base rate is certificates of deposit, sold by a
bank to institutional investors.

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 Other fixed -rate options are less common but work like the LIBOR and CD options. These inc lude federal funds (the
overnight rate, which is set by the Federal Reserve, at wh ich banks charge each other on overnight loans) and cost of
funds (the bank’s own funding rate).

Spread (margin)

Borro wer pays a specified spread over the base rate to borrow under loan agreements . The spread is typically expressed in
basis points. Further, spreads on many loans are tied to performance grids. In this case, the spread adjusts based on one or
more financial criteria. Ratings are typical in investment-grade loans. Financial rat ios for leveraged loans. Media and
communicat ions loans are invariably tied o the borro wer’s debt-to-cash-flow rat io.

LIBOR floors

As the name implies, LIBOR floors put a floor under the base rate for loans . For instance, if a loan has a 3% LIBOR floor
and LIBOR falls below this level, the base rate for any resets defaults to 3%.

Fees

Of course, fees are an essential element of the leveraged/syndicated loan process. Pro minent fees associated with syndicated
loans:

 Upfront fee
 Co mmit ment fee
 Facility fee
 Usage Fee
 Prepayment fee
 Admin istrative agent fee
 Letter of Credit (LOC) fee

Upfront fee

An upfront fee is a fee paid by the issuer at close. It is often tiered, with the lead arranger receiving a larger amount in
consideration for structuring and/or underwriting the loan. Co-underwriters will receive a lower fee, and then investors in the
general syndicate will likely have fees tied to their co mmit ment.

Most often, fees are paid on a lender’s final allocation. For examp le, a loan has t wo fee tiers: 100 bps (or 1%) for $25 million
commit ments and 50 bps for $15 million commit ments. A lender co mmitting to the $25 million tier will be paid on its final
allocation rather than on commit ment, which means that, in this examp le, if the loan is oversubscribed, lenders committing
$25 million would be allocated $20 million and receive a fee of $200,000 (or 1% of $20 million).

Somet imes upfront fees will be structured as a percentage of final allocation plus a flat fee. This happens most often for
larger fee tiers, to encourage potential lenders to step up for larger co mmit ments. The flat fee is paid regardless of the
lender’s final allocation.
Fees are usually paid to banks, mutual funds, and other non-offshore investors at close. CLOs and other offshore vehicles are
typically brought in after the loan closes as a “primary” assignment, and they simp ly buy the loan at a discount equal to the
fee offered in the primary assignment, for tax purposes.

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Commi tment fee

A commitment fee is a fee paid to lenders on undrawn amounts under a revolving credit or a term loan prior to draw-down.
On term loans, this fee is usually referred to as a “ticking” fee.

Facility fee

A facility fee is paid on a facility’s entire co mmitted amount, regardless of usage.

A facility fee is often charged instead of a commit ment fee on revolving credits to investment -grade borrowers, because these
facilit ies typically have competiti ve bi d options that allow a borrower to solicit the best bid from its syndicate group for a
given borrowing. The lenders that do not lend under the CBO are still paid for their co mmit ment.

Usage fee

A usage fee is a fee paid when the utilizat ion of a revolving credit is above, or more often, falls below a certain min imu m.

Preypayment fee

A prepayment fee is a feature generally associated with institutional term loans.

Typical prepay ment fees will be set on a sliding scale. For instance: 2% in year one and 1% in year t wo. The fee may be
applied to all repay ments under a loan loan including fro m asset sales and excess cash flow (a “hard” fee) or specifically to
discretionary payments made fro m a refinancing or out of cash on hand (a “soft” fee).

Administrati ve fee

An administrati ve agent fee is the annual fee paid to administer the loan (includ ing to distribute interest payments to the
syndication group, to update lender lists, and to manage borrowings).

For secured loans (particularly those backed by receivables and inventory) the agent often collects a collateral monitoring f ee,
to ensure that the promised collateral is in place.

Letter of credi t (LOC)

A letter of credit fee (LOC) can be any one of several types.

The most common – a fee for standby or financial LOCs – guarantees that lenders will support various corporate activities.
Because these LOCs are considered “borrowed funds” under capital guidelines, the fee is typically the same as the LIBOR
margin.

Fees for co mmercial LOCs (those supporting inventory or trade) are usually lower, because in these cases actual collateral is
submitted.

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The LOC is usually issued by a fronting bank (usually the agent) and syndicated to the lender group on a pro rata basis. The
group receives the LOC fee on their respective shares while the fronting bank receives an issuing (or fronting, or facing) fe e
for issuing and admin istering the LOC. Th is fee is almost always 12.5 bps to 25 bps (0.125% to 0.25%) of the LOC
commit ment.

Original-Issue Discounts

This is yet another term imported fro m the bond market.

The original-issue discount (OID), or the discount fro m par at which the loan is offered for sale to investors, is used in the
new issue market as a spread enhancement. If a loan is issued at 99 cents on the dollar to pay par, the OID is said to be 100
bps, or 1 point.

OID vs Upfront Fees

So, what’s the difference between an OID and an upfront fee? After all, in both cases the lender effectively pays less than par
for a loan.

Fro m the perspective of the lender, actually, there is no practical difference. Fro m an accounting perspective, an OID and a
fee may be recognized, and potentially taxed, differently.

Voting Rights

Amend ments or changes to a loan agreement must be approved by a certain percentage of lenders. Most loan a greements
have three levels of approval: required-lender level, full vote, and supermajority:

 The “required-lenders” level, usually just a simp le majority, is used for approval of non -material amend ments and
waivers or changes affecting one facility within a deal.
 A full vote of all lenders, including part icipants, is required to approve material changes such as RATS rights (rate,
amort ization, term, and security; or collateral), but as described below, there are occasions when changes in
amort ization and collateral may be approved by a lower percentage of lenders (a supermajority).
 A supermajority is typically 67-80% of lenders. It so metimes is required for certain material changes, such as
changes in term loan repayments and release of collateral.

Covenants

Loan agreements have a series of restrictions that dictate, to varying degrees, how borrowers can operate and carry
themselves financially.

For instance, one covenant may require the borrower to maintain its existing fiscal-year end. Another may prohibit it fro m
taking on new debt. Most agreements have financial co mpliance covenants, stipulating perhaps that a borrower must maintain
a prescribed level o f performance, which, if not maintained, gives banks the right to terminate the agreement or pus h the
borrower into default.

The size of the covenant package increases in proportion to a borrower’s financial risk. Agreements to investment -grade
companies are usually thin and simple. Agreements to leveraged borrowers are more restrictive.

The three primary types of loan covenants are affirmati ve, negati ve, and financial.

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Affirmati ve covenants

Affirmati ve covenants state what action the borrower must take to be in co mpliance with the loan.

These covenants are usually boilerp late, and require a borro wer to pay the bank interest and fees, for instance, or to provide
audited financial statements, maintain insurance, pay taxes, and so forth.

Negati ve covenants

Negati ve covenants limit the borrower’s activit ies in some way, such as undertaking new investmen ts.

Negative covenants, which are highly structured and customized to a borrower’s specific condit ion, can limit the type and
amount of acquisitions and investments, new debt issuance, liens, asset sales, and guarantees.

Financi al covenants

Financi al covenants enforce minimu m financial performance measures against the borrower, such: The company must
maintain a h igher level of current assets than of current liab ilities.

Broadly speaking, there are two types of financial covenants: mai ntenance and incurrence.

Under maintenance covenants, issuers must pass agreed-to tests of financial performance such as minimu m levels of cash
flow coverage and maximu m levels of leverage. If an issuer fails to achieve these levels, lenders have the right to accelerat e
the loan. In most cases, though, lenders will pass on this draconian option and instead grant a waiver in return for some
combination of a fee and/or spread increase; a repayment or a structuring concession such as additional collateral or seniority.

An incurrence covenant is tested only if an issuer takes an action, such as issuing debt or making an acquisition. If, on a pro
forma basis, the issuer fails the test then it is not allo wed to proceed without permission of the lenders.

Historically, maintenance tests were associated with leveraged loans and incurrence tests with investment -grade loans and
bonds. More recently, the evolution of covenant-lite loans (see above) has blurred the line.

In a tradit ional loan agreement, as a borro wer’s risk increases, financia l covenants become more tightly wound and extensive.
In general, there are five types of financial covenants –coverage, leverage, current rat io, tangible net wo rth, and maximu m
capital expenditures:

 A coverage covenant requires the borrower to maintain a min imu m level of cash flo w or earnings, relat ive to
specified expenses, most often interest, debt service (interest and repayments), and fixed charges (debt service,
capital expenditures, and/or rent).
 A leverage covenant sets a maximu m level o f debt, relative to either equity or cash flow, with total-debt-to-
EBITDA level being the most common. In some cases operating cash flow is used as the divisor. Moreover, some
agreements test leverage on the basis of net debt (total less cash and equivalents) or senior debt.
 A current-rati o covenant requires that the borrower maintain a min imu m ratio of current assets (cash, marketable
securities, accounts receivable, and inventories) to current liab ilit ies (accounts payable, short -term debt of less than
one year), but sometimes a “quick ratio,” in which inventories are excluded fro m the nu merator, is substituted.
 A tangi ble-net-worth (TNW) covenant requires that the borrower have a minimu m level of TNW (net worth less
intangible assets, such as goodwill, intellectual ass ets, excess value paid for acquired co mpanies), often with a build -
up provision, which increases the minimu m by a percentage of net income o r equity issuance.

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 A maxi mum-capital-expenditures covenant requires that the borrower limit cap ital expenditures (purchases of
property, plant, and equipment) to a certain amount, which may be increased by some percentage of cash flow or
equity issuance, but often allowing the borrower to carry fo rward unused amounts from one year to the next.

Mandatory Prepayments

Leveraged loans usually require a borrower to prepay with proceeds of excess cash flow, asset sales, debt issuance, or equity
issuance.

 Excess cash flow is typically defined as cash flow after all cash expenses, required dividends, debt repayments,
capital expenditures, and changes in working capital. The typical percentage required is 50 -75%.
 Asset sales are defined as net proceeds of asset sales, normally excluding receivables or inventories. The typical
percentage required is 100%.
 Debt issuance is defined as net proceeds from debt issuance. The typical percentage required is 100%.
 Equity issuance is defined as the net proceeds of equity issuance. The typical percentage required is 25% to 50%.
 Often, repay ments fro m excess cash flow and equity issuance are waived if the issuer meets a preset financial
hurdle, most often structured as a debt/EBITDA test.

Collateral

In the leveraged market, collateral usually includes all the tangible and intangible assets of the borrower and, in some case s,
specific assets that back a loan.

Virtually all leveraged loans and some of the more shaky investment -grade credits are backed by pledges of collateral.

In the asset-based market, for instance, that typically takes the form of inventories and receivables, with the maximu m
amount of the loan that the issuer may draw down capped by a formu la based off of these assets. The common ru le is that an
issuer can borrow against 50% of inventory and 80% of receivables. There are loans backed by certain equipment, real estate,
and other property as well.

In the leveraged market there are some loans that are backed by capital stock of operating units. In this structure the assets of
the issuer tend to be at the operating-company level and are unencumbered by liens, but the holding comp any pledges the
stock of the operating companies to the lenders. This effectively gives lenders control of these subsidiaries and their assets if
the company defaults.

The risk to lenders in this situation, simp ly put, is that a bankruptcy court collapses the holding company with the operating
companies and effectively renders the stock worthless. In these cases – this happened on a few occasions to lenders to retail
companies in the early 1990s – loan holders become unsecured lenders of the company and are put back on the same level
with other senior unsecured creditors.

Subsi diary guarantees

Those not collateral in the strict sense of the word, most leveraged loans are backed by the guarantees of subsidiaries so th at
if an issuer goes into bankruptcy all of its units are on the hook to repay the loan. This is often the case, too, for unsecured
investment-grade loans.

Negati ve pledge
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This is also not a literal form o f collateral, but most issuers agree not to pledge any assets to new lenders to ensure that the
interest of the loanholders are protected.

Springing liens

Some loans have provisions stipulating that borrowers sitting on the cusp of investment -grade and speculative-grade must
either attach collateral or release it if the issuer’s rating changes.

A ‘BBB’ or ‘BBB-’ issuer may be able to convince lenders to provide unsecured financing, but lenders may demand
springing liens in the event the issuer’s credit quality deteriorates.

Often, an issuer’s rating being lowered to ‘BB+’ or exceeding a predeter mined leverage level will t rigger this provision.
Likewise, lenders may demand collateral fro m a strong, speculative-grade issuer, but will o ffer to release under certain
circu mstances (if the issuer attains an investment-grade rating, for instance).

Change-of-control

Invariably, one of the events of default in a credit agreement is a change of issuer control.

For both investment-grade and leveraged issuers, an event of default in a credit agreement will be triggered by a merger, an
acquisition of the issuer, some substantial purchase of the issuer’s equity by a third party, or a change in the majority of the
board of directors.

For sponsor-backed leveraged issuers, the sponsor’s lowering its stake below a preset amount can also trip this clause.

Equi ty cures

These provisions allow issuers to fix a covenant violation – exceeding the maximu m leverage test for instance – by making
an equity contribution.

These provisions are generally found in private equity backed deals. The equity cure is a right, not an obligation. Therefore, a
private equity firm will want these provisions, which, if they think it’s worth it, allows them to cure a vio lation without g oing
through an amend ment process, during which lenders will often ask for wider spreads and/or fees, in e xchange for waiving
the violation, even with an infusion of new equity.

Some agreements don’t limit the number of equity cures, while others cap the number to, say, one per year or two over the
life of the loan. It’s a negotiated point, however, so there is no rule of thu mb.

Asset-based lending

Most of the information above refers to “cash flow” loans, loans that may be secured by collateral, but are repaid by cash
flow.

Asset-based lending is a distinct segment of the loan market. These loans are secured by specific assets and usually are
governed by a borrowing formu la (or a “borrowing base”). The most common type of asset -based loans are receivables
and/or inventory lines. These are revolving cred its that have a maximu m borrowing limit, perhaps $100 million, but also have
a cap based on the value of an issuer’s pledged receivables and inventories.

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Usually the receivables are p ledged and the issuer may borrow against 80%, give or take. Inventories are also often pledged
to secure borrowings. However, because they are obviously less liquid than receivables, lenders are less generous in their
formula. Indeed, the borrowing base for inventories is typically in the 50-65% range. In addition, the borrowing base may be
further divided into subcategories – for instance, 50% of work-in-process inventory and 65% of finished goods inventory.

In many receivables-based facilities issuers are required to place receivables in a “lock bo x.” That means that the bank lends
against the receivable, takes possession of it, and then collects it to pay down the loan.

In addition, asset-based lending is often done based on specific equip ment, real estate, car fleets, and an unlimited number of
other assets.

Bifurcated collateral

Most often, bifurcated collateral refers to cases where the issuer divides collateral pledge between asset-based loans and
funded term loans.

The way this works, typically, is that asset-based loans are secured by current assets like accounts receivables and
inventories, while term loans are secured by fixed assets like property, plant, and equip ment. Current assets are considered to
be a superior form o f collateral because they are more easily converted to cash.

Subsi diary guarantees

Though not collateral in the strict sense of the word, most leveraged loans are backed by the guarantees of subsidiaries, so
that if an issuer goes into bankruptcy all of its units are on the hook to repay the loan. This is often the case, too, for
unsecured investment-grade loans.

Negati ve pledge

This is also not a literal form o f collateral, but most issuers agree not to pledge any assets to new lenders to ensure that the
interest of the loanholders are protected.

Spread Calcul ati on

Calculating loan yields or spreads is not straightforward.

Unlike most bonds, which have long no-call periods and high-call premiu ms, most loans are prepayable at any time, typically
without prepayment fees. And even in cases where prepayment fees apply they are rarely more than 2% in year one and 1%
in year two. Therefore, affixing a spread-to-maturity or a spread-to-worst on loans is little mo re than a theoretical calculation.

This is because an issuer’s behavior is unpredictable. It may repay a loan early because a more co mpelling financial
opportunity presents itself or because the issuer is acquired, or because it is making an acquisition and needs a new financing.
Traders and investors will often speak of loan spreads, therefore, as a spread to a theoretical call.

Loans had a 15-month average life between 1997 and 2004. So, if you buy a loan with a spread of 250 bps at a price o f 101,
you might assume your spread-to-expected-life as the 250 bps less the amortized 100 bps premiu m, or LIBOR+170.
Conversely, if you bought the same loan at 99, the spread-to-expected life wou ld be LIBOR+330. Of course, if there’s a
LIBOR floor, the minimu m would apply.

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Default/ Restructuring

There are two p rimary types of loan defaults : technical defaults, and the much more serious payment defaul ts.

Technical defaults occur when the issuer violates a provision of the loan agreement. For instance, if an issuer doesn’t meet a
financial covenant test or fails to provide lenders with financial in formation or some other vio lation that doesn’t involve
payments.

When this occurs, the lenders can accelerate the loan and force the issuer into bankruptcy. That’s the most extreme measure.
In most cases, the issuer and lenders can agree on an amend ment that waives the violation in exchange for a fee, spread
increase, and/or tighter terms.

Payment defaults are a more serious matter. As the name imp lies, this type of default occurs when a company misses either
an interest or principal payment. There is often a pre-set period of t ime, say 30 days, during which an issuer can cure a
default (the “cure period”). After that, the lenders can choose to either provide a forbearance agreement that gives the issuer
some breathing room or take appropriate action, up to and including accelerat ing, or calling, the loan.

If the lenders accelerate, the company will generally declare bankruptcy and restructure debt via Chapter 11. If the co mpany
is not worth saving, however, because its primary business has cratered, then the issuer and lenders may agree to a Chapter 7
liquidation, under which the assets of the business are sold and the proceeds dispensed to the creditors.

Debtor-i n-possession loans

Debtor-i n-possession (DIP) loans are made to bankrupt entities. These loans constitute super-priority claims in the
bankruptcy distribution scheme, and thus sit ahead of all prepetition claims. Many DIPs are further secured by priming liens
on the debtor’s collateral.

Traditionally, prepetit ion lenders provided DIP loans as a way to keep a co mpany viable during the bankruptcy process and
therefore protect their claims. In the early 1990s a broad market for third-party DIP loans emerged. These non-prepetition
lenders were attracted to the market by the relat ively safety of most DIPs, based on their super-priority status, and relatively
wide margins. This was the case again the early 2000s default cycle.

In the late 2000s default cycle, however, the landscape shifted because of more dire economic conditions. As a result,
liquid ity was in far shorter supply, constraining availab ility of trad itional third -party DIPs. Likewise, with the severe
economic conditions eating away at debtors’ collateral – not to mention reducing enterprise values – prepetition lenders were
more wary of rely ing solely on the super-priority status of DIPs, and were more likely to ask for priming liens to secure
facilit ies.

The refusal of prepetit ion lenders to consent to such priming, co mb ined with the expense and uncertainty involved in a
priming fight in bankruptcy court, greatly reduced third-party participation in the DIP market. With liquidity in short supply,
new innovations in DIP lending cropped up aimed at bringing nontraditional lenders into the market. These include:

 Junior DIPs. These facilities are typically provided by bond holders or other unsecured debtors as part of a loan -to-
own strategy. In these transactions the providers receive much or all of the post-petition equity interest as an
incentive to provide the DIP loans.
 Roll-up DIPs. In some bankruptcies – LyondellBasell and Spectru m Brands are two 2009 examp les – DIP providers
were g iven the opportunity to roll up prepetition claims into junior DIPs that rank ahead of other prepetition secured
lenders. This sweetener was particularly co mpelling for lenders that had bought prepetition paper at distressed
prices, and were ab le to realize a gain by ro lling it into the junior DIPs.

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Junior and roll-up DIPs are suited to challenging markets during wh ich liquid ity is scarce. During more liquid times, issuers
can usual secure less costly financing in the form of tradit ional DIPs fro m p repetition lenders and/or third -party lenders.

Exi t loans

These are loans that finance an issuer’s emergence fro m bankruptcy. Typically the loans are pre -negotiated, and are part of
the company’s reorganization plan.

Sub-par buybacks

Sub-par loan buybacks are another technique that grew out of the bear market, that began in 2007. Performing paper fell to a
price not seen before in the loan market – with many names trading south of 70. Th is created an opportunity for issuers with
the financial wherewithal and the covenant room to repurchase loans via a tender, or in the open market, at prices below par.

Sub-par buybacks have deep roots in the bond market. Loans didn’t suffer the price declines before 2007 to make such
tenders attractive, however. In fact, most loan documents do not provide for a b uyback. Instead, issuers typically need obtain
lender approval via a 50.1% amendment.

Distressed exchanges

This is a negotiated tender in wh ich classholders will swap existing paper for a new series of bonds that typically have a
lower principal amount and, often, a lower yield. In exchange the bondholders might receive stepped -up treatment, going
fro m subordinated to senior, say, or fro m unsecured to second -lien.

Standard & Poor’s consider these programs a default and, in fact, the holders are agreeing to take a principal haircut in order
to allow the company to remain solvent and improve their ultimate recovery prospects.

This technique is used frequently in the bond market but rarely fo r first -lien loans. One good examp le was courtesy Harrah’s
Entertain ment. In 2009 the gaming co mpany issued $3.6 b illion of 10% second -priority senior secured notes due 2018 for
about $5.4 billion of bonds due between 2010 and 2018.

Default rate

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The leveraged loan default rate shot to a four-year high of 4.64% in April thanks to Energy Future Holdings, the leviathan
LBO loan issuer formerly known as TXU Energy. The EFH bankruptcy was years in the making, of course. And seeing as it is
only one deal – though big – loan market players say the default rate sans EFH is a more accurate market measure (hence
the blue line, above). Indeed, the rate has started to tick lower since EFH.

The Default Rate is calculated by either nu mber of loans or principal amount. The formula is similar.

For default rate by number of loans: the number of loans that default over a given 12-month period divided by the number of
loans outstanding at the beginning of that period.

For default rate by principal amount: the amount of loans that default over a 12 -month period divided by the total amount
outstanding at the beginning of the period.

Standard & Poor’s defines a default for the purposes of calculating default rates as a loan that is either (1) rated ’D’ by
Standard & Poor’s, (2) to an issuer that has filed for bankruptcy, or (3) in payment default on interest or principal.

Amend-to-Extend

An amend-to-extend transaction allo ws an issuer to push out part of its loan maturities through an amendment, rather than a
full-out refinancing.

Amend-to-extend transactions came into widespread use in 2009 as borrowers struggled to push out maturit ies in the face of
difficult lending conditions that made refinancing prohibitively expensive.

Amend-to-extend transactions have two phases, as the name implies.

The first is an amend ment in which at least 50.1% of the bank group approves the issuer’s ability to roll some or all existing
loans into longer-dated paper. Typically the amend ment sets a range for the amount that can be tendered via the new facility,
as well as the spread at which the longer-dated paper will pay interest.

The new debt is pari passu with the existing loan. But because it matures later and, thus, is structurally subordinated, it c arries
a higher rate and, in some cases, more attractive terms. Because issuers with big debt loads are expected to tackle debt
maturities over time, amid vary ing market conditions, in some cases accounts insist on most -favored-nation protection. Under
such protection the spread of the loan would increase if the issuer in question prints a loan at a wider margin.

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 LeveragedLoan Primer
The second phase is the conversion, in which lenders can exchange existing loans for new loans. In the end, the issuer is left
with two t ranches: (1) the legacy paper at the init ial spread and maturity and (2) the new longer-dated facility at a wider
spread. The innovation here: amend-to-extend allows an issuer to term-out loans without actually refinancing into a new
credit (which, obviously would require marking the entire loan to market, entailing higher spreads, a new OID, and stricter
covenants).

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