Capital Structure Joseph V. Rizzi Amsterdam Institute of Finance October, 2014
Approaches To Credit Analysis • Cash Flow • Impacts default risk • Balance Sheet • Determines Loss in Event of Default (LIED) • Liquidity • Valuation Amsterdam Institute of Finance October, 2014 2
Credit Analysis • Business Risk: EBITDA Volatility • Industry Characteristics • Firm Characteristics • Financial Risk: EBITDA Relative to Debt • Structural Risk • Issues • Priority of claim on assets and income • Control • Focus • Covenants, Seniority, Security Amsterdam Institute of Finance October, 2014
Credit Screening – Subject to market availability • Quantitative • Capitalization ROT Pre Crisis Crisis • Cash Equity >25% <25% 40%+ • Total Debt <6.0x >6% <5% • Senior Debt (1) <4.5x >5% <4% • First Lien <4.0x >4% <4% • Second Lien <0.5x >1% __ • Cash Flow • LTM EBITDA / PFI >2:1 • 7 x LTM FFOCF / TLA(2) >1:1 • Liquidity • Cash + MS + RCA / P+I (3) > 1.5 : 1 1:- TLA usually >20% of senior debt and amortizes at least 30% by year 5 2:- FFOCF = LTM EBITDA - (WCI + CAPEX + Taxes + PF Interest) 3:- Liquidity tested day 1. MS (Marketable Securities). RCA (Revolving Credit Availability). Revolver usually set at 1 x EBITDA Amsterdam Institute of Finance October, 2014
Debt Capacity Considerations • Debt capacity is derived from firm’s assets • Operating Cash Flows • Asset Sales / Asset Quality • Leveragability • Market Conditions • Target financing structure 2H07Crisis Credit curve shifts over time dependent on the economy, e.g., CCC Spreads 2007 500 2009 3,300 Current 750 Rates Overheated 1H07 Rating Amsterdam Institute of Finance October, 2014
Capitalization Alternatives • There are two different approaches to designing the capital structure: Balance Sheet Model Cash Flow Model 3 - 5x EBITDA 50% 5 - 6x EBITDA 30% Senior Debt Sub Debt Equity Equity 20% Amsterdam Institute of Finance October, 2014
Approaches to Determining Debt Capacity • Ratio Approach • Cash Flow • Advance Rate Amsterdam Institute of Finance October, 2014
Ratio Approach Market • Maximum senior debt and total debt ratios • Vary over cycle Peers • Identify • Rating Classification • Key Ratios Rating Agencies • Credit Statistics Amsterdam Institute of Finance October, 2014
Peer Comparison Amsterdam Institute of Finance October, 2014
Rating Agencies - Ratings as keys opening market doors Syndication CLO Amsterdam Institute of Finance October, 2014 • Important: Loan Market Evolution from a bank to an institutional market (back to a bank market?) • Impact: Majority of syndicated loans are rated • Pricing: Affected by rating • Market Access Amount Impacted by rating
S&P Ratings Generic Guidelines AAA AA A BBB BB B CCC EBITDA/I 20 12 6 4 2 1.5 <1 FD/EBITDA NM 1 2 3 4 5+ >6 Size Big 20B+ 15B+ 10B+ 5B+ 1B+ NM Amsterdam Institute of Finance October, 2014
Cash Flow • Maximum debt capacity formula:- MDC = f(operations, amortization, rate, asset sales) MDC = [EBIT / (i+ 1/n)] + AS + RF EBIT - Earnings Before Interest and Taxes i - Interest Rate n - Straight line loan amortization AS - Proceeds from Asset Sales RF - Refinancing Amsterdam Institute of Finance October, 2014
Financial Analysis • Opening Balance Sheet • Adjustments – from sources and uses – including purchase price assumptions • Proforma balance Sheet • Income Statement • Cash Flow Statement Capitalization table/transaction structure Debt Schedule Term sheet(s) Valuation/maximum purchase price Returns Analysis – IRR and MOC Amsterdam Institute of Finance October, 2014
Credibility of Cash Flow Projections • Issues • Adjustments (beware of solving for cash flows to justify price) • Normalization • Cyclicality • Bad Management • Value Test • Projections implied price • Reverse Engineer - Management implied forecast • Firms • Peers • Tie Into • Compensation • Covenants Amsterdam Institute of Finance October, 2014
Capital Structure Considerations Comparison CorporatePrivate Equity Rating – I/G Maximum Debt Capacity – NIG Capital Market Access Temporary Permanent IRR EPS Control Flexibility – covenants, dividends Upside Pricing Value Transfer/Mispricing Reason Differing motivations Amsterdam Institute of Finance October, 2014
Capital Structure Tradeoffs Amount Cost Flexibility Control Dilution Mispricing Issue Operationalize Ratings Target Comparative Credit Analysis Cash Flow Testing Market Conditions Amsterdam Institute of Finance October, 2014
In Practice • Macro/Market Level • Determine rating target • Use target rating level financial characteristics • Funded Debt/EBITDA • EBITDA/Interest Expense • Funded Debt/Total Cap Example: (A) Target Rating BB (B) EBITDA/Int for Target Rating c3.0x (C) Firm EBITDA $300mln (D) Interest Rate for Target Rating 10% (E) Maximum Debt Capacity = (C/B)/D = (300/3)/10% = $1,000 Amsterdam Institute of Finance October, 2014
EBIT – EPS Analysis • If EBIT > 5mlm – Debt Preferred • If EBIT < 5mlm – Equity Preferred EPS Indifference Point 5,000,000 10,000,000 0 EBIT Amsterdam Institute of Finance October, 2014
Institutional Loan Defaults % 1H14 0 2013 0 2012 1 2011 2 2010 3 2009 1 2008 5 2007 23 2006 20 2005 12 Source: S&P Capital IQ Amsterdam Institute of Finance October, 2014
Country Funding Styles 1H14(%) UK France Germany Bank Debt 46.4 50.1 43.8 2L 1.7 6.8 4.4 HYB --- --- 8.9 Equity 50.1 39.5 40.2 MEZ 1.5 --- --- Other 0.4 3.6 0.7 Source: S&P Capital IQ Amsterdam Institute of Finance October, 2014
New Issue Spreads and Credit StatisticsEurope & U.S. – 6ME 31/07/14 BB/BB- Europe U.S. Pro Rata Spread N/A L+239.0 Weighted Avg Institutional Spread N/A L+297.3 Deal Size (€MM) 397.58 924.06 Pro Rata Term (In Years) 5.00 4.81 Institutional Term (In Years) N/A 6.39 Revenues (€MM) N/A 3,027.86 EBITDA (€MM) N/A 664.82 Pro Forma Debt/EBITDA N/A 3.76X Pro Forma Senior Debt/EBITDA N/A 3.74X Pro Forma Cash Interest Coverage N/A 6.89X Observations 6 111 Source: S&P Capital IQ Amsterdam Institute of Finance October, 2014
New Issue Spreads and Credit StatisticsEurope & U.S. – 6ME 31/07/14 B+/B Europe U.S. Pro Rata Spread E+343.8 L+323.8 Weighted Avg Institutional Spread E+394.4 L+378.2 Deal Size (€MM) 480.67 488.44 Pro Rata Term (In Years) 4.82 4.96 Institutional Term (In Years) 6.03 6.18 Revenues (€MM) 2,974.90 1,578.91 EBITDA (€MM) 356.61 252.57 Pro Forma Debt/EBITDA 5.09X 4.92X Pro Forma Senior Debt/EBITDA 4.86X 4.88X Pro Forma Cash Interest Coverage 3.79X 4.50X Observations 39 381 Source: S&P Capital IQ Amsterdam Institute of Finance October, 2014
Pricing/Funding Nexus PPX FD/EBITDAEquity % EUR/U.S. EUR/U.S. EUR/U.S. 1H14 10/9.2 4.9/4.9 42%/38% 2013 9.7/8.8 4.7/4.7 42%/38% 2012 9.3/8.7 4.5/4.6 48%/38% 2011 8.8/8.8 4.4/4.4 45%/38% 2010 9.2/8.5 4.2/3.9 47%/45% 2009 8.9/7.7 4.1/4.1 45%/45% 2008 9.7/9.1 5.1/3.7 42%/40% 2007 9.7/9.7 5.9/4.9 30%/30% 2006 8.8/8.4 5.4/4.4 30%/30% Source: S&P Capital IQ Amsterdam Institute of Finance October, 2014
Tranches in the LBO Structure Amsterdam Institute of Finance October, 2014
Tranches in the LBO Structure Amsterdam Institute of Finance October, 2014
Sources and Uses Amsterdam Institute of Finance October, 2014
Different Menus As the credit curve shifts, the menu that is available to Issuers / Arrangers changes Bear Market Menu Bull Market Menu • Stretch Senior • Seller Notes • Senior Notes • Private Placements • Equity • R/C Lite • Mezzanine • Smaller • floors • Sweeps • Prepayment penalties • covenants • Tranche Term Loans • Covenant Light • High Yield Debt • Holding Company PIK • Bridge Loans • Second Lien • Hybrid Preferred • Cross Lien Facilities • Asset Carve-outs • OPCO/PROPCO • Recapitalizations Bull Market Menu Investor Friendly Issuer Friendly Amsterdam Institute of Finance October, 2014
