Mirus Credit Market Update112508

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INVESTMENT BANKING SERVICES SINCE 1987

Credit Market Update

December 2008

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How Tight is the Credit Market Today?Advertisement in BusinessWeek 11/17/08

General Electric, which relies on low-cost Commercial Paper to lend through GE Capital, has found that the contraction in CP has driven

up the cost of capital to a point where it is cheaper to offer debt instruments direct to consumers

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How Tight is the Credit Market Today?

ABL pricing is LIBOR + 500 to +600 (inclusive of points paid at closing)

Cash flow loans are pricing at LIBOR + 800 to +1500. Most middle-market borrowers closing on cash flow loans since mid-September are paying north of 15% all-in

Covenant-lite deals went away in 1H 2007 and have given way to an average of three maintenance covenants on new issues

LIBOR, taking a beating from Central Bankers world wide, is losing its luster as a benchmark - as such, nearly half of all loans in 1H 2008 included a LIBOR floor.

Recent loans are being priced with an absolute rate floor of 5.0% to 5.5%

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How Tight is the Credit Market Today?

There is virtually no mezzanine lending going on today. Sub-debt providers, tasked with getting unlevered returns of 15%, can do better in the secondary market, buying senior secured paper at a discount

There is virtually no DIP lending going on today, other than from participants already in the capital structure

Exit financing for companies in bankruptcy is nearly impossible to find

Major players like GE Capital, Madison, Wachovia, GMAC, Textron, and CIT are essentially out of the market

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How Tight is the Credit Market Today?Net percentage of U.S. banks that indicate tightening credit standards on corporate loans

-40

-20

0

20

40

60

80

100

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Shading indicates period of recession Large and Mid-Size Borrowers

Small Borrowers

Source: Federal Reserve (published in the Wall Street Journal, November 4, 2008)

Recent tightening is more significant and widespread than at anytime in the past 20 years.

Current bias among lenders is to tighten in anticipation of recession, falling corporate earnings, and rising default rates.

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Cost & Availability of Capital

Commercial Paper: Costs have doubled, and maturities have shortened to days, not weeks.CLO Market: Major finance companies, unable to raise capital in the CLO market, are having to draw down warehouse lines with ever-widening spreads.De-Levering: Major lenders are looking to de-lever their balance sheets, and are selling off loan participations and distressed assets.Competition from the Secondary Market: The glut of secondary market debt has driven up the implied interest rates on BB corporate bonds to 15% and higher.Staggering hedge fund redemptions, seizures (such as Highland Credit Strategies’ $672 million fund), and bankruptcy filings have generated liquidations of debt. Fortress said 11/13 that it received $2.6 billion in withdrawal requests for its funds, which manage $9.1 billion.

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Cost & Availability of Capital

Potential Liquidations of Debt Securities (by Investor Type)

Source: UBS, Standard & Poor’s

Note: Debt Maturing Between October 23, 2008 and January 23, 2009

Investor Type ( Mkt Value of Holdings X Assumed

Liquidation ) = Forced Liquidations - Near-Term

Maturities = Net Liquidations $

Collateralized Loan Obligations (CLOs) 179.3 5% 9.0 11.7 -2.7

Hedge Funds, High Yield Funds 136.8 50% 68.4 9.0 59.5

Prime Rate Funds 23.6 0.0 1.6 -1.6

Insurance Companies 14.2 0.0 0.9 -0.9

Finance Companies 28.3 0.0 1.9 -1.9

Banks 89.6 0.0 5.9 -5.9

As much as $46.6 Billion of debt securities, including traditional loans, syndications, and corporate bonds may trade before year-end

Until the selling pressure subsides, the secondary market will continue to compete with new borrowers for scarce capital

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Cost & Availability of CapitalWho owns the “Leveraged Loans”? Everybody.

Purchasers of Leveraged Loans Q1-Q3 2008:

“Leveraged Loans” are cash flow loans made at 4x – 6x EBITDA, many of which were used to finance LBOs and dividend recaps

It’s not just the hedge funds that provided the debt. It was BofA, Wachovia, GE Capital, Madison, Allied, CapitalSource and others.

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Cost & Availability of Capital

Sample of Benchmark Loans offering Yields upwards of 28%

The glut of corporate debt trading in the secondary market makes it possible to buy existing secured debt in large cap companies with

strong earnings at yields that are significantly “above market” relative to current loan underwriting.

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What are the Experts Saying?The great sucking sound of the secondary market: Bank Loans

“Performing bank loans with no near term probability of default, are trading at 71 cents on the dollar. It used to be that anything under 80 was ‘distressed’… when a bank can buy that loan at LIBOR +900, why lend at LIBOR+ 400 bp?”Bank of America

“We have bought out several positions from [Large National Bank] in club deals where we already had an interest, generally at a discount that gave us returns better than what we are getting in primary lending [which is currently L+600]”Wells Fargo

“We didn’t do syndications on the origination side, but we have several relationships at [Large Regional Banks] which have given us the opportunity to buy participations [in recent months] at a discount” Danversbank

“There are more non-bank lenders than banks, and the delevering of the non-bank lenders is driving the market, rather than the bank work-out officers.” Spring Street Capital

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What are the Experts Saying?About default rates

“There is an expectation that default rates across all industry sectors will rise from current historic lows” RBS Citizens

“Default rates don’t really matter, because everything is trading like it will default. If I had to guess, I’d say defaults will be 15% next year” Monarch Alternative Capital LP

“I have been involved in several situations where lenders have refused to deliver even routine ammendments, and are instead putting companies in default.” Choate

“Lenders got into bad habits, and for years their work-out strategy was ‘go borrow from someone else’, but that is no longer the case” Turnaround Professional

“High yield default rates will go to 10%. We will get a couple of 10% years like we had in 1991 and 1992” King Street Capital

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What are the Experts Paying?Implied default rates and loss given default

Loan Index Spread (S) (% over LIBOR) Default Rate (D)

Loss Given Default (L)

(D) x (L) = (A) Anticipated Risk Spread

(S) - (A) = Excess Spread

WHERE IS THE MARKET TODAY?

Current Market for Bank Loans 6.0% 3.0% 30.0% 0.9% 5.1%Current Market for Leveraged Loans 14.0% 3.0% 30.0% 0.9% 13.1%

WHAT IS "NORMAL"?

Long-Term Average 3.3% 3.8% 30.0% 1.1% 2.2%Historical Worst-Case 8.0% 8.0% 30.0% 2.4% 5.6%

MARKET PRICING RELATIVE TO LONG-TERM AVERAGE EXCESS SPREAD

Current Market for Bank Loans 6.0% 7.6% 50.0% 3.8% 2.2%Current Market for Leveraged Loans 14.0% 23.6% 50.0% 11.8% 2.2%

Buying secured bank loans at a discount of 39%*, generates an implied LIBOR spread of 1400bp.

1400bp suggests that either defaults will reach 23.6% with loss given default of 50%, or some similar scenario.

If we experience 18% defaults (10% greater than the worst ever for loans), lenders would have to recover just 53% (25% less than historic

average) to match historical MAX excess spread.*Lyondell Chemical Company, $16 billion in assets, Bank Debt/EBITDA = 2x. TLB traded at 61 as of October 23rd, a 17.5% YTM

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What are the Experts Saying?Default rates on Corporate Debt Since 1990

Looking back over the last 40* years, the highest default rate was less than 15%!

Source: Standard & Poor’s LCD, FRM * Data back to 1990 shown.

Given the history of loan defaults over the past 40* years, the “worst case” scenario would seem to be <15% default rate. The average loss on default is 30%. Therefore the likelihood of a loss, on average would warrant an excess spread of ~450bp. Yet ABL is now pricing at +600bp,

and cash flow loans at +800bp.

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Current M&A ClimateDebt Multiples are down relative to 2007

Source: Standard & Poor’s LCD

Subordinated Debt/EBITDA

Second Lien & Other Sr. Debt/EBITDA

Senior (First Lien) Debt/EBITDA

0

1

2

3

4

5

6

7

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08

Debt financing, which drove up LBO valuations through 2007, has dropped off significantly

Second Lien, which pumped up LBO debt in 2006 and 2007, has effectively gone away

Debt Multiples for Large LBOs (EBITDA >$50M)

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Current M&A ClimateLower-Middle Market Debt Multiples are at 2002 Levels

Debt Multiples for Lower Middle-Market LBOs (EBITDA <$10M)

Source: Mirus Survey Data

Subordinated Debt/EBITDA

Second Lien & Other Sr. Debt/EBITDA

Senior (First Lien) Debt/EBITDA

0

1

2

3

4

5

6

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08 4Q08

Tightening credit standards and higher interest rates have reduced debt available for LBOs, driving down valuations for LBOs (and M&A overall)

Senior leverage on lower middle-market deals is down to approximately 2x EBITDA, from an average multiple of more than 4x in Spring 2007

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Current M&A Climate

6051

4034 33

5146

3221

2617

1117

104

10 10 611 12 10 9

15 18 2130

4129

35 32 34

6168

52

8995

106

67 64

32 27

0

20

40

60

80

100

120

2Q98

4Q98

2Q99

4Q99

2Q00

4Q00

2Q01

4Q01

2Q02

4Q02

2Q03

4Q03

2Q04

4Q04

2Q05

4Q05

2Q06

4Q06

2Q07

4Q07

2Q08

M&A Volume ($B)

Leveraged M&A Volume ($ Billions)

Source: Standard & Poor’s LCD

30.2%

43.7%

32.4%

05

101520253035404550

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08

Source: Standard & Poor’s LCD

Equity Contribution (%) to LBOs

With continued market uncertainty and a higher equity requirement in LBOs, leveraged M&A volume fell off in 2008, dropping to only $27.1 billion in Q2,

74% lower than the Q2’07 all-time high of $105.6 billion

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What are the Experts Saying?About the current LBO market

“The market (for LBO debt) is broken and will need to be reconstituted in some fashion.” Bank of America

“ABL is now pricing at L+500 or 600. Senior leverage, if you can get it, is at 2x (EBITDA). Nobody with a healthy and growing business is a seller right now, to the chagrin of the Private Equity guys.” HIG Capital

“DIP lending really isn’t available right now” Sun Capital Partners

“Right now we are looking at micro cap and smaller public companies that have 4x and 5x levereage that can't get liquidity, and doing PIPEs” HIG Capital

“I fear that banks are going to take this opportunity to put pressure on disfavored borrowers to exit [the facility].”Choate

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Current M&A ClimateLarge LBOs held up through Q3, driven by equity, not debt

Sources: Standard & Poors LCD

Breakdown of Valuations in Large LBOs (target EBITDA >$50M)

0

2

4

6

8

10

12

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08

7.9x

6.1x

9.8x

Subordinated Debt & Other/EBITDA

Senior Secured Debt/EBITDA

Equity/EBITDA

5.7x SENIOR

4.5x 3.6x

Despite tightening credit that brought senior debt multiples from 5.7x in 2007 to 3.6x in Q3, buyers continued paying high multiples through August of 2008, filling the void with more equity and mezz

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Current M&A ClimateMiddle-Market LBO prices are back to 2003-2004 levels

Sources: Based on Mirus Survey (middle-market debt multiples) and Standard & Poors LCD (equity contribution)

Breakdown of Debt and Equity in LBOs (target EBITDA <$10M)

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H 08 3Q 08 4Q 08

Subordinated Debt/EBITDA

Senior "Stretch" /EBITDA

Senior Secured Debt/EBITDA

Equity/EBITDA

Seller-financed subordinated debt

2.1x3.7x

SENIOR2x

Lower Middle-Market Valuations held up through early September close to 6x EBITDA. However, senior secured is now at 2.1x and

there is no “stretch” or mezzanine debt available.

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Fall-Out Q4 2008

Borrowers are drawing down revolvers to “test” their availability (or horde cash)Lenders, trying to protect their balance sheets, are finding creative reasons (technical defaults) to not fundAsset-Based Lenders are being directed by credit managers to get new appraisalsAppraisers, worried about a flood of distressed assets coming into the market, are issuing very conservative appraisals on equipment, inventory, real estate and other assetsABL formulas will require many borrowers to contract their revolving credit facilities in Q1 2009Weakness in retail, automotive, building products and consumer discretionary will result in significant defaults in Q4.

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Expectations for 2009

Banks are looking to de-lever, reducing their loans outstanding by 10%-20%, meaning significantly less capital available to borrowers.Leveraged lenders, such as GE Capital, Textron, Newstar, etc. may need to de-lever by as much as 30%, depending on what happens with CP and TARP.CLOs and Hedge Fund assets will mature and create new demand, without supply to matchRefinancings will be more difficult, especially for overleveraged borrowersDefault rates may reach 10% as soon as late Q1 2009, as borrowers run into issues with collateral appraisals, declining revenues, shrinking margins, severance costs, restructuring charges, etc.

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Expectations for 2009

With DIP financing scarce, borrowers will be forced to work out more loans with their lenders to avoid uncertainty of Chapter 11Inter-creditor agreements and complex capital structures, as has been seen with the home mortgage market, will create systemic challenges to effective work-outs