Tuesday, April 17, 2007

How I go into College or the SLM LBO...

In case you are living under a rock, Sallie Mae is to be taken private by four investors. SLM Corp., which is their less known official name, might just be the most prominent investment-grade bond issuer to be taken private. While SLM is not a major component of the Lehman Aggregate, they are a major issuer of floating-rate notes (FRN). As such, I'd suspect this transaction will touch certain investors not used to dealing with this kind of corporate event risk.

SLM's bonds have widened substantially. FRNs in the 5-year range were trading around LIBOR +25ish, now more like +120. Its an extremely volatile market, and so the spread is changing as I'm typing this. A 100bps move on a 5-year bond is about 3 points.

I'm very surprised by this transaction. Although SLM has come up before in LBO talks, I didn't believe the company could withstand a large increase in leverage. But upon looking at what little detail has been made public so far, the buyout is gong to be funded with $16.5 billion in debt and $8.5 billion in equity. Looking at SLM's balance sheet, they currently have $112 billion in debt versus $4 billion in equity. So after the transaction, they'd have $128 billion in debt versus $12 billion in equity? That's a decrease in leverage from 28x to 10.7x.

It also occurs to me that the backup financing that JP Morgan and Bank of America are providing may be to help ensure an investment-grade rating, not as has been reported, to protect against the possibility of a junk rating. Consider that if BofA and Morgan thought the company would be junk rated, then the credit line would immediately be used. That makes the credit line de facto equity contributed to the deal, and would greatly decrease the IRR on the transaction.

On the other hand, if the ratings agencies see that there is a large, untapped credit line, the risk of a sudden bankruptcy greatly diminishes. In fact, the credit line is nearly 2x their entire loan portfolio. The ratings agencies should allow for greater leverage when the company has ample liquidity available to them.

With any private transaction, the devil is in the details, and we haven't seen too many of those yet. My quick take is that SLM winds up getting downgraded into the Baa/BBB range, but no further. That should allow the bond spreads to tighten from here.


MING CHEN said...

Should we be using the market cap in leverage calculation? SLM's current market cap is 23b. The LBO would increase it's financial leverage ratio from around 5X to 17X...

Anonymous said...

dont use the 8.5bn equity in the leverage calcs, that won't go onto SLM books, it'll be used to pay the current shareholders.

So leverage goes from 28x to 32x.

Vivek Vish said...

Seems like an odd buy. What if the government starts issuing loans themselves and stops subsidizing private ones? Seems like a logical move from the government's standpoint (lower costs) and from students' standpoints (lower yields).

Anonymous said...

Please forgive me:

What is LIBOR?

What is IRR?

In general, where can one look at other floating-rate notes?

mOOm said...

Maybe I don't understand these LBOs but the way I figure it $25 billion gets paid to the existing shareholders, so the asset column doesn't change but the debt column goes up by the 16.5 billion and so they end up with negative equity? Or am I thinking about this all wrong.

mOOm said...

I read an FT article that explained this. As JP Morgan is one of the acquirers they are going to use their lending capacity to meet the capital requirements while going to negative equity in SLM. They need a bank involved in the takeover for this to work.

Accrued Interest said...

Good questions all. There aren't as many good answers.

I do believe I misspoke about the leverage. The $8.5 in equity gets paid out and I believe becomes part of goodwill. My merger accounting is a bit rusty since I passed the CFA exam 6 years ago. Therefore equity doesn't go negative, debt increases by $16.5 billion, and leverage increases accordingly. Anyone who knows this for a fact one way or the other I'd love to hear a confirmation.

LIBOR (London Interbank Offer Rate) is a common short-term benchmark rate. IRR is internal rate of return and is the basic measure of any investment's return. Try bloomberg.com under market date/rates for a good summary of short-term rates.

Anonymous said...

Tom, thanks for correcting your analysis of SLM. With SLM CDS trading like Sallie is a B credit, there may be some value here for a HY/IG crossover investor. On their conference call, Moody's cited several reasons that could raise the rating:

1. SLM's leading market position and consistent profitability;
2. If JPM and BAC are strategic buyers (if the line of credit is longer than 5 years, for instance)
3. If the lending platforms are combined -- unlikely, at least according to the SLM press release.

And even if junk rated, SLM can issue AAA-rated student loan ABS and keep generating profits that way.

Finally, this is not a done deal -- equity arb spreads are around 8%, way above the risk-free rate.