NEW YORK (Reuters) - A slow start to the year in the U.S. leveraged loan market is expected to ensure that a $4.3 billion highly leveraged loan backing pet retailer PetSmart Inc’s PETM.O private equity buyout will find buyers, despite a three-notch downgrade by S&P immediately before launch.
S&P downgraded PetSmart’s corporate rating to B+ from BB+ on Monday following BC Partner’s $8.4 billion buyout. The $4.3 billion, seven-year term loan B, which is the biggest U.S. leveraged loan to launch this year, was rated BB- and a proposed $1.9 billion note offering was rated B-.
Although the post-acquisition downgrade was expected, S&P said that higher leverage stemming from the acquisition debt would lead to weaker credit protection; $6.2 billion of the $8.7 billion buyout is being financed with debt, giving pro-forma leverage of about 6.2 times.
This is just over the threshold of 6.0 times leverage which U.S. regulators outlined as acceptable last year, under leveraged lending guidelines designed to clamp down on riskier lending, along with the ability to repay debt.
Moody’s put the deal’s lease-adjusted leverage higher at 7.2 times, compared with 2.5 times before the acquisition, and rated PetSmart B1 and the term loan Ba3. Investors said that their analyses fell between the two agencies’ estimates at just under 7.0 times.
Arranging banks and investors have become wary of lending to highly leveraged loans to avoid incurring regulatory wrath, although both camps are prepared to make exceptions for relationships and return respectively.
Citigroup is leading PetSmart’s loan and is a joint arranger with Barclays, Deutsche Bank, Nomura, Jefferies, Royal Bank of Canada and Macquarie. Bank of America Merrill Lynch, Credit Suisse, Goldman Sachs, RBC and Wells Fargo passed on the opportunity to arrange the deal in December due to high leverage.
“I suspect at these leverage levels everyone went into this responsibly with their eyes open and with a clear view of the ability to sell this in the market,” said Jay Ptashek, a debt financing partner at Kirkland Ellis LP, adding that flex should be sufficient to deal with any potential issues.
Investors are more flexible and more likely to lend to large, liquid loans such as PetSmart in a low dealflow environment, particularly when deals are few and far between and priced to sell with downgrades factored in.
U.S. leveraged loan volume is substantially lower so far this year and shows a 69 percent drop with $33 billion of deals completed by early February, compared to $107 billion in the same period of 2014, after a drop in refinancing activity.
PetSmart’s price guidance of 450-475bp over Libor with a 1 percent Libor Floor and Original Issue Discount (OID) of 99 is 100bp higher than a similar $3.95 billion, seven-year term loan that backed discount retailer Dollar Tree’s DLTR.O $8.5 billion acquisition of Family Dollar Stores Inc FDO.N.
Dollar Tree was able to cut pricing on the loan by 25bp to 350bp from the lower end of price guidance of 375-400bp this week. With higher leverage and less potential synergies, PetSmart is unlikely to be able to repeat this performance and could face pressure from investors to raise pricing.
The argument for higher pricing could be aided by a much smaller $300 million buyout deal for retailer EyeSmart Express LLC late last year, which had leverage of 5.0 times and priced at 400bp, tighter than guidance of 425bp. Moody’s rated the company and loan B1 and S&P assigned a B corporate rating to the company
Given PetSmart’s high leverage, it is vital that the company continues to use its solid cashflow to continue to pay down debt in the next few years as the company is not immune to economic downturns despite its solid cashflow, investors said.
“Although we believe PetSmart will use most of its free cash flow for debt reduction, we expect leverage in the high 5.0 times area in the next year. We are therefore revising our assessment of its financial risk profile to ‘highly leveraged’ from ‘intermediate,” S&P credit analyst Andy Sookram said.
Moody’s expects PetSmart to cut leverage to below 6.0 times within two years from its current level of 7.2 times.
Editing By Tessa Walsh