TH Lee Leveraged-Loan Deal Seen Solving Question With SOFR

(Bloomberg) -- Private equity firm Thomas H. Lee Partners got $1.1 billion of loans this week for a leveraged buyout that offers a possible solution to the question of how to price debt based on a new benchmark. 

TH Lee tied its loans for the purchase of a unit of Brooks Automation Inc. to the Secured Overnight Financing Rate, or SOFR, a new benchmark for borrowing that regulators are backing. About a dozen other companies have used SOFR in the leveraged loan market rather than the London interbank offered rate, the scandal-plagued benchmark that can’t be used for new transactions effective Jan. 1. 

Those other SOFR loans were priced using a “credit spread adjustment” that when added to the new benchmark was designed to generally result in a rate similar to the level of Libor, which trades higher than SOFR. The borrower also paid interest on top of that, known as the margin. Presenting the interest that way was meant to allow new pricing to seem familiar to investors, because it could be viewed as a Libor-like rate they were used to plus the margin. 

For the Brooks Automation loan, TH Lee isn’t offering a standalone credit spread adjustment, and is instead just making its margin larger. It’s the first U.S. leveraged loan to do so, according to Bloomberg data. Some money managers, including KKR & Co., think that’s a better standard to use in the future for new transactions, and investors should just get used to seeking a higher margin. 

Gordian Knot 

The latest loan is meant to cut a Gordian knot that developed as deals actually priced: it’s not clear how big the credit spread adjustment should be. For example, regulators recommended that for three-month term SOFR, the adjustment for existing loans should be about 0.26 percentage point, or 26 basis points, based on the five-year average difference between the new rate and three-month Libor. But previous deals priced with three-month adjustments at 15 basis points, because whatever the difference was historically, the old and new rates are much closer to each other now.

The leveraged loan market has been relatively slow to move to SOFR, and the standards for how debt will be priced are still evolving. Much of this discussion is essentially moot as long as the Federal Reserve keeps rates low, thanks to a different part of the pricing, SOFR floors, which provide a minimum benchmark rate that investors receive. So far SOFR leveraged loans have generally had a floor of at least half a percentage point, meaning investors get at least 50 basis point of interest no matter how low SOFR trades, plus the margin. One-month term SOFR currently trades at just over 4 basis points.

A standalone credit spread adjustment only becomes relevant once rates rise and exceed these floors. But TH Lee’s new loan gives investors the benefit immediately by putting 10 extra basis points directly into the loan’s margin.

“We still strongly believe that the spread and the floor are your true levers to use when pricing risk and that just because we have a new reference rate, we shouldn’t price risk differently,” said Tal Reback, who leads the Libor transition at KKR. Reback is also a member of the Alternative Reference Rates Committee, the Federal Reserve-backed body that’s overseeing the transition away from Libor in the U.S.

Simpler Way?

TH Lee decided to fold the adjustment into the margin of the loan because it was simpler than using a separate credit spread adjustment, according to a person with knowledge of the matter who asked not to be identified discussing a private transaction. The firm opted for SOFR because the buyout deal isn’t expected to close until the first half of 2022, after the deadline for no new Libor loans, the person added.

Representatives for TH Lee, Barclays Plc, which led the first-lien portion of the deal, and Goldman Sachs Group Inc., which led the second-lien tranche, declined to comment. 

For the Brooks Automation loan, the first-lien portion was discussed at 325 basis points over Libor. Then pricing changed to 335 basis points over SOFR. That 10 basis point increase, added directly to the margin, was used in prior deals for when companies borrow using a one-month benchmark. The company did the same thing with the second-lien portion, which priced at 560 basis points over SOFR, compared with 550 basis points over Libor. 

That’s different than how JPMorgan Chase & Co. ended up pricing the first SOFR U.S. leveraged loan for real estate lending company Walker & Dunlop Inc. That loan had a 10-, 15-, and 25-basis point credit spread adjustment depending on whether the company used one-month, three-month, or six-month term SOFR, respectively. JPMorgan had originally proposed a single 10 basis point adjustment, regardless of the borrowing term, but investors successfully pushed back to get the forward-looking curve at the time. 

The final pricing for Walker & Dunlop has served as a template used by about a dozen other SOFR loans until Brooks Automation. But it’s not clear what the standards will be over time, underscoring how difficult the shift away from Libor is. 

“Libor is like salt,” said KKR’s Reback. “It’s in everything, but it’s really hard to take it out once it’s in the dish.”

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