In the shadow of an unfriendly and overhung credit market, Sallie Mae shareholders approved a buyout last week that would add as much as $16.5 billion to the leveraged finance pipeline. But don't consider the deal closed just yet. In light of government subsidy cuts, the private equity group let it be known that they may scuttle the deal altogether. Are the buyers really looking for an out, or are they making noise to help squeeze a better deal from the beleaguered student loan provider?

The Reston, Va.-based company, also known as SLM Corp., agreed in April to a $25 billion buyout led by J.C. Flowers & Co. and including Friedman Fleischer & Lowe, JPMorgan Chase Bank and Bank of America. J.C. Flowers and Friedman Fleischer & Lowe agreed to invest $4.4 billion and own 50.2% of the company, and JPMorgan and Bank of America agreed to each invest $2.2 billion and own 24.9%.

The company is considering pricing $12.5 billion in term loans and $4 billion in high yield bonds before the end of the year, according to Fitch Ratings' forward high yield and leveraged loan calendars. Banc of America Securities and JPMorgan are the underwriters for the debt and agreed to provide additional liquidity to Sallie Mae prior to the deal's closing. Sallie Mae said it expects the deal to close by October.

Potential trouble with the deal surfaced last month, when both the U.S. Senate and the U.S. House of Representatives voted to cut student loan subsidies by almost $20 billion. The two houses must confer on the cuts and also reconcile with the Bush administration, which sought a smaller reduction of $16 billion.

The buyout group informed Sallie Mae that the pending legislation under consideration could cause a failure of conditions needed to close the deal.

The company said it strongly disagreed and vowed to close the deal as quickly as possible and "take all steps to protect shareholders' interests."

What is at issue is whether or not the cuts authorized by Congress would constitute a "material adverse change" as defined by the buyout agreement.

In addition to the votes in Congress authorizing the subsidy cuts, the credit markets are a very different place today than they were when the deal was announced in April. The J.C. Flowers-led group will have to pay significantly more for the debt package it needs to finance the deal. The deal carries a $900 million breakup fee.

The public speculation over whether or not the deal would get done has helped send stock prices down.

"The market is saying, We don't think the deal is going to get done,'" said one high yield portfolio manager. "The market is getting more and more skeptical." This adds power to the J.C. Flowers consortium's position, which could negotiate a significantly lower price and still present Sallie Mae shareholders with an attractive premium.

If the matter ends up in court, both sides stand to lose more than they stand to gain. Whereas if the two sides renegotiate the deal, Sallie Mae will still see the buyout through and the investor group improves its position.

It is in Sallie Mae's interest to do what it needs to do to get the deal done, as its shareholders would likely still come away with a hefty premium for their stock even if the buyout price drops by a few dollars a share.

Also, its standing in the credit markets would be harmed if it lost the deal, according to market observers. "Should the merger transaction unravel, Sallie Mae would have the difficult task of re-establishing itself in the debt markets, having potentially disadvantaged many participants as a result of the merger financing," said Ernest Napier, a primary credit analyst with Standard & Poor's, in a report.

In addition to the government subsidy cuts, the company faces economic difficulties that may impede its ability to delever. Sallie Mae has assets besides its student loans that have significant credit risk. Student loan delinquencies have increased in the private sector, S&P pointed out, noting that it may be too early to tell whether this is a trend that will continue.

Both S&P and Moody's Investors Service expect Sallie Mae to maintain its leading position in the student loan industry and believe it will benefit from the agreement with the shareholder banks that are pledged to provide liquidity.

Sallie Mae originated $23.4 billion in student loans last year and represents 27% of all student debt in the U.S.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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