Posted: 28 Apr, 2017
Last week, Freshfields’ London office hosted an event for TMA UK. The event was a great success with over 120 attendees from more than 90 organisations.
The evening kicked off with a presentation from Catherine Shuttleworth and Sean Lacey from Freshfields. A panel discussion followed, chaired by Lindsay Hingston, with partners Richard Tett and Andy Hagan, also from Freshfields, and external panellists David Beckett (SC Lowy), Tom Kilpatrick (Barings) and Jarek Golebiowski (Deloitte). A number of questions from the floor generated a very engaging debate.
Topic: the impact of the developments in the leveraged financing markets on distressed transactions.
Three key themes
(1) How leveraged lending has changed since 2008
Back in 2008, the market predicted tightened credit terms, more conservative structures and a limited role for CLOs relative to that in the pre-crunch markets.
Market dynamics then changed as European banks became increasingly constrained by increased capital requirements and regulation and reputational concerns.
Institutional investors filled the gap left by the banks, both in the secondary and distressed markets (including unlocking restructurings by buying up bank positions and funding distressed deals).
We saw an explosion in the issuance of European high yield debt to refinance pre-credit crunch leveraged deals and make up for the relative lack of liquidity in the loan market.
Borrowers were attracted by the ability to raise bonds with US-style flexible, incurrence only covenants which replaced more restrictive European loan financings with traditional maintenance financial covenants requiring ongoing quarterly compliance with a set of financial metrics.
We also saw the rise of direct lending by credit funds disintermediating investment banks and also taking the place of traditional commercial bank-led club deals, particularly for medium-sized companies.
More recently, the leveraged loan markets have evolved to compete with high yield bonds in terms and pricing. There has been a recent swing back in favour of leveraged loans with a number of current examples of high yield bonds being refinanced by loans.
(2) Current market dynamics, products and terms
Currently there is plenty of liquidity in the financing markets with large volumes of capital to be invested, predominantly by CLOs which began to resurface in 2013 and grew rapidly over the following three years.
This is driving competition for assets and opens up opportunities for businesses of all sizes to obtain financing with relatively low interest rates.
It has also led to an increasing convergence of terms and investors across the leveraged finance markets, particularly between leveraged loans and high yield bonds.
As these markets compete with one another, the terms are becoming increasingly borrower-friendly; for instance loan financings, particularly of larger deals, will typically have one or no financial covenants.
‘Does it feel like 2006/2007 again?’ was a much-repeated question during the panel session and the drinks that followed. There are clear differences between where we are now and then.
Where there are similarities is in the abundant liquidity in the credit markets (particularly from the CLOs) which means that borrowers – from mid cap upwards – and sponsors are able to agree financings that give them latitude to grow, with fewer restrictions and controls for the creditors, and at relatively low interest rates.
(3) Potential implications for restructuring
The terms of the leveraged finance documents being written today are very different from those in the last distressed cycle, with fewer traditional lender protections and very limited covenants.
This gives rise to a new set of restructuring challenges going forward, as there will no longer be the usual triggers in the documents to start a restructuring process, for example following a financial covenant default; the aim of financial covenants being to flag under-performance before real (and potentially unrecoverable) distress hits.
Under un-covenanted documents, a borrower’s performance could decline significantly as it enters distress, but without giving rise to a potential breach of those documents prompting the borrower to consider discussions with its creditors to seek a waiver or more significant restructuring (or a means for the creditors to enforce security/appoint an administrator etc.).
Instead, creditors may have to wait until debt maturity, a liquidity event (such as the borrower not having enough cash to make an interest payment date) or a need to improve its financial position to achieve sign off of its annual accounts, in order for the borrower to start restructuring discussions.
For English companies, the directors may need to consider whether it is appropriate to engage at an earlier stage as the focus of their duties shifts in favour of the creditors’ interests. However, that is not the case across all jurisdictions.
For some companies, the lack of covenants will give them the breathing space they need to trade through the period of distress and rebuild, rather than running the business to meet quarterly covenants, which were originally set when the financing was agreed. For others, there is a question whether the lack of a documentary trigger which requires them to get around the table with key creditors may simply postpone the inevitable, unless they engage early with stakeholders to achieve a positive outcome.
There were a number of interesting questions from the floor. A few attendees felt the markets were reminiscent of 2007 and queried whether or when the cycle may turn, with panellists predicting that liquidity may become constrained if interest rates rise or quantitative easing ends.
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