The Banking & Finance guide provides expert legal commentary on the key issues for businesses involved in Banking & Finance. The guide covers the important developments in the most significant jurisdictions.
Last Updated October 21, 2016
Maurice Allen is one of London’s leading finance lawyers, advising clients on complex transactions and cross-border financings. His experience spans acquisition financings, telecom financings, restructurings, direct lending, mezzanine and other forms of junior lending. Practicing law for more than 30 years in London's sophisticated finance market, Maurice has acted for both debtors and creditors in the investment grade and leveraged finance market. Maurice serves as senior partner of Ropes & Gray’s London office.
The London office is an integral part of Ropes & Gray’s global team of over 1,100 professionals across 11 offices. The firm has built the office to reflect the changing global economy, augmenting the firm’s traditional core strengths while identifying and capturing future growth areas. The firm’s team services all aspects of equity investments, private equity, M&A, private equity real estate, asset management, bank/bond financing, structured finance, restructuring and insolvency, special situations, government enforcement, litigation, regulatory and tax. Ropes & Gray has both English and US law capabilities and a strong reputation within the European legal and business community and has longstanding relationships with leading local firms in all major European jurisdictions.
The strong performance of the loan markets in 2014 was supported by improved confidence in the US and European economic recovery as well as favourable market conditions. The value of loans syndicated globally in 2014 was approximately USD 3.9tn and although values declined in the first two quarters of 2015, the loan market remains robust. In Europe, the market view is that the volume of leveraged loan issuance in 2015 could exceed that of 2014.
The performance of the loan markets can be attributed in part to a number of developments that have been emerging in response to global regulatory pressures on banks to deleverage following the 2008 credit crisis. Key trends that have arisen as a result of the post-crisis reduction in traditional bank lending and the need to fill the funding gap include the rise in alternative lenders and the growth of European high yield. These developments have heightened the competition between alternative lenders and banks, and between loans and bonds, permitting borrowers and sponsors to push for more favourable structuring and terms, higher leverage and lower pricing.
The competitive environment is also providing borrowers with access to a wider variety of funding products in the leveraged debt market such as bonds, senior loans, institutional term loan B (TLB) tranches, mezzanine, unitranche and second liens. In addition, European borrowers continue to access the US TLB market. Together, these factors are driving the increasing convergence of the European and US leveraged loan and high yield markets, and are remodelling the framework of global banking and finance in 2015.
Banking Regulatory Reforms
The intense banking regulatory reforms that were introduced following the 2008 credit crisis in order to reduce the systemic risk in the banking industry placed an enormous constraint on bank lending. Markets worldwide have been affected by the application of new capital regulations, increased stress-testing and supervision. Reforms in the banking sector in the US include the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act in December 2013, including what is commonly known a the Volker Rule. In Europe, the Basel III/CRD IV capital and liquidity rules require banks to hold higher reserves for bank deposits and borrowing and have resulted in banks focussing on how best to allocate their capital, and concentrating on their main clients.
Many companies requiring access to credit continue to turn to the bond market or to alternative lenders such as insurance companies, institutional investors, private equity and pension funds. Alternative lenders are not subject to the same deleveraging pressures and regulations as traditional banks and this has enabled them to thrive. There is strong demand for credit from businesses of all sizes but bank liquidity has significantly decreased and this supply and demand imbalance has fundamentally changed the funding landscape.
The Growth of European High Yield
The rise of high yield continues to be the big theme in the European leveraged debt markets, which traditionally was almost completely dominated by bank loans. As more investors tap European high yield, the broadening investor base is naturally encouraging the increased convergence of terms in the high yield and leveraged loan markets.
Over the last few years, investors eager for yield have increasingly been turning to the European high yield market. Smaller issuers have been tapping the high yield markets and, following the market volatility in the last quarter of 2014, the high yield market opened once again to small and first-time issuers in 2015. Although the yields on new issuance at the end of the first quarter of 2015 were at their tightest levels on record, issuance of European high yield debt was particularly strong, partly as a result of quantitative easing in Europe. The second quarter of 2015 was also very strong, however this was followed by a poor third quarter reflecting volatility in the market resulting from concerns over the Greek debt crisis and the slowdown in Chinese growth. Although the market expects more peaks and troughs during the last quarter of 2015, the general feeling is that high-yield has shown a certain amount of resilience as compared to other risk assets.
Covenant Loose and Covenant-Lite Structures
In the US, the rise in alternative lenders has led to the growth of the US TLB, which is the tranche of the loan agreement for institutional investors such as hedge funds, credit funds, private equity funds and pension funds. These investors are usually familiar with the high yield market and are generally comfortable accepting certain bond-like terms in their loans.
US TLBs are increasingly adopting the covenant-lite features of high yield bonds, where the financial maintenance covenants, such as maximum leverage and minimum interest coverage ratios are replaced with incurrence covenants. In 2014, the majority of US TLBs were covenant-lite.
Covenant-lite loans are particularly prevalent in the large corporate market in the US. There are, however, an increasing number of examples of sponsors in the higher middle market able to negotiate covenant-lite loans. In addition, there is some loosening of covenants within the middle market where one or two covenants are dropped.
Covenant-lite structures have also emerged in the European large cap institutional market. In 2014, over a quarter of first lien loans were covenant-lite and this number has increased significantly in 2015. The European mid market has also seen a range of deals syndicated on a covenant-lite basis in 2015 to date. As is the case in the US, true covenant-lite structures in the mid market are not yet quite the norm but borrowers are increasingly obtaining looser covenants. There has been a significant trend towards including in the senior facilities agreement a single maintenance covenant which tests leverage for the benefit of the term and the revolving lenders.
Where a revolving facility agreement is included in the structure, a springing financial maintenance covenant for the benefit of the revolving facility lenders is common, where leverage is typically tested quarterly and only applies when the borrower’s utilization exceeds a specific percentage (typically around 30 per cent, but can range from 15- 35 per cent).
The leverage ratios are frequently calculated on a net basis, often with no cap on the cash that may be netted. Equity cures are generally included to allow the covenant default to be cured and in the current market, for strong borrowers, the permitted number of equity cures is increasing to up to five times during the life of the loan. In addition, in some US-style loan facilities, the equity cure can be used to increase the EBITDA with a cash contribution covering the amount necessary to cure the default.
The US Influence
Not only are loan and bond terms converging with loan facilities increasingly adopting bond covenant packages, but the European leveraged loan market is also converging towards the US leveraged loan market.
Over recent years, there has been a trend for European borrowers to enter into US TLBs governed by New York law. This has encouraged the adoption in European leveraged loan documentation of certain provisions which were previously only customary in the US leveraged loan market. Examples of such provisions include soft call protection provisions, lower lending voting threshold and grower baskets for the incurrence of additional debt, acquisitions and disposals. The grower baskets in European leveraged transactions in 2015 increasingly are soft capped by reference to EBITDA. Other US-style provisions that are becoming more standard in European leveraged facilities are provisions permitting incremental facilities that are usually subject to a leverage ratio and sometimes also permit an additional fixed amount that is not subject to the ratio. Portability clauses, popular in US leveraged loan facilities, were increasingly emerging in European leveraged facilities during 2014, however their use has declined in 2015.
Leveraged Loan Guidelines
Whereas the loan market in the US has seen a general deterioration of credit quality over recent years, there has been a slight improvement in the credit quality of the new-issue market in the US in the year to date. This development is in part a reaction to the increased regulatory scrutiny of leveraged lending. In the US, the Federal Reserve Board, Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency issued the Interagency Guidance on Leveraged Lending in March 2013. This guidance is aimed at stemming the rise in high-risk lending in order to prevent systemic risk to the banking sector. According to the guidance, total debt to EBITDA in loan transactions should be limited to not more than 6 times. In addition, the guidance makes it clear that a company must be able to repay its total debt within five to seven years.
The guidance is having an increasing impact on traditional banks, which are beginning to avoid transactions with leverage ratios above 6.00:1.00. Banks are carrying out increased diligence during the commitment stage of transactions in order to verify sponsor projections and financial covenants are tightening. It remains to be seen whether the guidance will lead to unregulated lenders stepping in instead.
The regulatory scrutiny of leveraged lending in the US is beginning to impact the leveraged lending market in Europe. Although there are no equivalent restrictions in Europe, the loan market in Europe is generally influenced by the trends in the US. In addition, in May 2015, European banks were requested by the European Central Bank to provide certain information on their leveraged lending operations. European regulations may therefore eventually be adopted.
Alternative lenders are providing finance via a range of product such as private placements, unitranche, senior loans and other direct lending. This has helped to sustain the growth in volumes of loans and bonds. Debt funds and other alternative lenders continue to increase their share of the European and US mid-market in 2015, particularly with unitranche financings. Unitranche combines the senior and subordinated tranches into one debt instrument with a blended interest rate, with the “junior” unitranche lender receiving a higher portion of the blended interest rate to reflect the heightened risk. They are extremely popular with private equity owned companies at the lower end of the middle market.
In transactions involving more than one unitranche provider, the priority and subordination terms of the financing are documented in an agreement among lenders (AAL). The AAL also documents the terms of the first out tranche and the riskier last out tranche, which has a higher yield. The pricing and its apportionment between the lenders is also set out in the AAL. The lenders document their respective voting rights in this document as well as the applicable payment waterfall.
Unitranche has spread to countries such as France, Germany and Spain and has developed some market standard features. However, the attraction of unitranche financings is that they are flexible and can be adapted to suit particularly complex needs. Unitranche appeals to certain sponsors because there is typically a tighter lender group and the structure and covenant package are bespoke to the particular transaction. In the European market, the key terms of the agreement are increasingly included in the intercreditor agreement.
Collaboration between Banks and Alternative Lenders
Although alternative lenders are playing an increasing role in the loan markets, traditional banks have been able to strengthen their balance sheets and are offering competitive deals in the market. In many cases, alternative lenders are collaborating with the traditional banks where the size of the deal is too large for them to underwrite on their own or where they are unable to provide revolving or capex facilities or hedging. Similarly, traditional banks have avoided offering unitranche financings as the first-loss piece of the unitranche often fails the banks credit compliance standards. Some banks and alternative lenders have therefore sought to overcome these limitations by forging formal alliances.
Mezzanine, second lien, subordinated high yield and PIK financings continue to provide borrowers with increased options for their capital structures. The rise of alternative lenders in the market is encouraging the offering of innovative funding solutions for borrowers involving subordinated and senior debt.
Mezzanine financings have declined over the years because of the cheap senior pricing, low interest rates, growth in unitranche financing and competition with high yield. They are, however, still targeted by certain debt funds seeking yield, but in many cases the larger debt funds that used to concentrate on mezzanine-only financing have evolved so that they offer a much greater variety of products.
In the face of challenging banking regulatory scrutiny and the wider variety of market participants, the loan market has had to adapt. The ability to adapt has also been critical to the success of law firms operating in the banking and finance sector. As the leveraged loan and high-yield bond markets continue to converge, it is essential that law firms are able to offer a fully integrated bank/bond leveraged finance service. In addition, the offering of a strong and integrated US and domestic practice is competitively advantageous for law firms wishing to maintain their relationships with traditional players in the banking sector while servicing the broadening investor base. This investor base is increasingly crossing geographic borders, resulting in new debt products and US-style documentation provisions increasingly being seen in the European market. Effective legal advice in this area increasingly requires specialist knowledge of both US and English banking and finance law.