The Banking & Finance guide provides expert legal commentary on key issues for businesses. The guide covers the important developments in the most significant jurisdictions.
Last Updated April 26, 2018
2017 to date has seen a largely benign set of market conditions across the global finance markets. Macroeconomic factors and various regulatory challenges have largely been set aside by the market. After a brief hiatus in Europe pending the outcome of the French elections, other political events including the status of the United Kingdom's exit from the European Union have barely impacted the market.
Despite the possible sources of uncertainty, the market has been characterised by high levels of liquidity, increasing demand for assets and the search for yield which has enabled sponsors to push for more favourable structuring and documentation terms. The borrower-friendly environment has permitted the key trends of 2016 to continue throughout 2017 to date. Convergence between the US and European finance markets and between the high yield and loan markets has continued to intensify, as has the entrenchment of covenant-lite and covenant loose structures. In addition, the sustained supply/demand imbalance in the debt markets has also reinforced the increasing significance of non-banks in the European mid-market.
Covenant Erosion, Convergence and Covenant Lite/Loose Continue
As the leveraged finance markets picked up in the Autumn of 2016 and as the European Central Bank began buying corporate bonds, competition for yield heightened and interest rates remained low, shifting the balance of power back towards borrowers in the leveraged loan and high yield markets. This has continued apace in 2017. In the European high yield market, for example, a larger proportion of offerings were “high-yield-lite” offerings lacking key protections for creditors such as restrictions on the ability of companies to make restricted payments and raise incremental debt.
The demand for deals has continued throughout the year to date and, with declining refinancing activity as most borrowers have already taken the opportunity to lock in lower rates, the lack of supply has intensified. The demand/supply imbalance has sustained the borrower-friendly environment, in which borrowers and sponsors have been able to negotiate very aggressively. They continue to import the flexible terms of bonds into their loans. In addition, European loans have continued to import flexible New York terms into their deal documentation. This convergence of European and US leveraged loans and high yield bonds is a continuing trend in 2017 which is expected to continue into 2018.
In the European market, although covenant-lite loan issuance has been rising, the overall trend has been towards “covenant-loose” structures incorporating a single maintenance covenant (often required by the investment policy of some investors) which tests leverage for the benefit of both the term and revolving lenders. The amount of covenant-lite issuance has continued to rise particularly in the large cap market, reflecting a borrower-friendly market, in which lenders are achieving fewer, and less protective, covenants in part as a means of competing with the high yield market. Even where there are maintenance covenants, increased levels of covenant headroom, extensive addbacks and proforma adjustments act to reduce the early warning nature of any remaining maintenance covenants. In addition, the amount of permitted equity cures has been increasing. The permitted number of equity cures is often set at five times during the life of the loan and borrowers are increasingly being permitted to use the equity cure to increase EBITDA instead of repaying debt.
Other evidence of adoption in European leveraged loan documentation of certain provisions which were previously only customary in the US leveraged loan market includes the use of grower baskets for the incurrence of additional debt, amongst other things, with a move away from hard capped baskets.
In the mid-market, covenant erosion and weakened protections for lenders have also increasingly been featuring in the smaller European loans other than those in the unitranche market which is continuing to hold out against the move to covenant-lite terms.
US Leveraged Lending Guidelines
The impact of the Guidance on Leveraged Lending (“USGuidance”) issued by US bank regulatory agencies remains on-going. Additional clarity provided by US regulators and stricter enforcement of the US Guidance has meant that the Guidelines have begun to bite.
The US Guidance outlines certain minimum expectations in relation to leveraged lending, including the expectation that banks should adopt a robust risk management framework, the lack of which could contribute to supervisory findings that it is engaged in unsafe banking practices. According to the US Guidance, total debt to EBITDA in loan transactions should be limited to not more than 6x. In addition, the US Guidance makes it clear that a company must be able to repay its total debt from cash on the balance sheet within five to seven years, and calculation of this debt amount may include incremental capacity and even debt baskets, notwithstanding the uncommitted nature of both those categories.
European Leveraged Lending Guidelines
The European Central Bank in May 2017 published its final Guidance on Leveraged Transactions which officially enters into force in November 2017 (the "European Guidance"). The European Guidance falls short of a full prohibition on lending to such credits but will be significant from a regulatory supervision perspective. Under the European Guidance, "significant credit institutions" in Europe may have to report exposure to certain credits with a post-financing leverage of more than 4x with additional supervisory and management responsibilities for credits with leverage of more than 6x. This is likely to have a significant impact on the bank funded portion of the European leveraged markets which may result in some bank sources of capital being displaced in favour of the unregulated market save for businesses where significant revolving facilities are needed for working capital where leverage limits are likely to fall.
Direct Lending and the Success of Unitranche Financing in Europe
Increased capital requirements, intensified regulatory scrutiny and tightening lending restrictions following the financial crisis have created a trend towards a reduction in traditional bank lending globally. Alternative lenders are increasingly taking the opportunity to fill the funding gap with a variety of products such as senior loans, private placements, preferred equity and unitranche financings and many of them are safely entrenched in the market as sources of follow-on financing and refinancings. The European direct lending market has expanded considerably during recent years and continues to evolve.
In Europe, unitranche financings are predominantly provided by non-banks (often acting in small groups) or by larger credit funds, acting alone. The alternative lenders behind unitranche deals market the certainty of funding without flex provisions that this gives. The vast majority of unitranche financings in Europe follow a “vanilla” unitranche structure with senior banks providing the revolving credit facility on a super senior basis and credit funds providing the term debt. 2017 to date has seen a trend towards larger unitranche deal sizes and this is likely to continue although fund concentration limits are likely to limit the maximum size that a single fund will print. Above a deal size of around £500 million, the liquid markets tend to become more competitive which acts as a constraint on the maximum size that borrowers favour for unitranche deals.
Low interest rates and continued appetite for yield mean that alternative lenders have been looking to provide unitranche financings in the large corporate market in order to increase the size of their deals. In order to do this, limited partners have begun to form partnerships with funds so that they can co-invest jointly on large cap deals.
Looking at the trends in the direct lending market, it is expected that alternative lenders will try to forge alliances with private companies where there are no sponsors involved in order to fund growth. In addition, they will continue to collaborate with banks and other funds in providing unitranche financing.
Low interest rates, the overwhelming demand for yield and the flow of supply of investments for investors in the debt markets have been key features of 2017 to date and are expected to continue into the beginning of 2018. The demand/supply imbalance will inevitably help sustain the increasingly aggressive terms favouring borrowers and sponsors in leveraged deals with benefits particularly for sellers in auction deals. It will also encourage continuing convergence in Europe between high-yield bond terms and loan terms and between the US loan market and the European loan market, particularly with respect to the use of grower baskets, more flexibility around incremental debt and less de-levering of structures. Covenant-lite and covenant loose structures are further examples of that convergence and have become well-established structures in the European debt markets. It is also expected that other elements of bond documentation will increasingly filter down-market into smaller loan transactions.
Restrictions on European banks carrying out leveraged lending will provide more headway for the already growing direct lending market in Europe. It remains to be seen whether regulation of non-banks will be introduced in the near future, but in the meantime, alternative lenders continue to take every opportunity to increase their market share.
We can also expect further evolution of the European cross-border finance markets as the details of the United Kingdom’s future relationship with the European Union evolve.