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: October 08, 2019
This year, 2019, has been a mixed one for the European financing markets, amid uncertainty around the general European economic outlook. In the European leveraged loan market, volumes of loans and high-yield bond issuances have been down approximately 50% from equivalent periods in 2018, largely driven by a reduction in M&A activity, with a high proportion of remaining activity being attributed to non-acquisition related supply including refinancings and recapitalisations.
The softer market conditions have consequentially led to (somewhat) less aggressive terms as investors push back and there has been increased use of market flex. The general outlook, however, remains relatively positive – 2017 and 2018 were record years, and while the market in 2019 has dropped from this peak it still remains stronger than the years leading up to 2017 and investors seem optimistic about pipeline.
While European banking and finance is, of course, not all about leveraged finance, the leveraged finance market nonetheless remains the most dynamic part of the banking market, with a number of different recognisable themes and trends, as noted below.
The Continued Rise of “Covenant-lite” Loans and Associated Convergence of Terms
Covenant-lite loans were, not so many years ago, a common feature in the US leveraged finance market but not in Europe. This has clearly changed significantly in recent years, with the percentage of loans in the European leveraged finance market that are covenant-lite now exceeding 85% – in fact, they now constitute a higher proportion of the European leveraged finance market than the equivalent proportion of the US leveraged finance market. This has been driven by several factors.
First, the institutional investor base (and demand for floating rate yield) has deepened, and their portfolio approach to investing in loans has resulted in a “capital markets” approach to the origination and distribution of term loans. Investors in European term loans hold both cross-border term loans (with terms and conditions that reflect market practice in the USA) and high-yield bonds. Together, these three types of instruments comprise the universe of financing options available to private equity sponsors raising debt in Europe and the USA. Second, an increasing number of private equity firms and their legal counsel drive the financing process extremely competitively with a view to getting to the same substantive result on documentary terms for any given portfolio company or acquisition financing. Third, there are a larger number of players competing for arranging and underwriting roles on European deals; as such, the European banks tend to be less co-ordinated than their counterparts in the USA in “holding the line” in negotiations with sponsors around documentary points.
All of this, in turn, has resulted in increasingly attractive terms for borrowers and further convergence in terms of European term loans, US term loans and high-yield bonds, to a point where the position in European term loans for top-tier PE-sponsored deals is no longer (or at least not appreciably) “more conservative” than US term loans or high-yield bonds – and, in certain areas (for some sponsors), has even overtaken the US market.
In addition, although investors in European term loans have in 2019 been pushing back, via use of market flex in syndication, on particularly aggressive terms – notably in areas such as uncapped EBITDA adjustments, ability to make restricted payments or repay junior debt, step-downs for required prepayments of asset sale proceeds, portability, and “MFN” sunsets and carve-outs – the overall terms for the transaction as a whole have not been tightened in any meaningful way.
Capital Structure Options and Flexibility
High-yield bonds remain a key component of the market in 2019. Regardless of how deals ultimately get done, a very substantial portion of large new deals now look from the outset to both an “all loan” (ie, senior and second lien loans) or a “bank/bond” (ie, senior secured loans and high-yield bonds, which can be senior secured or junior/unsecured) capital structure (with the decision made at a later stage).
Furthermore, whatever day-one capital structure is ultimately chosen, the documentary architecture will permit sponsors/borrowers to plug in different types of debt going forward (without amendments required to the existing documentation, in particular the intercreditor arrangements). As a result, a credit that may today be a “loan only” issuer in the market could subsequently be both a loan and bond issuer or only a bond issuer, and vice versa. This is a further reason for convergence across terms and conditions, aimed at ensuring the sponsor does not end up with materially different terms and conditions solely due to the choice over time as to the type of instrument (ie, loan – whether European or US – or high-yield bond).
Cross-border products in both directions (ie, where loans are issued by European borrowers into the US institutional market and where loans are issued by US borrowers into the European institutional market) are a continued feature in 2019. The depth of the US leveraged finance market and the strength of demand from investors in it remains an attractive source of capital to European borrowers.
As discussed above, the convergence of terms across products has meant that European institutional investors have become familiar with US-style loan and bond covenant packages, making it easier for US borrowers to tap into the European institutional market. In the case of such cross-border loans issued into the US market, the documentary terms and conditions tend to be almost entirely reflective of the terms of the domestic US leveraged finance market (governed by New York law), but with certain modifications made to deal with the underlying difference in corporate structure and legal regimes. In the case of cross-border loans issued into the European market, the documentary terms and conditions will either be reflective of the US market (with amendments as described previously) or of the European market, and European investors seem comfortable with either New York or English law-governed documents (aided, as already discussed, by the convergence of terms across these instruments).
Finally, while the convergence of terms has generally involved the US term loan market influencing European term loans, the rise in cross-border transactions has, interestingly, also led to some European terms being adopted in the US market. These include margin-based (not yield-based) MFN protection and certain looser provisions in respect of financial covenant equity cure mechanics.
Transformation of the Direct Lending Market
In recent years there has been a rise in the provision of financing by private credit funds on a bilateral or club basis, as an alternative to the bank/term loan and high-yield bond products. Credit funds increasingly compete with banks to underwrite deals directly, whether in full or together with another credit fund, and whether for the entire capital structure or part (eg, privately placed second lien/junior debt). This rise in terms of growth of deal flow has slowed to some extent in 2019 as the market has matured, but direct lenders continue to target deals and, in particular, to raise funds that need to be deployed. Deloitte has reported that a record USD16.9 billion has been raised in the first quarter of 2019 alone, compared to USD7.9 billion in the same quarter last year.
As a consequence, direct lenders are more willing than ever to finance larger deals and to compete with underwriting banks on documentary terms. This means that, while in previous years the terms of the deals done by such funds were much more conservative than the alternative financing sources available to private equity firms and companies in Europe – and were generally utilised in the small or mid-cap transactions – in 2019 the terms and conditions executed on such transactions moved closer in a meaningful way to the terms in the large cap syndicated or even high-yield bond markets, and have been deployed on larger cap transactions. In (admittedly rarer) cases direct lenders have been seen to review terms for an existing (already committed) underwritten syndicated bank deal or high-yield bond deal and agree to provide financing on exactly equivalent terms via a bilateral loan.
Generally, on the whole, some meaningful differences do remain, given the difference in underlying investment philosophy between such credit funds (who take and hold the relevant credit) on the one hand and underwriting/arranging banks (who syndicate to institutional/CLO investors) on the other. In particular, the direct lenders remain more focused on the integrity of the capital structure and generally require a financial covenant to be included. This means that this is not a homogenous market. However, the factors mentioned above, combined with the philosophy of the sponsors and their legal counsel (as to desiring to achieve the same documentary terms for all their portfolio companies, regardless of the size of the transaction or the type of debt product issued) is narrowing the gap.
Increase in Corporate Lending
There has been an evident growth in corporate borrowers in the leveraged loan space in 2019. While corporate borrowers in this area have been common in the USA, they were previously rare in Europe where the leveraged market tends to be sponsor-driven. Recent reports have, however, indicated that the number of corporate borrowers in the European leveraged loan market has been growing, as the corporate borrowers turn away from traditional local bank-lending relationships and seek greater flexibility from other funding sources – in particular, raising long-term debt that does not have financial covenants.
This year, 2019, has been an exciting one for European leveraged finance due to a number of inter-related factors as described above – ie, convergence, cross-border deals, substantial shifts in approach to direct lending transactions, the increase in corporate lending, etc. Despite a reduction in European deal volumes, borrowers (influenced by the US leveraged finance market) have continued to seek the most aggressive documentary terms and large sponsors continue to gain the most flexible terms. Investor push-back, aided by services such as “covenant review”, is slowly increasing but has yet to significantly tighten transactions as a whole.
The impact of Brexit and other European economic uncertainties remain to be seen, but it is clear that when the next default cycle comes (whenever that may be) the European market has been set up for some interesting restructurings. The lack of maintenance covenants as an early warning system, combined with the significant flexibility of incurrence-based high-yield bond-style covenants to incur other debt and effect other significant transactions, together with greater borrower control over transferability of loans seem almost certain to provide for different outcomes – and different opportunities – next time around.