The Banking and Finance Landscape in Germany
After a year of COVID-19 pandemic lockdowns and uncertainties, the German lending market in 2021 has been slowly transitioning back to pre-pandemic conditions. Equity investors and lenders regained confidence in valuating businesses, resulting in a healthy M&A pipeline and attractive financing terms. At the same time, many businesses were still struggling with the consequences of lockdowns and other restrictions, and the focus on securing sufficient liquidity and covenant headroom continued for many borrowers. So, if one wanted to describe the lending market in 2021 with a short and catchy phrase, "mixed bag" would hit the spot.
On one side of the spectrum, avoiding insolvency continued to be the top priority for many businesses, particularly those active in the leisure and travel industries and similar businesses.
In light of the fact that Germany has a very strict insolvency regime, the German legislator reacted quickly at the beginning of the COVID-19 pandemic and comprehensively modified the German insolvency regime with a view to preventing insolvencies of companies that encountered financial difficulties as a result of the COVID-19 pandemic. These modifications addressed nearly all insolvency-related obligations and restrictions which typically apply to insolvent companies, their directors and their creditors and which would usually frustrate the affected companies’ going concern status and their ability to continue trading, including a suspension of directors’ insolvency filing obligation and a lifting of the restrictions for new third-party and shareholder financings.
While these measures provided a significant relief during the early and middle stages of the COVID-19 pandemic for many companies during the COVID-19 pandemic, they gradually expired alongside the further development of the state-aid programmes, the economic recovery in many sectors and increasing concerns about the macro-economic effects of further delaying inevitable insolvencies. The modified regime ceased to apply from October 2020 onwards to companies which became illiquid and continued to apply in relation to companies which became over-indebted without at the same time being illiquid until end of December 2020. Only those companies which applied for, or were, for legal or factual reasons, prevented from applying for, the so-called November and December support programmes continued to benefit from the modified regime, but only until the end of April 2021. The support programmes were introduced to provide liquidity support to businesses affected by the lockdowns imposed from November 2020 onwards.
Despite the strict German insolvency filing regime being fully applicable once more, insolvencies remain at remarkably low levels. This is not only due to a strong economic recovery and healthy business models, but also to the continued availability of equity and debt financing sources indicating the investors’ confidence in the sustainability of the economic recovery.
New Pre-insolvency Restructuring Tool
While being required to introduce a pre-insolvency restructuring regime as a matter of EU law on the one hand and recognising the need for a pre-insolvency restructuring regime in light of the economic distortions caused by the COVID-19 pandemic on the other hand, the German legislator has finally introduced the long-awaited new German scheme at the beginning of January 2021.
The availability of this new German scheme significantly changes the German restructuring landscape and elevates it to an internationally competitive level as it closes the gap between fully consensual out-of-court restructurings and in-court restructurings by providing a pre-insolvency restructuring instrument which allows for a cram-down of hold-out creditors and shareholders. Especially over-leveraged debtors which require a restructuring of their capital structure, but which are at the same time able to continue their business operations in an ordinary manner may make use of this new restructuring tool.
So far, the German scheme is still widely untested for complex large cap and mid cap restructurings and has only been used for a few rather small and straight-forward restructuring transactions. However, it is already visible that its mere availability has a disciplinary effect on potential holdouts and facilitates fully consensual solutions.
At the start of 2020, the German government was also quick to respond to the liquidity needs of the economy and offered COVID-affected businesses, inter alia, subsidised loans through state-owned bank KfW. Two main programmes were used: first, the entrepreneurial loan programme (Unternehmerkredit) with the programme No 037, a long-standing loan programme by KfW which was extended to cover COVID-affected businesses. Second, the programme for direct participation in syndicated financing facilities (Direktbeteiligung für Konsortialfinanzierung) with No 855. This new programme was specifically designed to support larger companies with new syndicated loan facilities or an additional tranche in existing syndicated loan facilities. For more details on both programmes, please see last year's Trends and Developments article on the German loan market.
Both programmes remain open for the time being, with no specific limit on the aggregate amount to be lent by KfW, and though the number of new applications for new loans decreased considerably, borrowers still make use of the KfW-programmes where commercial lenders are unwilling to support their businesses with stable liquidity at affordable terms.
Trends in early 2021
It was heartening to see that in early 2021, on the basis of solid results for the financial year 2020, many borrowers were confident enough to cancel undrawn credit lines under the KfW-programmes or were even in a position to prepay KfW-loans, thereby returning to the non-subsidised capital market as their only source of debt capital. While cancelling of undrawn lines is a simple exercise, repaying drawn KfW-loans can be more of a challenge. The loans under the No 855 programme were mostly priced with a floating interest rate in line with the existing syndicated loans in which the KfW-tranche was integrated. A floating rate interest loan can be repaid at the end of each interest period (commonly with a duration of one to six months) without any break costs, and even repaying during a running interest period is possible under most loan agreements with only low break costs in relation to the remainder of the interest period. Repaying a No 037 programme loan, however, is quite different.
The entrepreneurial loans under the Unternehmerkredit-programme were granted with standardised pricing of around 2% fixed interest per annum and tenors between two and six years. Under German law, the borrower does not have the right to cancel and prepay fixed rate loans (save for a statutory termination right ten years after first drawdown). So unless an early repayment was agreed upon and reflected in the loan agreement documenting the No 037 loan, borrowers must obtain the consent of the lending commercial banks (and, indirectly, of KfW as the provider of 80% of the respective loan funds) to an early repayment. The early repayment will mostly come at a hefty price – break costs will fall due for the remainder of the loan's tenor, and given the current interest environment, such break costs can be considerable. There is anecdotal evidence that KfW may be amenable to waiving break costs on its part of the funding but in the absence of such a waiver, the borrower is stuck between a rock and a hard place: either pay break costs, thereby straining liquidity and potentially jeopardizing the early stage recovery of the business, or keep the KfW-loan in place and continue to comply with the restrictions in the loan documentation, most importantly on dividends to shareholders and sometimes acquisitions. It remains to be seen if KfW will indeed grant partial or full waivers of break costs on its funding.
Where conditions became even more dire for a business, which was the case in numerous businesses in the leisure and travel industries, applying for financial support from the Economic Stabilisation Fund was often the measure of last resort. The so-called Economic Stabilisation Fund was established by the German government to stabilise the economy in response to the COVID-19 pandemic. The Economic Stabilisation Fund can support businesses from all sectors in the real economy with a view to strengthening their capital base and tackling liquidity shortages.
The support is made available by means of federal guarantees for borrowed capital and/or recapitalisation measures with a view to strengthening equity in the form of equity injections through silent partnerships and subordinated loans. Especially companies lacking sufficient senior debt capacity turned to the Economic Stabilisation Fund for financial support as the fund is able to provide financial support also by means of equity investments and subordinated debt, thereby allowing a recapitalization and access to additional liquidity without increasing the senior debt burden.
Covenant Waivers and the Return to Covenant Protection
In 2020, with the lockdown measures taking their toll on public and economic life, the operating performance of German businesses had been adversely impacted with only few exceptions, namely businesses selling sanitary products, IT infrastructure for home office application and other products and services that were in high demand as a consequence of the pandemic. EBITDA (earnings before interest, tax, depreciation and amortisation), as the key metric for measuring operating performance and testing financial covenants, went down considerably for many borrowers, in particular in industries depending on travel, leisure and public life in general. Thereby, net leverage, the most common financial covenant in corporate and leveraged lending, was often sent skyward.
Businesses with maintenance financial covenants, tested mostly on a quarterly, sometimes half-yearly basis, were quick to react and negotiated covenant relaxations in various forms. Lenders were often willing to grant such waivers. In some cases, covenant levels just needed to be increased to grant more headroom for underperformance. Where the leverage trajectory was forecast to be steeper, the leverage covenant was suspended for a few quarters, mostly until early or mid-2021, accompanied by a minimum liquidity covenant.
At the time of writing, many of the temporary covenant relaxations have come, or are about to come, to an end. In many cases there were further extensions of the COVID-19 arrangements due to the fact that with the third and fourth quarter in 2020 still heavily impacted by lock-downs and similar restrictions, the LTM (last twelve months) numbers which form the basis of the EBITDA calculation were still lagging behind pre-crisis levels. Some borrowers with a good recovery and positive outlook even managed to take the opportunity of covenant negotiations and agree on an extension of the loans' tenor where maturities were looming in 2022 or early 2023. Most reset leverage levels are higher than in the original agreements but are healthy enough to convince lenders to keep lending on attractive terms, though often with a slight upward adjustment of interest margin.
Adjustments, or more traditionally "add-backs", to the consolidated EBITDA of borrowing groups remain a focal point of the parties' attention. Already in the quarterly financial statements for the first quarter of 2020, sponsors and corporates started making COVID-19-related adjustments to their quarterly results by qualifying the consequences of the pandemic as so-called "Exceptional Items". These are certain items of an "exceptional, one off, unusual, non-recurring or extraordinary" nature which are not to be taken into account when calculating EBITDA. This was met with scrutiny by lenders, and the proper construction of the financial definitions in facilities agreements became a point of intense discussion. Lenders did not resist COVID-adjustments as a matter of principle, but, in line with past practice in comparable situations (the financial crisis after the Lehman insolvency, flight curfews, etc), were unwilling to accept lost revenue as an adjustable exceptional item in the EBITDA calculation.
The views on this were quite controversial. On the one hand, some sponsors took the view that the effects of the pandemic are clearly exceptional and can, as such, be normalised in any EBITDA calculation. On the other hand, concerned lenders feared businesses could sail through their covenant testing despite being badly hit by the COVID-19 crisis, leaving lenders on the side-line hoping that the business would not run out of cash.
For many, the match between borrowers and lenders ended in a draw: The borrowers and sponsors pushed their point and in some case simply normalised lost revenue, at least in parts, whilst lenders mostly held the line and did not accept pure lost revenue adjustments, but softened their stance with an accommodating approach towards specific items of adjustments (in particular, cost items). Moreover, where a covenant suspension or temporary adjustment was agreed, the exceptional item-discussion quickly became redundant and borrowers were able to turn their attention back to their operative business rather than lender negotiations.
Private debt lenders
Many market participants were curious to see how private debt lenders would react in a crisis as compared to the more traditional bank lender clubs. Would negotiations with private debt funds be tougher for borrowers, given the predominance of just one lender? Experience shows all lender classes reacted very rationally and commercially.
Private debt lenders played their strength and often obtained necessary credit approvals within days of being informed of adverse COVID 19-consequences, showcasing their agility and reliability. But also bank lender clubs and syndicates were generally very responsive and accommodating, and with only majority lenders' consent being required under the loan documentation for most covenant waivers, there were not many stand-off situations caused by dissenting lenders.
One mega-trend is, of course, the rise of ESG (environmental, social and governance) and similar financings. There has been a steady increase in green loans and/or bonds (ie, loans/bonds aiming to promote the application of funds by a borrower (solely) towards "green" projects) and of "sustainability linked loans", incentivising the borrower to achieve predetermined sustainability KPIs (key performance indicators, measured against performance indicators as reported by the company or with external ratings) by an additional margin ratchet.
Although there is no established market standard documentation for such financings yet, a high percentage of new debt capital transactions now features a green/ESG-component. Even in leveraged buy-out financing facilities, parties start structuring green/ESG-features into the documentation. Given that it is very difficult for the acquiror to set KPIs for the business prior to closing of the acquisition, the parties often only agree on the general goal-posts for a green/ESG-ratchet and negotiate the exact KPIs, the respective reporting and testing at a later stage, often around the time of the first financial covenant testing (ie, between two and three full financial quarters after the closing) when the acquiror had sufficient time to take control of the business and work with the management on identifying suitable green/ESG-targets.
New Deal Activity
Fortunately, despite ongoing lockdowns and other COVID 19-related restrictions, the market came back fairly strong in the second half of 2020 and continues to be buoyant to this day. Lenders were offering debt capital at attractive terms both in general lending and in acquisition finance. On the M&A-side, competition for attractive assets is fierce, and in many cases, buyers win auctions by aggressive pre-emptive bids, often all-equity financed.
In private debt financings, there were a number of new developments. First of all, it seems that private debt is coming of age. There are many experienced debt funds by now so that sponsors are spoilt for choice. In some cases, sponsors put together unitranche clubs with a number of debt fund lenders, resembling the traditional club of lending banks. Whilst the financing process becomes more complex due to the increased number of participants, raising large facilities becomes easier, and a unitranche club forms a stronger basis for future growth financed by incremental facilities from the incumbent lenders. Banks providing the super senior revolving facilities have become more confident and often not only offer a first out term loan piece at attractive super senior pricing, but indeed require a super senior term loan tranche as a condition to their super senior revolver.
Unitranche lenders are being pushed by sponsors to provide "covenant lite" financings where there is no maintenance leverage covenant but only a springing financial covenant concept if the revolving facility is drawn by more than a certain percentage. Though some "cov lite" financings have been seen in the market, a maintenance leverage covenant with quarterly testing remains the norm, with parties' attention focused on initial covenant levels, a high flat-out level even where the business delevers, ability to lever upwards again by debt-financed add-on acquisitions, covenant resets following material acquisitions and, of course, pro forma adjustments in various shapes and forms in the covenant calculation.
The coming months will see a lot of activity, a bullish market in general and, hopefully, a healthy and sustainable recovery of the economy in general.