How Brexit will impact leveraged loans

Author: IFLR Correspondent | Published: 23 Aug 2016
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Ronan Wicks, Shearman & Sterling

Although the UK electorate’s vote to leave the EU on June 23 2016 will have far reaching implications, the referendum result itself does not have any legal force in the short term. However, there will be changes felt in the leveraged finance market – in volumes, volatility and documentation.

While August has traditionally been a quiet month in the City, it seems that the summer slowdown may have started early this year and is set to continue into September. Some investors held back on acquisitions before the vote; some are now reviewing existing deal structures and terms following the vote; and others are taking stock of potential new targets.

The result, according to Dealogic, is that private equity investments in the UK have slumped 95% since the Brexit referendum, as buyers become more cautious over asset valuations. Seventeen deals worth $165 million were struck between June 24 and August 2, compared with 20 worth $3.27 billion in the same period last year. Across Europe too, latest data from Dealogic shows that the value of European investments has also dropped.

While lower and mid-market deals continue to be done, buyers and sellers alike are holding back on big ticket deals. It’s not just pricing affecting market activity; it will also be difficult to model the impact of Brexit on certain businesses over the next few years until the initial period of uncertainty has passed. The few success stories of this summer, however, show continuing investor appetite for certain businesses and oversubscription in financings on a number of recent deals.

The true impact of the Brexit vote on private equity activity should become apparent over the coming

months. In the medium term, this will likely give way to increased activity, given the potential for acquiring attractively priced assets, while taking advantage of foreign exchange fluctuations. In particular, increased activity with respect to bolt-on acquisitions funded from committed acquisition facilities, incremental facilities or tap issuances under existing bond indentures are expected. Anecdotally, we hear that bond markets are already picking up.

Financial market volatility

The Brexit vote caused some initial volatility in the financial markets and the outlook for the short to medium term is still unclear. There will likely be implications for the cost of sterling borrowing and foreign exchange hedging as well as an impact on earnings, revenues  and balance sheets of international businesses.

This may lead to both a practical and a documentary impact on existing and future financing agreements. For example, provisions relating to the foreign exchange rate used for financial covenant calculations and the revaluation of certain facilities (such as letter of credit facilities denominated in non-sterling currencies) may need to be reviewed to mitigate exchange rate volatility. Further consideration should also be given to baskets denominated in a currency that may not be aligned with the underlying permitted activities.

Material adverse change

The specific wording of each financing agreement must be reviewed and applied on a case-by-case basis. Generally, we would not expect Brexit to trigger a material adverse change provision in financing agreements. This concept is not usually linked to the financial markets or political developments but, instead, to the business of the borrower and its ability to meet its financial commitments. As such, borrowers in industries highly regulated by the EU may be more sensitive to the effects of the EU and the UK not agreeing to favourable exit arrangements going forward. In such situations, we may see new provisions tailored for Brexit in financing arrangements (including with respect to flex items).

Tax

As has been noted widely, direct taxation is not generally an EU competence. Given this limited remit and the UK’s existing bilateral tax treaties with all of the other member states of the EU, we do not expect material changes to the withholding tax position on leveraged finance or to the tax provisions contained in financing agreements as a result of the Brexit vote or Brexit itself, particularly in relation to UK borrowers.

These points will need to be reviewed, however, where domestic rules relied on by an EU borrower for exemption from withholding tax on interest are dependent on the lender being resident in an EU/EEA jurisdiction. In such a case, exemption could cease to apply to payments made to a UK lender following Brexit (unless the relevant bilateral tax treaty provides for similar relief). While this is likely to be the exception rather than the rule, a potential example is the recently introduced specific exemption from Italian withholding for certain categories of loans made by an EU resident lender to an Italian borrower.

Brexit may, however, have a greater impact on the way leveraged loan deals are structured within the

borrower group. EU directives which limit withholding tax on certain categories of intra-group payments may cease to apply following Brexit. This could impact dividends received by a UK parent company from certain EU subsidiaries, dividends received by an EU parent company from a UK subsidiary and interest on intragroup loans between UK companies and certain EU affiliates, unless a similar exemption is provided under the domestic law of the EU counterparty jurisdiction or its bilateral tax treaty with the UK. This may require borrowers to rethink the way they structure their intra-group funding and how they service their debt.

Governing law and jurisdiction

Investors are expected to continue to favour London for its sophisticated market infrastructure and capacity for both complex and large volume capital raising, in addition to its nexus with English law as the preferred choice of law for borrowers and lenders alike.

English law is one of the most popular choices of law for financing contracts due to its long-standing history and reputation for predictability and reliability. English courts have been similarly favoured for their consistency, independence, expertise, commerciality and relative efficiency. Although relevant EU laws such as the Rome I Regulation (which governs the recognition of parties’ choice of law) will no longer apply to the UK following Brexit, it is unlikely that the English courts will depart from their long-standing position of giving effect to contracting parties’ choice of governing law. Other EU member states bound by the Rome I Regulation will also continue to recognise parties’ choice of English law.


"Definitions relating to permitted acquisitions, permitted joint ventures and cash equivalent investments...may now need to be reviewed."


The recognition of the jurisdiction of English courts and the enforceability of English court judgments in other EU member states are currently subject to the recast Brussels Regulation, which will not apply to the UK following Brexit. However, whilst there are a number of possibilities as to how jurisdiction and enforcement of judgments may be regulated post-Brexit, we do not believe that the recognition of the jurisdiction of English courts, or the enforceability of their judgments in the EU, will be substantially compromised. The worst case scenario for the recognition of English courts’ jurisdiction in the EU would be that such recognition was not governed by any international treaty or convention. As a practical comparison, if this were to occur, then English judgments would have the same status in the EU as those of the New York courts—where a lack of recognition by treaty has not proved to be a barrier to European companies tapping the New York law term loan B and high-yield bond markets for their capital needs.

Documentation impact

Brexit will necessitate certain technical changes to financing documentation as customary formulations of certain provisions include references to specific EU legislation. For example, the representation given by each obligor on its centre of main interest and the provisions relating to the selection of auditors, sanctions and increased costs typically include references to EU legislation.

Similarly, the definitions relating to permitted acquisitions, permitted joint ventures and cash equivalent investments also often include references to the EU and to EU member states, which may now need to be reviewed.

To address any potential passporting issues, it is likely that banks with non-UK lending entities which are authorised to lend to borrowers in the EU will look to include flexibility to designate affiliates to act as lenders of particular loans. As noted above, many lenders already originate loans through non-UK entities and would therefore expect to be able to do this with minimal operational disruption.

Provisions regarding illegality, increased costs and the so-called"bail-in clauses relating to the EU’s Bank Recovery and Resolution Directive will also need to be tailored to the UK’s model for its interaction with the EU going forward.

Passporting Implications

A number of EU jurisdictions, including France, ordinarily require banks to be licensed in their jurisdiction in order to lend to corporate borrowers there. Currently, UK banks are exempted from these local licensing requirements as a result of their being authorised by the UK’s own regulators, together with the well-known passporting rights available to EEA credit institutions.

Depending on the outcome of the UK’s exit negotiations, UK banks may lose these rights upon Brexit taking effect. However, many lenders already originate loans through non-UK entities, including Irish and Luxembourg domiciled affiliates, for unrelated reasons and we can expect to see this trend continue wherever possible under applicable regulatory and tax regimes.

Alternative lending structures may also be used in certain circumstances and jurisdictions in order to enable entities which do not have a banking licence to enter into lending transactions. In other EU jurisdictions, for instance Spain and Luxembourg, a local licence is not required to engage in lending activity and so the loss of passporting rights should not impact the ability of UK banks to lend to companies in those jurisdictions.

Ronan Wicks, head of Shearman & Sterling's European finance practice

 


 

 

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