An all-American comeback?

Author: | Published: 1 Oct 2013
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Douglas Buffone, director and counsel at Credit Suisse, outlines how the global hunt for yield is impacting US leveraged and acquisition financing

Year-to-date US leveraged loan volumes total $445 billion, up from $270 billion at this time last year.

It's thanks primarily to heavy demand from institutional loan buyers, such as credit funds, pensions, endowments and collaterised loan obligations (CLOs), for higher-yielding floating-rate investments.

Credit Suisse's Douglas Buffone explores how sustainable the market rebound is and explains how demand from yield-hungry investors is affecting US leveraged and acquisition financing.

Unlike most years, the US leveraged loan market did not see a big summer slowdown this year, as US issuers took advantage of declining yields and high levels of demand. To what extent do you expect this rebound to continue and how is it impacting transaction structure?

In previous years, summer slowdowns have been driven by developments in external markets, such as the European debt crisis. But this year there were no big outside shocks to the system. That said, there is some uncertainty as we go into an increasing interest rate environment.

"It’s vital that we establish the rules of the game for all parties"

Over the past 18 months low interest rates have driven down yields, and prompted investors to flock to the high yield bond and leveraged loan markets. There was a similar flood of money into the system during the last strong cycle of 2005-2007. Back then money flows were primarily concentrated around the large numbers of newly created collaterised loan obligations (CLOs). Today, however, we're seeing increasing activity from a number of different classes of investor, not just CLOs. This rapid flow of money from one asset class to another is new to this cycle. It suggests that investor appetite for leverage finance risk may not be as stable as in previous cycles.

It's hard to predict how the market will react as interest rates rise - that is the risk going forward. That said, I still think that the rest of the year will be fairly strong.

How has investors' re-emerging confidence impacted the US high yield market?

As mentioned, we're seeing more activity from a much more varied investor base than during previous cycles. That in turn is facilitating the speedy movement of resources from one asset class to another. I'm not sure if this has been driven by re-emerging confidence, or if it's just another consequence of the global hunt for yield.

Regardless, as demand increases, the pendulum swings to borrowers, and borrowers tend to push beyond the usual limits. There have been a lot more cov-lite deals this year than in previous cycles, for example, and that's primarily been a function of demand.

We're in a very borrower-friendly period and that brings with it not only cov-lite but also other loan agreement provisions favourable to borrowers, such as looser equity cure provisions, reduced excess cashflow prepayments and various other things investors may care about. And while there has been little change to date in how leveraged finance deals are getting done, we are beginning to see some innovation in the market. For example, precaps, a provision that permits a change of control under certain circumstances, are beginning to be used to some effect.

Do you expect the Dell LBO will herald a revival of big buy-outs?

In my view, that is not likely.

Certainly, it was rare to see three mega-LBOs announced in April within just a couple of weeks of each other. The Dell LBO was the first to be announced. It was followed by Liberty Global's buyout of Virgin Media and finally the Heinz LBO.

"The rapid flow of money from one asset class to another is new to this cycle"

But it's important to remember those deals were all products of unique circumstances, and their announcement in such quick succession was probably nothing more than coincidence.

The Dell buyout, for example, was helped greatly by the fact the software company's founder, Michael Dell, was behind it. There were substantial tax benefits motivating the Liberty Global/Virgin Media transaction, and the Heinz deal was driven by Berkshire Hathaway's long-standing interest in the food company. Each deal was therefore motivated by very specific circumstances.

Undoubtedly their announcement proved it's possible to get a big deal done, but I don't think we are going to see a series of them. It's telling that, until recently, there have been no mega-LBOs announced since, even though the market has been strong in the intervening period.

I'm confident we will continue to see buyouts announced, such as BMC Software and Neiman Marcus, but I don't see a flood of mega-deals of the size common in the 2007 cycle on the horizon.

I also expect more acquisitions will be structured as tender offers following the recent change in Delaware law, which dropped the percentage of shares needed to approve a short-form merger from 90% to 50%, under certain circumstances.

That said, I'm not sure we've gone through the complete legal analysis to date to get banks comfortable with committing to more tender offers on this basis. Certainly from a legal perspective, we would want to make sure all the right boxes are checked. After all, a tender offer is usually more complicated than a more traditional merger structure. Such transactions require compliance with both the Federal Reserve and New York Stock Exchange (NYSE) margin rules, for example. In the latter, there are certain restrictions on participating margin loans out to other lenders; while the Fed requires institutional lenders to register if they purchase margin loans – a factor which could impact banks' syndication strategies if lenders are unwilling to cooperate. I don't think we've explored the legal implications of this rule change in enough detail as yet.

The 'cashless roll' is being used with increasing frequency and transparency in US syndicated credit facilities. What are the consequences of this?This is a really big concern of mine, and something we as a bank have been on top of for some time.

We have been doing cashless rolls for several years. But the mechanism has only really gained prominence in the last six to eight months, thanks primarily to the concern of certain CLOs that they are beyond their reinvestment period and thereby are restricted from investing in new loans. Such restrictions do not apply, however, if they are simply modifying an existing loan.

"I don’t think we are anywhere near pre-crisis levels as yet"

This has prompted certain CLOs to request the ability to roll their position from an old deal to a new deal via an in-kind exchange, or 'cashless rollover', of existing term loans for new or amended term loans from the same lender to the same borrower. For years, this was a mechanism used sparingly. But in recent months we've seen cashless rolls frequently offered to all existing lenders in credit facilities being refinanced, repriced or extended.

This concerns me for three reasons.

First, it's not clear to me whether or not, in facilitating such activity, banks are enabling CLO managers to do something they are not otherwise permitted to do. After all, we have no obligation to check if such transactions meet the charter requirements of every CLO that requests this mechanism. But what if a CLO were to fail? It is possible its investors could conclude its manager did not have the authority to rollover their position and the banks that enabled it could find themselves liable. That might seem a stretch to some, but you never know what you are going to be sued for.

That said, it is simply not possible to monitor whether or not each CLO charter document permits this activity, given the number of permutations involved and frankly the banks don't want the responsibility of checking. Its permissibility is going to vary from CLO to CLO and deal to deal. It will depend too on how many different complications are incorporated in the transaction. While it might be easy to make the case that a straight repricing is essentially the same deal with a different price, that becomes harder when you're completely changing the security package from first lien to second lien, for example.

Second, US credit agreements do not contemplate cashless rolls. In a bid to address this, Credit Suisse, along with certain other large sell-side institutions, are working with the Loan Syndications and Trading Association (LSTA) to come up with new form language for our credit agreements that allows this.

I believe the LSTA is keen to ensure this mechanism is utilised in a way that protects all the parties involved. It's vital that we establish the rules of the game for all parties.

Finally, there are a number of potential tax issues relating to funds' use of this mechanism. For example, it's unclear what the tax implications are, if on the one hand a transaction is deemed a cashless roll and on the other it is a refinancing loan held by the lead arranger for several days.

Credit Suisse has dealt with these issues uniquely, in requiring those using this mechanism to sign a separate cashless roll letter that sets out the mechanics of the trade and thereby addresses the issue that the credit agreement doesn't permit this. It also asks for reps from the CLO that this complies with their charter, doesn't conflict with their organisational documentation and so on. Effectively, this acts as a release from all parties, to allow us to carry out the trade for the borrower and the lender without fear of repercussions at a later date.

I believe some banks have started to incorporate similar provisions into the actual amendment documentation. But as every amendment is going to be different, and the provision becomes redundant if a lender does not opt to use a cashless rollover, utilising a separate letter is the best approach in our view.

What other pressure points are concerning those active in the US syndicated space?

Fronting arrangements – and more specifically the length of time they last – are becoming an increasing bone of contention among agent banks.

A fronting bank within a syndication usually only takes pro rata exposure to the borrower but continues to collect interest from the borrower at the specified rate until physical assignment of all the loans has taken place. In light of that, the backstop banks to the agreement would obviously prefer for this arrangement to be as short as possible.

That has proven to be difficult recently, as more deals come to market and settlement times increase.

In order to be as transparent and as liquid as possible, the market needs for these assignments to happen more quickly. Unfortunately, however, recent deal flow and in particular the upsurge in refinancings has prompted these assignments to lengthen as arranger banks' under-resourced operations teams struggle to keep up. The implementation of longer fronting arrangements are a direct consequence of that.

"Investor appetite for leverage finance risk may not be as stable as in previous cycles"

The 'Disqualified Lender List' is a further pressure point in the market. First introduced around six years ago, this catalogue of blacklisted investors was historically not public and was limited to excluding certain distressed investors from acting as assignees on a loan. However, in recent years, borrowers have pushed the limits in not only expanding the list to include affiliates of disqualified lenders, but also in stipulating they do not want these parties as participants in the loan. What's more, in some cases, the list is no longer static. In certain credit facilities, the borrower has the right to update the list after closing. This latter point is of particular concern to lenders. All of those restrictions are difficult to police. It also requires the list to be readily available to the syndicate of lenders in each deal. Clearly, it has the potential to hinder liquidity in a deal and to disrupt trading.

Indeed, it remains unclear what happens to those trades found to involve a party on the Disqualified Lender List. For example, some borrowers have stipulated a trade becomes void if it is found to include disqualified lenders. That's all well and good, but what happens if the disqualified entity has sold the loan prior to being identified? Who then owns the loan?

The LSTA is working to address these issues by driving the implementation of a market standard approach. It's certainly helpful to have them involved. But as borrowers are not well represented in the Association, it's hard to say how quickly this issue will resolve itself.

How has EU sponsors' increasing use of US loans to fund EU acquisitions affected US loan documentation?

The US loan market is more open than its European counterpart, and that has prompted a spate of US-financed European acquisitions. There's a whole host of issues arising as these two worlds collide. These include legal, tax, and operational matters.

There are certain provisions within the EU M&A model that are not found in its US equivalent, for instance, and vice versa. The European 'certain funds' concept is a good example here. Derived from the application of the UK Takeover Code in respect of UK public M&A transactions, it aims to ensure that the selling shareholders of listed companies have limited risk as to whether they will receive payment for their shares. It is not a provision US market participants are familiar with.

The US Xerox provision is a further example. Named after their use in the 2009 agreement for Xerox's acquisition of Affiliated Computer Services, these provisions make clear that the buyer's payment of the reverse break-up fee not only limits any further remedies of the seller against the buyer and its affiliates, but against the lenders as well. It is rare to see the concept implemented in European transactions.

Even so, I expect these deals will continue to get done and as more European deals are financed through the US, we should see a corresponding rise in each market's understanding of the other's idiosyncrasies. Efforts to accommodate these via hybrid EU and US-style loan documentation may well follow.

Indeed, this is already something we're seeing in the market. Going forward, it is likely to play out on a transaction-by-transaction basis.

The rapid increase in loan issuance levels, especially covenant-lite loans, and more aggressive tone in the market over the last year have some concerned the US loan market is rapidly returning to the pre-crisis time period. How warranted are these concerns?

Certainly, leverage levels have crept up and equity checks have continually migrated down. Even so, I am not overly concerned. I don't think we are anywhere near where we were pre-crisis.

Leverage levels have yet to reach the same level, and equity checks have generally not slipped below 20% – those are some of the factors that we look at. Average deal size is also not as big as it was. What's more we're not seeing a spate of mega-LBOs, or at least not to the level that was common in 2007.

We also pay close attention to how long our commitments stay outstanding, how quickly we can syndicate deals and how much flex we have. Undoubtedly the market has learned its lessons in terms of mistakes made by arrangers in previous cycles.

Of course, we are in a borrower-friendly environment so we are seeing more aggressive terms, and there are certainly a lot more cov-lite deals coming to market. However, cov-lite deals have historically outperformed covenant-heavy transactions, so there's an argument that concerns about cov-lite are in part misplaced. That said, there is a risk that the more cov-lite deals come to market the more opportunity there is for poor credits to finance via this route. That could prompt a slew of cov-lite deals to fail in the next cycle, and thereby produce worse returns on loans.

Undoubtedly, the market is more aggressive than it was two to three years ago, but I don't think we are at or near pre-crisis levels as yet.

How do you expect Basel III implementation and the US QE taper to affect the US's leveraged and acquisition financing markets?

The QE taper is not going to be good for the leveraged and acquisition finance markets, although recent Fed statements suggest tapering will not begin as early as previously indicated. But equally it is something that is going to affect the entire banking sector.

I expect Basel III will have a more nuanced impact on leveraged and acquisition funding.

As Credit Suisse is already a Basel III-complaint bank, its implementation is not going to impact us as significantly as some of our competitors. But for those US banks that are not even Basel II-compliant, the shift to get up to speed with Basel III requirements will prove immensely challenging. It will impact how they do deals, and the types of deals that they are willing to underwrite.

About the author

Douglas Buffone
Director and counsel, Credit Suisse
New York, US

Based in New York, Douglas Buffone is a director and counsel in the legal and compliance department of Credit Suisse, supporting their credit products, leveraged finance, corporate lending, portfolio management and global recovery management groups.

Prior to joining Credit Suisse, Buffone was an associate with Shearman & Sterling where he specialised in leveraged bank finance, structured finance and securitisation transactions. He received a joint JD/MBA degree from Hofstra University.

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