The UK leveraged lending market is receiving a big boost from debt funds providing competition that is also driving improvements in banks. But this progress could be derailed by Brexit if a passporting arrangement is not made.
The growing number of debt funds coming to market is providing borrowers with an attractive alternative to banks, given that they tend to be more flexible and provide more favourable terms. Private debt fundraising reached $100 billion for the first time ever last year and average fund size grew to $1 billion, more than double the average size for the previous year ($478 million). Ares’ $3.4 billion direct lending fund and KKR’s $2.4 billion global credit fund are just two of the mammoth funds to close in the last 10 months.
Because private equity firms are focused almost entirely on returns, they are more willing to provide favourable terms to lenders. This is helped in part by the lack of regulation in what is a historically unregulated sector. IFLR reported last month that the European Central Bank is planning to limit gearing in excess of six times Ebitda, in an attempt to reduce the average leverage levels and bring them in line with the US – a jurisdiction that has warned against gearing exceeding the same level. But this is only guidance and it’s been reported that private equity firms aren’t complying in practice.
Dentons partner Lee Federman said that the growth of private debt funds is forcing banks to adapt so that they can compete.
“We are seeing some borrowers achieve incredibly favourable loan terms even in these uncertain times,” he said. “Banks need to remain competitive, particularly as the debt funds and other alternate capital providers look to increase market share”.
Another potential threat to banks’ future success is Brexit, an economic uncertainty that may harm a borrower's financial health and make a breach of covenant or other default under their loan documentation more likely. The UK’s likely departure from the single market could lead to contract rights for loans being unenforceable if there is no passporting arrangement with the EU. However the Rome I regulation allows a party to choose a governing law where it is comfortable and familiar, a big move towards a European-wide private law. But whether the regulation will apply after Brexit remains to be seen.
KEY TAKEAWAYS
The growth of private debt funds is forcing banks to provide more favourable terms to lenders;
Brexit could mean some loan contracts are unenforceable. LMA managing director Nick Voisey is urging the government to ensure existing loan contracts are grandfathered into law if no passporting arrangement is found;
Brexit has yet to impact the market as of yet and there is an expectation that volumes will pick up in 2019 and 2021.
Federman said clients are continuing to choose English law to govern their loan agreements and while a limited number of bankers have been relocated to Ireland, Luxembourg and Germany, this is unlikely to risk London’s status as the financial centre of Europe. However, the business community’s collective calls for certainty are growing ever louder.
Nick Voisey, managing director at the Loan Markets Association, says it is crucial that some clarity is offered so the loans market can remain efficient.
“It is unclear whether after Brexit you could enforce contract rights for loans,” he said. “Without a passporting arrangement with the EU, the UK would have to fall back on prior bilateral conventions with individual countries”.
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"Banks need to remain competitive, particularly as the debt funds and other alternate capital providers look to increase market share" |
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A hard Brexit could invalidate cross-border loan contracts if one of the contracting parties is not EU regulated. UK Finance and the Associated Financial Markets in Europe recently provided a hypothetical example of a company, named Europa, based in a EU27 member state that entered into a five-year US denominated revolving credit agreement with a UK-based bank. If the UK leaves the EU without a transitional agreement, the relationship will be governed partly by EU regulations and the EU licensing regime where Europa is based, but these regimes differ widely across the continent. If Europa wants to alter its revolving credit facility, in certain member states there is no exemption to conduct regulated activities with certain types of customers. Therefore if it legally cannot continue to contract with the UK-based bank, Europa faces a time-consuming and expensive restructuring process. Voisey urged the government to ensure that existing contracts are grandfathered into new law after Brexit to avoid circumstances of this type arising.
Ashurst partner Rob Aird however says that many institutions are less worried about grandfathering after Brexit now.
“They are growing more comfortable that the majority of their decisions and actions currently will be accepted,” he said. Nevertheless, some EU jurisdictions are extremely difficult to deal with as a third country. Aird said that some may move existing business units to their European bases, which would help to alleviate any of the potential challenges that may arise.
Because the UK domestic market structure is highly regulated, structured finance divisions are most likely to be relocated back into the EU. Commercial lending is not highly regulated and as a result, these are unlikely to be relocated out of the UK.
Ashurst corporate lending strategy director Dave Rome said that the Brexit instability has not dampened leveraged finance, even though corporate lending has fallen slightly. Across Europe, the Middle East and Africa, leveraged financing reached $166 billion last year, more than double the previous year’s total and higher than at any point since the financial crisis. Rome anticipates an increase in refinancing volumes in the latter part of this year and a further pick up in 2019 and 2021, regardless of Brexit.
“Most banks have an operation in Europe already or are in the process of setting one up”, he said. “If they have to, then they can lend out of that EU-domiciled operation so it’s hard to see it affecting liquidity in the market.”
There are a number of challenges confronting the UK loans market currently and how it performs may mainly depend on the UK government’s actions in Brussels. But before Brexit, greater competition in the market from private debt funds will undoubtedly benefit lenders. Banks need to adapt quickly to keep up.
See also
Brexit could change century-old UK insolvency rule
The UK and the single market: options available