A great time to be a borrower
S Neal McKnight and Presley L Warner, Sullivan & Cromwell
Three underlying themes describe the current state of the international financial markets: the constrained supply of new debt; the high investor demand for debt; and an agnosticism among investors between bank debt and bond debt, leading to the convergence of pricing and terms between bank debt and bonds.
These have created an environment of tight pricing and borrower-friendly terms in the international financing markets.
Constrained supply of new debt
"There hasn't been much new supply and investors have cash they need to spend."
Tom O'Reilly, head of non-investment-grade credit for Neuberger Berman Group to the Wall Street Journal on August 8 2017.
Geopolitical uncertainty arising after the Brexit vote and the US election has helped to reduce new leveraged acquisitions and associated new debt issuances. Recent new debt issuances have resulted primarily from refinancing or re-pricing transactions, and those do not create a net increase in supply. At the same time, historically high valuations in US equity markets have been great for equity investors, but M&A activity leading to new debt issuances has reduced, as principals wait for uncertainty to resolve and for toppy valuations to be justified. These dynamics are particularly pronounced in Europe.
High investor demand for debt
High demand for debt comes from various sources.
Central banks have been buying government securities and leaving yield-starved fixed-income investors to scramble for what is left.
Institutional investors in the credit markets have proliferated as fixed income investors reach for yield in a continuing low-interest rate environment, and many new debt issuances are over-subscribed.
The increase of private credit providers willing to 'lend and hold' has further increased demand for fixed-income paper. In addition to underwriting banks sourcing financings and syndicating debt to institutional bank loan and bond investors, borrowers can approach private credit providers who will lend and hold for the long term and save borrowers from syndication and pricing risks. Private credit providers can often offer more leverage than commercial banks or underwritten financings (sometimes in connection with an equity-kicker).
Chinese outbound M&A is often financed by Chinese banks rather than international lenders. In addition, the One Belt One Road (OBOR) initiative and constraints on domestic Chinese lending are likely to increase Chinese banks' participation in the international financing markets, which will add to the players competing to invest in debt financing.
Investor agnosticism between bank and bond debt
Institutional investor agnosticism between bank loans and bonds, when combined with high demand and limited supply, is leading towards an increasing convergence of pricing and terms between bank debt and bond debt for many credits.
But this convergence leads investors to get the worst of both worlds – not the best. Borrowers get the economic benefits of bank debt (floating rate, limited call protection, limited disclosure) with the covenant structure of bond debt (incurrence covenants and related flexibility, which vastly reduces the need for waivers during the life of the instrument). Borrowers raising financing in Europe have lately been preferring loans to bonds because they get the benefit of loan pricing and flexibility with bond-like covenants.
The erosion of (or in some cases disappearance of) financial maintenance covenants is a good example of the consequences of bank/bond convergence. In the bank loan world, historically financial maintenance covenants were the key protection for banks. Financial maintenance covenants gave banks an early warning of financial difficulty and allowed banks to take control of a distressed situation before it deteriorated beyond hope.
Immediately after the financial crisis in 2008/2009, most borrowers rated below A- could expect to give two or (in Europe) three financial maintenance covenants in bank loans.
This is leading to long-term debt capital imposing far fewer constraints on borrowers than bank debt has historically
But under current market conditions, borrowers often only expect to give financial maintenance covenants in bank debt if they are syndicating to commercial banks and are rated below A-, or if they are leveraged borrowers and must have continuing bank debt in their structure. For example, banks normally provide revolving and other undrawn facilities at more competitive pricing than institutional investors, and banks will normally require a maintenance covenant for that exposure. But in such leveraged deals, the maintenance covenant is often set with high headroom and is only triggered after a certain level of drawing. Furthermore, in the US the majority of term loans issued to sub-investment grade borrowers are now covenant-lite and do not contain any financial maintenance covenants.
One of the idiosyncrasies of the effect of the proliferation of institutional investors (as opposed to traditional bank lenders) and current market conditions is that investment grade borrowers syndicating bank debt to commercial banks may have financial maintenance covenants while non-investment grade borrowers may not – i.e. lenders to the better credit have financial maintenance covenant protections while lenders to the poorer credit do not. This is a function of the investor base for leveraged borrowers (institutional investors) as compared to the investor base for investment grade borrowers (commercial banks). The tighter investment-grade pricing closes out institutional investors and brings in commercial bank lenders, but commercial bank lenders often bring financial covenants. Institutional investors rely on portfolio diversification and liquidity (and the corresponding ability to trade out of distressed positions) to manage their exposures and do not demand financial covenants. Bank lenders have historically not relied on liquidity to trade out of distressed position, hence they often have entrenched requirements for financial covenants.
Private credit providers generally take a 'lend and hold' approach, which is more consistent with a commercial bank approach, and accordingly may seek financial maintenance covenants in certain circumstances. But increasing competition between private credit providers often leads them to forego financial maintenance covenants in order to win financing mandates, or as part of the negotiations around an equity-kicker.
In addition to financial maintenance covenants, bank/bond convergence results in other bank loan covenants looking more like bond covenants. Bond covenants are structured on the assumption that the borrower will not be seeking waivers of bond covenants in the same way it would seek waivers from relationship banks on bank loans. So, bond covenants start from the premise that bondholders exert far less control over the borrower than bank lenders. This is leading to long-term debt capital imposing far fewer constraints on borrowers than bank debt has historically.
How borrowers are responding
Borrowers are keenly aware of competitive market dynamics among potential investors and they normally seek to arbitrage across all products and markets. Where market conditions allow it, European borrowers consider accessing the US market, and US borrowers consider accessing the European market – both the bond market and bank debt market. Borrowers will work with underwriting banks that can cover all markets and products, and will also often work with 'lend and hold' direct lenders to ensure full competition across products and markets to achieve best execution, pricing and terms.
So long as the current benign economic conditions continue, we expect to see greater convergence between bank and bond debt and continued pressure on pricing and terms. Even apart from current economic conditions, institutional demand for liquidity between instruments will also drive convergence between bank and bond terms.
Will a market shock or a surprise issuer default see a return to financial covenants for bank debt? This will depend on the extent to which a market shock adjusts the current supply/demand imbalance. In Europe in mid-2007, a handful of covenant-lite deals were financed (though not syndicated), yet bank debt went back to including financial covenants after the financial crisis because only banks provided liquidity at that time (and only some banks at that). Today, unlike in 2007, the bond market in Europe is firmly established (though a market shock could result in the market being shut for a period) and it is likely that investors with capital to deploy will continue to be agnostic between bank and bond debt, provided debt markets are open for business. So, the convergence and relaxation of terms for borrowers is likely here to stay.
Will there be a continued role for underwriting banks long-term? Of course. Only banks will be able to provide capital quickly and provide sizeable underwriting commitments (though direct lending funds are increasing their ability to underwrite financings). But institutional investor demand for long-term bank debt and bond debt will continue, so financings initially underwritten by banks can be expected to be syndicated or refinanced on very borrower-friendly terms.
Other developments to watch
In Europe there is no clarity on what financial markets will look like after Brexit. If the effect is to impose additional regulatory and administrative burdens on banks and investors active in the European capital markets, this is likely to flow through to increased pricing for borrowers seeking to raise finance in London and Europe.
Fintech, blockchain and the continuing march of direct lending funds into the financial markets may be expected to increase financing options available to borrowers, with corresponding increases in demand for paper and competitive tension between financial products and markets.
For now, it is a great time to be a borrower.
About the author
S Neal McKnight
Partner, Sullivan & Cromwell
New York, US
T: +1 212 558 3316
F: +1 212 558 3588
Neal McKnight is co-head of the firm's finance and restructuring group. He advises financial institution, sponsor and corporate clients on a broad range of corporate financing transactions, including capital markets offerings, revolver and term loan facilities, receivables and asset-based facilities, and securitisations. McKnight has particular expertise in acquisition financings, and has acted in a number of refinancing and recapitalisation transactions in the bank and bond markets, as well as financings in distressed contexts.
McKnight's securities experience includes debt and equity offerings (including high yield debt offerings) under Rule 144A and Regulation S, SEC-registered offerings, exchange offers, project and infrastructure bonds and structured financings. He has also acted in a number of M&A and joint-venture transactions. McKnight's clients have included AT&T, Bayer, Canadian Pension Plan Investment Board, Crescent Capital, Gartner, Goldman Sachs, Ontario Teachers' Pension Plan Board, Rhône Capital and United Rentals.
Neal was resident in the Firm's London office for almost 10 years, returning to the New York office in 2008. He has extensive experience in cross-border and multi-jurisdictional financing and M&A transactions.
About the author
Presley L Warner
Partner, Sullivan & Cromwell
T: +44 20 7959 8900
F: +44 20 7959 8950
Presley Warner is a member of Sullivan & Cromwell's corporate and finance, credit and leveraged finance, and restructuring and bankruptcy practices. Warner advises financial institutions, private equity and corporate clients on a broad range of cross-border financing.
His private equity transactions include advising sponsors and lenders on leveraged private and public-to-private transactions in the UK and Europe through first lien, mezzanine, PIK and hybrid instruments, leveraged recapitalisations, bid financings, Opco/Propco structured financings and related intercreditor arrangements. Warner's corporate transactions include advising corporates and lenders on event-driven investment grade financings and build-out transactions, and his restructuring transactions include advising creditors and corporate and private equity-owned debtors on restructurings in the UK, Europe and the Middle East.