The loan markets are in a sluggish mood. Having spoken to a number of senior bankers, direct lenders and advisors in the past few weeks, all agree the market is “quiet”.
Why? In short, there has been a distinct lack of merger and acquisition activity (who can blame boards for sitting on their hands given the ongoing political and economic uncertainty?) and a possible misconception that refinancing may lead to lenders increasing pricing or tightening controls.
Either way, first quarter volume numbers for the Europe, Middle East and Africa (EMEA) loan markets made for dismal reading and back up the anecdotal feeling that markets are quiet. Second quarter numbers are not expected to show much improvement and, while there are some who see a pick-up in activity in the third and fourth quarters, this is certainly not a view universally held.
Other themes evident are that liquidity is available but banks and lenders are becoming more selective. This is not something we should be surprised about: lenders have an obligation to their shareholders and investors to maximise returns.
Provision of balance sheet/liquidity has long been thought of as a loss leader by banks. No one can blame such lenders for eventually exercising their choice to curtail such provision if the relationship does not add up returns-wise.
liquidity is available but banks and lenders are becoming more selective
Such selectivity and greater returns discipline is relatively new, but perhaps ought to have been in evidence earlier in the post-great financial crisis recovery. Since the noughties, an era of low interest rates and easy money has sustained a borrower-friendly market for a decade and change, even allowing so-called zombie credits to survive when the market’s integrity perhaps would have been better served by seeing such over-levered entities fall by the wayside.
We are now faced with stubbornly high inflation, ongoing geopolitical risks with no real end in sight, and a recession looming. Corporates face prolonged higher energy and input costs, and supply chain issues coupled with higher underlying interest costs.
In addition we now also have constant chatter about a new credit crunch in the light of various factors, US regional banking failures, persistent negative noise around commercial real estate values, increased regulation, and an increasingly lender-friendly environment.
Looking at what motivates a bank to lend (in the relationship-driven market, there is a view that price and related controls do not reflect risk), as stated the loan has, particularly for banks, long been seen as a loss leader, a pay-to-play-type instrument – the ticket to greater advisory riches.
The advent of direct lenders has disrupted this view to a certain extent, and it is probably fair to say that the riskier (leveraged) end of the market has always been more returns-focused, though even borrowers at this end of the market have been able to chalk up some significant wins in terms of the distinct lack of controls.
What does this mean for the corporate loan market?
Given the liquidity still available, there has been no discernible movement in market dynamics at the investment-grade end of the market. Borrowers with an investment-grade rating (either actual or perceived), especially where ancillary business is seen as readily available to compete for, seem to have no problem attracting liquidity.
Price tenor and controls in terms of covenants remain as they were and, save for the odd exiting bank (usually replaced by another enthusiastic lender), deals are being done with minimal fuss. The current issue is the lack of opportunity to deploy capital.
At the other end of the market (unrated/crossover/leveraged), prospects for borrowers are patchier. Some are suggesting the market is polarised between ‘good’ credits and those considered not so good or perhaps in more difficult sectors.
The extent of such bifurcation is a discussion for another day, but there is little doubt that the increase in funding options afforded by the rise in activity by credit funds does offer some encouragement. It is not easy, it is taking longer and it is getting more expensive and perhaps a little more restrictive in terms of tenor, controls and permissions. Liquidity is, however, perceived to still be available for most borrowers in most sectors.
Who will fund is another question. Banks are currently perceived as increasingly risk averse: less willing to push the boundaries leverage-wise or indeed provide the working capital needed in deals structured alongside senior term debt given returns relative to risk.
[the ABL market] may allow banks and funds to work together on financing packages, though there are some obvious challenges
Credit funds provide greater leverage and more flexibility and there are early signs that, despite the increased cost, sponsor-owned borrowers will continue to favour these factors and thus banks may well lose out in any competitive process.
One trend that has started to gather momentum is borrowers exploring different financing solutions, the prime example being tranches of debt or entire deals focused on asset-backed structures rather than traditional cash flow lending.
Businesses with a strong receivables book, good counterparty risk profiles, or realisable stock are increasingly looking at the asset-backed lending (ABL) market as an alternative and/or additional source of finance. The ABL market is traditionally a touch cheaper, thus creating a lower blended cost of funds and affording banks a route into competing with credit funds in certain circumstances.
It may also allow banks and funds to work together on financing packages, though there are some obvious challenges to overcome with regard to speed of execution and intercreditor agreements. The two classes of lenders (term loan and ABL) could also have very different priorities should a borrower get into stress or distress – it may be a question of who gets to drive the restructuring bus.
All that said, it is likely that such structures will be seen more frequently in the not-too-distant future.
While the market may be quiet and currently more reliant on hope than expectation of a pick-up in activity, banks have a lot to think about. With the recovery, when it comes, there may be much for the ever-innovative loan markets to address.
Dave Rome is a strategic director in the corporate lending team at law firm Ashurst.
