A drastic shift in fortunes for leveraged finance

A dramatic turnaround in circumstances has played out in the leveraged finance sector over the past few months. The opening weeks of 2020 saw record levels of issuance, with more than $233bn-worth of high-yield bonds and leveraged loans issued in the US in January and February, and more than $53bn in European markets, according to Dealogic. Hence US issuance more than doubled year on year, and European issuance more than trebled, compared with 2019.

There was a lot of opportunistic business, with issuers taking advantage of favourable market conditions to finance debt re-pricings and dividend recapitalisations, as well as some mergers and acquisitions.

As Diarmuid Toomey, co-head of leveraged debt capital markets for Europe, Middle East and Africa (EMEA) at Deutsche Bank, says: “It was a very busy start to the year for both leveraged loans and high-yield bonds. In February it felt like almost every day brought a new record, whether that was for a record low coupon or some other feature. It was a very risk-on market.”

Although there had been plenty of speculation about how long the bull market could continue, with global trade tensions and disruption off the back of the US presidential election among the potential causes for concern, it is unlikely that anyone could have foreseen the market coming to a juddering halt in such a dramatic fashion as a result of the global coronavirus outbreak. “It was an incredibly strong start to the year but, at a totally unscientific level, there was an impending feeling that something was going to happen to slow things down,” says Jake Mincemoyer, head of American banking at White & Case. “Of course, no one could have predicted this specific set of circumstances.”

A full stop

Against a highly volatile market backdrop, issuance had effectively ground to a halt in the opening weeks of March. As one London-based leverage finance banker remarked at the time: “We are in stasis.” Adam Freeman, head of leveraged finance at law firm Linklaters, says: “A lot of people have hit pause. It is very hard in the middle of a situation like this for people to price the risk. The market will struggle until there’s more certainty.”

In secondary markets, huge outflows from high-yield mutual funds and exchange-traded funds (ETFs) became apparent in late February, in the order of billions of dollars. One New York-based leveraged finance banker believes the sell-off is a function of investors wanting liquidity, rather than a comment on the assets themselves. “Sometimes investors will sell what is most sellable, rather than necessarily because they actually want to sell,” he says. “A lot of the outflows we are seeing are likely to be down to institutional investors who [have viewed] ETFs as a good place to keep a proportion of their portfolio in order to get access to liquidity quickly, as they can immediately draw out their investments.”

In mid-March the market even saw investors selling off archetypal safe assets such as sovereign bonds, including US Treasuries, in a further display of investors seeking liquidity. “For investors, they’re looking to put a floor under the negative and once they know what they’re dealing with, they will be more prepared to buy,” says Nishan Srinivasan, co-head of EMEA debt capital markets solutions at Credit Suisse.

Impact unknown

The million-dollar question is, how long will these conditions persist, and how wide will the impact be? With increasing numbers of people affected by Covid-19 and with the likelihood that economies the world over will be severely constrained for a number of months yet, it is hard for market participants to find any real certainty.

“Everyone is trying to digest the news flow,” says Mr Toomey. “Clearly there are some sectors that are very directly affected, such as airlines, shipping and hospitality. For other industries we have still yet to see the full extent of the impact and it will take some time before the ripple effects are clear.”

What is clear is that there is unlikely to be a quick turnaround in fortunes, and the world is entering a period when many businesses will struggle. Some are trying to see the bright side, given that prior to 2020 there had been a long period of favourable financing conditions and many companies had taken the opportunity to push down their cost of borrowing and lengthen debt maturities.

John Gregory, head of leveraged finance syndicate at Wells Fargo, says that while there are very real concerns about the economy, “on the flipside we have had years and years of incredible financing scenarios, with very long-term maturities”. As a result, a lot of companies will be in a stronger position to ride out the coming months than they might otherwise have been.

However, some businesses that do have debt maturing in the coming months, and others facing severe difficulty, may have little choice other than to come to the markets at a less-than-opportune moment. Those that do are likely to pay a premium if they want to get deals over the line.

“In the current environment, there is a higher bar for deals to come to market – higher pricing, more detailed covenants, and lower leverage – but how long that persists for is difficult to know. The situation is changing day by day,” says Mr Toomey.

Investor shift

Although at present investor behaviour suggests there is little appetite for high-risk debt, once the situation begins to normalise there is an argument that investors could be in a relatively stronger position than they have been in recent years, not only in terms of being able to push for higher coupons but also on better covenant protections.

There has been a long-term trend on both sides of the Atlantic towards the erosion of covenant protections, such as those that can prevent issuers from incurring additional debt, paying dividends or selling assets in the event of financial difficulty, and can therefore protect investors' interests. The increasing role of private equity firms in the industry, who have not been afraid to pursue aggressive deals, has fundamentally shifted the marketplace to one where ‘covenant-lite’ deals are the norm. In January 2020, for example, 99% of institutional issuance was covenant lite, according to S&P Global Market Intelligence, and this is hardly an unusual ratio.

The industry is heavily based on precedent, so where one deal takes a certain approach on covenants, others will often follow. “Once things go on for long enough people become accustomed to that, and it is harder to change the longer it goes on,” says Stuart Brinkworth, European head of leveraged finance at law firm Mayer Brown.

Mr Freeman adds that while it is “a marketplace that has always evolved over time”, it is also true that “sponsors are increasingly sophisticated in how they operate – they pay repeat fees and have lots of negotiating power”.

Igniting controversy

There is fierce debate about what damage the weakening of covenants has caused, and in particular whether in the long run it will lead to a greater number of defaults during a downturn.

Some in the industry believe that concerns about weaker covenants can be overblown, however. Robin Harvey, co-head of private equity at Allen & Overy, believes that in many cases private equity firms are likely to be far more hands-on in working with companies in difficulty than looking at covenants alone would suggest. “In my experience, sponsors will work hard with struggling companies to try and turn a situation around,” he says. “They are mindful of their reputation and how they are perceived to have treated creditors.” Others question to what extent this approach would remain in a scenario with many companies facing difficulty simultaneously, and private equity firms feeling they needed to act decisively to protect their own interests.

Wells Fargo’s Mr Gregory also believes that having fewer covenants can sometimes allow companies to have valuable flexibility at a difficult moment. “Being covenant-lite is not necessarily a bad thing; sometimes it can allow companies to ‘kick the can’ for a little longer and come out OK on the other side,” he says.

Whether or not investors use the current market upheaval to reset the balance in the longer term, and to push for higher levels of covenant protection, remains to be seen. “Clearly due to the market dynamics there is more debate going on now about covenants than a couple of months ago,” says Mr Srinivasan. “But there has been a healthy dialogue, led by investors, for the best part of two years. We will have a debate on every deal that we do and we also have our own internal policy on covenants.”

Mr Gregory encourages investors to use their voice, as there has been some “more aggressive sponsor deals, with more flexibility and aspects that aren’t necessarily creditor-friendly, getting over the line. When that happens investors need to read the documentation really carefully and be willing to push back. This is a market that is heavily based on precedent.”

Regulators step in

In recent years a number of regulatory bodies have raised concerns about the potential for leveraged finance markets to affect the wider economy in the event of a downturn. As we enter a period of pronounced economic difficulty, these concerns could be resurface. Leveraged finance markets have grown considerably in the past decade, including the volume of collateralised loan obligation (CLO) issuance. CLOs are a form of securitisation, where bundles of leveraged loans are packaged together and managed as a fund. Looser covenants are just one issue that has been flagged up as a risk factor.

In one of the latest examples, in December 2019 the Financial Stability Board published a report highlighting vulnerabilities that it believed had grown within leveraged loan markets since the financial crisis, saying: “Borrowers’ leverage has increased; changes in loan documentation have weakened creditor protection; and shifts in the composition of creditors of non-banks may have increased the complexity of these markets.” The report also highlighted the fact that although global banks continue to have the most direct exposure to leveraged loans and CLOs, a growing number of non-bank investors are also exposed.

While some in the sector welcome regulatory scrutiny and believe it helps to put ‘guardrails’ on industry behaviour, most believe the level of systemic risk in the system is not comparable with before the financial crisis.

“I don’t think that banks have the same exposure as in the past,” says Mr Brinkworth. “The market has reorganised itself since the last crisis and therefore there isn’t the same level of systemic risk. In a downturn, the CLO market may get hit, and there is a lot of paper held by private institutions, but ordinary individuals within society are not exposed to it.”

Recovery time

Allen & Overy’s Mr Harvey is also keen to defend the market. “This a big and growing market, with sophisticated participants operating in it,” he says. “Investors are very good at pricing risk and are able to make money within a changing environment.”

In the short term, this growing market is likely to remain subdued, but there is hope that it will bounce back. One particularly bullish London-based leveraged finance banker, who did not want to be named, says: “Everyone had been waiting for some kind of catalyst to affect activity. Frankly, the markets had been getting a little frothy, and they needed to drop. For now we have to go with the headlines and see when we hit the bottom. At the moment we don’t know where the bottom is, but long-term I would expect to see a V-shaped recovery.”

This is a sentiment echoed by Mr Brinkworth. “At the moment, everyone is very consumed by it,” he says. “Their attention for doing deals has been diverted and is instead focused on this one thing. The deals not being done will pile up, but not because of systemic issues with the market, rather as a side effect of what’s happening with coronavirus.”