No rest for the weary – after weathering an unprecedented pandemic, we find ourselves in a different kind of turbulence: volatile capital markets.
I recently had the opportunity to attend the 17th annual AFME European Leveraged Finance Conference and the following are my takeaways from the event:
Accessing the public capital markets will continue to be challenging in the near future.
With the backdrop of volatile and challenging macro-economic conditions, investors are taking a more defensive posture. They are looking to reduce their exposure in terms of tenor, some are limiting their exposure to the United Kingdom and are gravitating towards higher quality credits. There is a real concern as to how and which companies will withstand current economic challenges. Rating agencies are concerned about interest rate coverage (the ratio of a company’s earnings to its interest rate obligations), the ability of companies to pass on rising costs to customers and the ability of companies to cope with rising inflation.
Increasing apprehension about borrowers’ flexibility under existing financing documentation.
In the past decade, defaults have been very low (less than 1%) while liquidity has remained very high. In this environment, covenants became increasingly permissive. However, now investors are more concerned about how much value borrowers can erode (due to permissive covenants) and to what extent this would limit recovery in a downside scenario. They are also worried about being subordinated to other creditors either due to the borrower being able to incur super senior debt or the borrower being able to strip assets out of the credit group and lien these assets with new debt.
Private credit has provided an interim solution, but it cannot substitute public capital markets in the long term.
Users of capital have tapped alternative financing sources including private credit in these challenging times. From the borrower’s perspective, the main upside of private credit has been a more straightforward process than a public syndication. However, private credit deals generally contain more restrictive covenants than syndicated deals and most importantly the pot of money is too small. A borrower coming to existing lenders for an upsize on its existing financing may be told there is no further capital available.
Increase in liability management transactions, restructurings and distress related M&A transactions is probable.
Borrowers who cannot refinance their existing debt with new money may resort to a variety of liability management transactions to push maturities out. Various European countries have also adopted a restructuring directive which may encourage the clearing up of balance sheets of certain zombie companies. Finally, as companies navigate the challenging economic times, we may see a wave of distress-related mergers and consolidations.
ESG financing to be more closely scrutinised by investors.
Scrutiny will increase on ESG financing when markets return. Investors will want the ESG targets to be more ambitious than what the borrower would do in the ordinary course. Investors will also focus on third-party verification and reporting vis-à-vis the ESG targets. Finally, the financial penalty for not meeting the ESG targets has to be meaningful enough to deter borrowers from neglecting the ESG targets set out at the beginning of the financing.