In the 10 years since the financial crisis debt funds have become a very significant source of liquidity in the European loans market. This is particularly the case in mid-market leveraged financings where the debt funds are most active.
Hogan Lovells has a strong and long track record in acting for both banks and funds and it's fair to say that when we first started advising debt funds and were speaking to the banks about those deals, they saw the funds as a threat and were looking for ways to compete. Today most banks accept that debt funds are here to stay and debt funds and banks have continued to explore creative ways of teaming up together to fund leveraged finance deals to provide added value to sponsor clients.
One of the panels at the Hogan Lovells FIS Summit in London on 15 January 2019 explored this topic1.
When debt funds first started to enter the European leveraged loans market and to lend alongside banks on transactions, many banks were sceptical about their ability to "drive the bus" on documentation issues and particularly about how they would behave regarding requests for waivers, consents and amendments. That evolved with time as institutions became used to working together. It helps that debt funds are generally staffed by ex-bankers, well trained in credit fundamentals.
The balance of power in these collaborations will depend upon where the risk lies as between the debt fund and the bank in a particular transaction. Banks do not have the same appetite for leverage as the debt funds do. Where a bank is lending a relatively small super-senior revolving credit facility (SS RCF) sitting above a much larger term loan provided by the debt fund, then clearly the debt fund needs to know that to protect its investment it is in the driving seat when it comes to documentary rights, subject to the now well-trodden path of certain entrenched protections being given to the SS RCF piece.
Recently this relationship has evolved in some instances where banks have come into the term loan alongside the debt fund in addition to lending the SS RCF. The strip of the term loan funded by the banks will have priority ranking (alongside the SS RCF) and, depending on the quantum of this priority debt, the banks may be able to argue for some enhanced protections in this scenario. Debt funds would generally prefer to provide all of the term debt themselves but they acknowledge that, for the right deal, this structure can help to lower the pricing to keep the sponsor happy. These arrangements are often referred to (somewhat confusingly) as "first loss/second loss" or "first out/last out" deals.
When collaboration between banks and debt funds was in its infancy, institutions explored whether there should be some formalising of relationships by way of tie-ups. Some institutions have invested much time and effort in this and entered into formal joint venture type arrangements such as the GE/Ares programme and, more recently, the collaboration between SMBC and Park Square Capital. However, it is now more common for institutions not to want to have an exclusive relationship and instead to team up on a deal by deal basis rather than to have a formal co-operation agreement.
This means that the development of trusted relationships between principals at the institutions remains key. In the European market this approach is also consistent with the role of the debt advisors who bring together potential lenders for particular transactions. It is also extremely difficult for lenders to dislodge an incumbent clearing bank on a transaction given that management will normally have had a long relationship with that bank which will have generated loyalty and so debt funds need to be free to work with different banks in order to not limit their deal chances.
The legal protections – UK perspective
It is obvious that the various protections written into the intercreditor agreement on a transaction are required to support this collaboration between banks and debt funds on a financing. When the European Market was first developing it was common to see these bank and debt fund protections contained in a document to which the borrower was not even party. This document was normally called an AAL (Agreement Amongst Lenders); being a concept imported from the United States. It is still seen occasionally but these days tends to be limited for use by U.S. debt funds who have moved into the European Market.
It is now more typical for all terms to be transparent and contained in an intercreditor agreement to which the borrower is party too.
On amendments and waivers requiring "Majority Lender" consent, the debt fund will usually be able to control the decision making process. Banks providing a SS RCF gain protection through the entrenchment of fundamental terms which would require unanimous lender consent to change. There will also be an additional list of reserved matters which give the bank an independent vote on certain other key items, including regarding the disposal of assets, grant of new security, incurrence of debt and (on some transactions) the making of acquisitions.
On top of this, the bank will still have the benefit of certain events of default which will enable them to push for an enforcement even if the debt fund does not agree with that course of action. These will typically include an insolvency of the RCF borrower and other specified "material events of default" as defined in the facilities agreement (generally being non-payment of RCF fees, interest or principal and breach of key negative undertakings and/or the negative pledge – often with additional materiality built into these provisions for these purposes; on many deals this list will also include the breach of a separate super senior financial covenant).
A breach of any SS RCF default will trigger the start of a standstill period which would then force the debt fund to take action or to otherwise reach agreement with the bank and the borrower as to how to proceed. If enforcement action were to be commenced, the intercreditor agreement will contain provisions to protect the bank and to ensure that the debt fund progresses that action diligently (and certainly before the business is able to deteriorate too badly) and if this is not done, control of the enforcement process would then pass to the bank who could step in to drive matters forward to recover proceeds to repay the SS RCF. Fair value protections will then kick in to protect the debt fund as they would not be paid any recoveries towards their term debt until such time as the SS RCF had been repaid in full.
Perspective from Continental Europe
The approach is quite different in the rest of Europe. For a start, formal tie ups between banks and debt funds are not seen and financial institutions work together on a relationship basis instead.
AALs and a blended approach to margin sharing between investors are also just not seen. One reason is that non-bank lenders cannot lend to borrowers in many European countries, including France and (in many cases) Italy. To circumvent this problem, deals can instead be structured by way of bonds combined with a more typical working capital facility provided by a bank. Accordingly, banks and debt funds usually work together on a more traditional senior/junior basis, with their relationship documented in a transparent intercreditor agreement.
Whilst some debt funds have only limited restructuring capability, this will probably change very quickly and, as mentioned at the outset, debt funds are generally stocked with ex-bankers who will have relevant experience. From the debt funds' perspective, on a restructuring the debt fund personnel on that transaction will not normally change from those individuals who originally negotiated the deal and who committed their funds' money to that investment, whereas banks often pass the deal to their colleagues in a separate restructuring team. This change in relationships can really change the dynamics of the situation.
Until recently, the market had little experience of how debt funds would react in a restructuring of a leveraged financing and this was often cited as being of concern to banks. Over the last couple of years there have now been several "behind closed doors" restructuring negotiations on deals in which both funds and banks have an interest and so parties are starting to feel more comfortable about this process, although it's fair to say that the structures employed to achieve the types of bank/fund collaborations referred to above have not been tested.