This article will look at market trends which we expect to impact the mid-market in the year ahead.
2016 was a year of small but steady growth in the domestic M&A market. Global political turbulance turned an optimistic market into a cautious one in which participants continue to adopt a 'wait and see' approach. What can we expect to see in the mid-market for 2017?
The terms of Britain's exit from the EU are still very much unknown. The Loan Market Association (LMA) has confirmed that it is not looking to change the terms of its documents (including the governing law) at present, but the coming months and years will no doubt see advisers focused on 'future proofing' documents as far as is possible, for example by including Article 55 'bail-in' wording as a matter of course. 'Bail-in' provisions, which aim to minimise loss and disruption should a financial institution fail, are currently only required to be included by UK banks contracting under non-EEA law documents. If the Bank Recovery and Resolution Directive no longer applies in the UK following Brexit, bail-in language may need to be included in agreements governed by English law to ensure counterparties remain compliant.
During the exit negotiation process, the key focus of many in the finance market will be on changes to existing passporting arrangements - the ability of financial institutions authorised within the EEA to trade with (and lend to) other EEA companies without the need for a jurisdiction specific authorisation. If an alternative to the current regime isn't agreed, removal from the single market will have a heavy impact on current lends and future deals, and could result in bank headquarters being moved.
Once we have clarity on what will happen, the market will need to find an approach to deal with those provisions in current lends which will cause issues post-exit.
Increasing regulation & accounting changes
The increase in regulation affecting the market continues to make an impact, with continued focus by regulators on compliance with international sanctions and anti-bribery legislation.
There are a number of EU-driven changes set in train that we have to assume will be implemented notwithstanding Brexit. The Fourth Money Laundering Directive (4MLD) will seek to give effect to updated international anti-money-laundering and counter-financing of terrorism standards set by the Financial Action Task Force, to be transposed into national law by the end of June 2017. A draft is not yet available but we do know that 4MLD will impact KYC requirements; for example the exemptions under simplified due diligence for e.g. certain credit and financial institutions do not currently appear.
In addition, 'obliged' (i.e. regulated) entities will need to implement new controls including compliance management and employee screening.
The introduction of the requirement in 2016 for companies to keep registers of persons with significant control (PSC) over them has led to evidence of compliance being introduced as a condition precedent to lending and companies being subject to ongoing obligations in relation to the PSC regime under many loan agreements. The PSC regime may assist in the initial information gathering process when undertaking client due diligence.
Bank reforms are again likely to draw resources away from the front line, as many banks are now moving towards the implementation stage of their ring-fencing process required as a result of the Vickers report, in readiness for the 2019 deadline.
Recent and upcoming changes to the International Financial Reporting Standards (IFRS) have resulted in changes to financial reporting which have led to some borrowers requesting covenant amendments to ensure terms are clarified and testing continues on the basis originally anticipated in the agreement.
2017 will no doubt see continued competition to lend. In the mid-market it is now common to see funds participating in syndicates alongside more traditional lenders, which has resulted in more competitive pricing and loan terms. While some funds do still have limitations around what they can offer in terms of day to day lending and banking, their presence will continue to drive competition on pricing and terms. However, it is possible that Brexit related risks and exposures could result in increased pricing.
This competition has led to a shift in bargaining power towards borrowers allowing those in a strong position to negotiate the inclusion of favourable provisions more typically seen in the larger syndicated loans market. Provisions that are now considered commonplace in the mid-market include white lists on transfers, and accordion facilities, both of which have recently been included in the LMA loan agreements. Many lenders are now also offering terms with fewer and simplified covenants, which were previously seen more commonly in the US market and on unitranche lends.
There is a lot of speculation about M&A activity in 2017 and many are expecting a slowdown due to the uncertainty and currency volatility caused by Brexit, the US election result, the slowdown of other global markets and a number of upcoming European elections. The long term effect of Brexit on the pound remains unknown, and at this stage in the year it is unclear exactly how Britain's access to the single market will look following negotiations with the EU.
However, on the flip side, what we do know is that British firms are likely to look more attractive to overseas buyers due to the weaker pound, and that purely domestic deals, particularly of companies with limited FX and EU trade exposures, should not be too heavily impacted. M&A will continue to provide one of the best and quickest routes to growth and concerns around recruitment of skilled workers could also help drive acquisitions as investors seek to buy and build rather than rely on recruitment.