When you see a superhero there is usually a villain lurking somewhere. It is probably a bit premature to label Brexit as the villain especially considering that judgement should only be passed once it has had a fair trial, and that trial can only commence once the UK divorces the EU. But I need a villain so it has to be Brexit.
There has been an inundation of Brexit related articles in the media, some suggesting a rather bleak future in the aftermath of Brexit and others painting a more positive picture…But what are UK corporate borrowers mostly concerned about?
Brexit Side Effects
Borrowers do not necessarily fear Brexit itself but rather its unknown side effects; for example, will it cause a contraction of the lender pool, reduced liquidity in the financing markets and/or an increase in pricing on deals?
There is a real risk that some lenders may face higher funding costs as a result of Brexit; it remains to be seen however whether they will pass these costs onto borrowers. The Loan Market Association (LMA) loan agreement contains a standard increased costs clause which is drafted in deliberately wide terms in an attempt to cover all circumstances which could increase a lender’s costs as a result of a change in law or regulation; therefore, to the extent that there has been an increase in a lender’s costs as a result of a change in law or regulation - whether or not brought about by Brexit - lenders could seek to recover such increased costs under this clause.
In the Government’s White Paper on Brexit (presented to Parliament in February 2017) it was confirmed that the UK ‘will not be seeking membership of the Single Market’. EU passports enable unrestricted trade across the EU as they allow lenders and other financial companies to operate across the EU without having to obtain approval for access to each EU country. Following an exit from the Single Market it would be unlawful for UK financial institutions to provide funding to EU borrowers without being authorised in the relevant EU country, if that EU country requires a lender to be authorised in order to make loans. But what does this mean for UK corporate borrowers (as opposed to EU borrowers)? UK banks and foreign banks with licences from the UK’s Prudential Regulation Authority will continue to be able to fund lending to UK corporate borrowers regardless of whether or not the UK is part of the Single Market. Additionally, institutional wholesale lending in the UK is not regulated. However, EU banks which operate in the UK under passports will lose the ability to fund through deposit-taking and will need to apply for banking licences if the UK government does not offer some form of ‘grandfathering arrangement’ for such banks. Even though an exit from the Single Market may not have a direct impact on UK corporate borrowers it could indirectly affect them as it will no doubt have some financial implications for those lenders who rely on their passports to sell their products into the EU and they may seek to pass on some costs to borrowers. In addition, there is also a risk that foreign banks may decide to find another base from which to conduct their passporting activities across Europe, which may result in (among other things) a flight of capital from the City and a contraction of the local lending pool.
All of these potential side effects could have a detrimental impact on a UK borrower’s access to funding and as a result hereof some UK borrowers may have to turn to my so-called ‘superheroes’. The only problem is that these superheroes are different - they come at a price but are nonetheless superheroes because they provide depth to the UK lending market and provide borrowers with much needed optionality and flexibility.
Are Alternative Lenders the New Superheroes?
There has been some talk in the market about the rise of the alternative lender (although I am yet to see one wearing a cape) – will they save the UK corporate borrower from the villain called Brexit? Many sceptics suggested that Brexit would cause a chink in the UK corporate borrower’s armour but it has now been more than eight months since the referendum and the financing markets across Europe remain liquid and pricing is still competitive. That said, there will continue to be uncertainty for some time to come as Brexit will not happen in a flash and arrows are being fired from all directions at the White Paper which did not turn out to be the White Knight that some had hoped it would be.
There are many established alternative lenders who have been actively lending in the UK mid-market for many years now; they continue to be an attractive option for those borrowers who want access to bullet structures and more flexibility on the make-up of the covenant package. Their unitranche facilities have especially been very popular, and they also seem to be able to hold very large loan sizes for leveraged loans. All of these advantages (including the ease of transacting) do, of course, come at a price and it will depend on the individual borrower whether it is a price worth paying.
Most superheroes have a weakness and this holds true for alternative lenders too: they need longer notice periods for drawdowns (although, in respect of the first drawdown, this is offset by the overall increased speed of execution); they cannot provide clearing and ancillary facilities; and as mentioned above, they tend to be more expensive than traditional senior bank debt. Any relationship with alternative lenders would therefore be non-exclusive; for example, the term debt would be provided by the alternative lenders with a super senior revolving facility with ancillary facilities (including hedging) being provided by banks.
Any Brexit-related price increases on bank deals would of course narrow the pricing gap between bank deals and alternative lender deals, bringing it a little bit closer to home for some borrowers. But alternative lenders may too seek to pass on certain Brexit-related costs to borrowers; for example, those alternative lenders who have raised capital in euros, and who are funding in sterling, may want to pass onto borrowers any increase (post-Brexit) in the cost for buying a sterling/euro swap.
Borrowers could also explore other methods of alternative funding such as private placements. The past few years there has been a push to stimulate the UK private placement market with the introduction of, for example, standardised LMA documents and an exemption from UK withholding tax for interest paid on ‘qualifying private placements’. The exemption, which came into force on 1 January 2016, under the Income Tax Act 2007 (ITA) as supplemented by the Qualifying Private Placement Regulations 2015 (SI 2015/2002) (Regulations) is aimed at transferable unlisted debt instruments that cannot benefit from the ‘quoted Eurobond exemption’; it enables direct lending from states with a double taxation treaty whether or not the treaty provides for a nil rate of withholding tax, and without making treaty claims (the exemption can also apply to UK investors).
For some borrowers private placements may very well be the golden key that they have been waiting for to unlock the door to a whole new universe of investors such as insurers, pension funds and asset managers. Private placements offer borrowers many advantages including: longer maturity dates than bank debt; quick implementation due to the standardised LMA document; (depending on the investor base) they can be structured as loans or bonds; and they offer borrowers covenant flexibility. As expected, however, this superhero has its own kryptonite in the form of, among other things, a make-whole on early repayment and minimum deal sizes.
Other Traditional Sources of Funding
In addition to private placements there are also the bond markets with many corporates considering venturing into, for example, the high yield bond market with its very attractive cov-lite terms. As with anything else, it too has its disadvantages with, for example, its long non-call periods and generally high refinancing costs.
From a borrower’s point of view, there are many different choices when looking for debt capital each with its own advantages and disadvantages; the trick is to find the right one that works for the particular borrower.
The Closing Scene
It is all about having quick and affordable access to funding. If the lenders in the UK market can continue to provide such access regardless of Brexit, and at a reasonable price, then generally speaking UK corporate borrowers should not have too much to fear in a post-Brexit world. In addition, there will always be a few superheroes circling above happy to answer any distress calls. Only time will tell whether more UK corporate borrowers will call upon the superheroes in the aftermath of Brexit and perhaps more interestingly who these superheroes will be. There is certainly a possibility that, when unmasked, it could be any of Mr Alternative Lender, Mr Private Placement or Mr Bonds. The good news for UK corporate borrowers is that they have more than one option and that is a positive story.
This article originally appeared in Issue 7 of the Global Banking and Finance Review Magazine.