The recent Debtwire European Mid-Market Forum opened with a presentation from Paul Johnson of the Institute of Fiscal Studies. He warned the delegates of storm clouds gathering over the economy, suggesting that we may begin to see an increasing number of distressed credits – perhaps not as significant as in the aftermath of the financial crisis, but that the general mood suggests an imminent turning of the credit cycle.
This was the backdrop to the "When direct lending turns distressed" panel, moderated by Mariana Valle of Debtwire, in which Hogan Lovells restructuring partner, Tom Astle took part. The other panellists were Steve Morris from Beechbrook Capital, Tristan Nagler from Aurelius Investments and Ciara O'Neill from DC Advisory.
The first (and perhaps obvious) point which emerged from the discussion was that there is nothing inherent in direct lending transactions which makes them any more susceptible to distress than any other financing. It is the performance of the credit, and the sector in which it operates which will determine whether problems arise. The more interesting question, given that direct lending in Europe has not gone through a full credit cycle since it gained prominence over the past 10 years or so, is how the direct lenders will approach these situations.
One of the key themes which emerged from the discussion was that direct lenders invest "patient capital". They are generally prepared to continue working with sponsors over the longer term, provided that they see "good investor behaviour". That is not to say that they won't take action where they need to do so to protect their position, but they are more likely to play the long game.
The other dynamic identified was that when direct lending deals hit issues, it tends to be the team who originated the deal who will also work through those problems. This can influence behaviour since the individuals involved will be aware of the importance of maintaining the relationship with a sponsor in order to safeguard future deal flow.
Of course, dealing with a distressed borrower is a time consuming exercise and the panel suggested that a number of funds may not currently have sufficient resources to deal with the demands of restructurings as well as continuing to originate new deals. There are a few notable exceptions to this where institutions have taken on restructuring specialists to assist the relationship teams in navigating their way through these challenges – although they tend to be used as additional specialist support for, rather than replacements of, the relationship team.
The panel also discussed the development of "first out, last out" and other similar structures which have been adopted in European direct lending deals in recent times and considered how this will impact potential restructurings. They concluded that a simple super senior RCF was unlikely to significantly influence outcomes as it would be expected that, in all but the most difficult situations, the RCF lender would be expected to be paid out in full given its position at the top of the waterfall. However, as the "first out" tranche of the term loan represents an increasingly large proportion of the overall debt, it is possible to see potential for conflict between the creditor groups where the value breaks close to the first out tranche.
The panellists did identify potential issues where super senior lenders are kept at arm's length from discussions with the borrower, given their limited consent and enforcement rights, and only brought into the process late in the day. This strategy can create problems as value deteriorates and it then becomes necessary to obtain the support of those creditors in order to pursue a successful restructuring.
Finally, the panel discussed how current documentation is likely to influence the way that restructurings play out. Of course, the loosening of terms means that lenders may not have the triggers to allow them to get involved until later in the process, although clearly mid-market direct lending has generally not gone as far as the "covenant lite" terms seen in the large cap market. This could mean that in a future downturn we see more formal insolvencies because creditors have not had the opportunity to restructure deals before it is too late.
The other area where there has been further erosion of lenders' rights in recent times has been around transferability, with the circumstances in which debt becomes freely transferable becoming more limited. In practice, this may be less of an issue since, as mentioned before, the ability of the direct lenders to work through processes (rather than sell at a discount), as well as their desire to maintain their reputation for relationship lending, would suggest that many would be unlikely to exercise any such transfer rights in any event.