The explosion of restructuring work since the start of the year means an increasingly large number of hedge funds, banks, agents and advisers are poring over 2005-07 leveraged loan deals.
Now is the time to look at what the market might have done differently, particularly from a restructuring perspective, and improve structures and documentation. These changes are driven by credit issues (making the documentation more watertight for lenders), downside issues (making deals more restructuring-friendly) and a few home truths.
The rapid emergence of sponsor-friendly loan terms in 2002-06 reflected the massive liquidity increase in the market, resulting in far more emphasis on distribution than credit. That market has now gone. The deals that are being done now are more like those from many years ago, club and ‘take-and-hold’ deals, where documentation is negotiated before signing with large groups of arrangers, which may not even plan to syndicate the deal.
This is not to advocate retrading every conceded term ever given to sponsors.
We need a balanced market that enables sponsors to get fair and flexible deals. The market needs deals that get done and syndicated to bring dealflow back to life and rebuild market confidence.
Key credit issues are leverage and credit protection. At the peak of the market, debt levels could be increased significantly with limited or no conditions. This could be done through incremental facilities, committed but undrawn acquisition and capex lines, ‘structural adjustment’ provisions, revolving credit facility amounting to term debt and significant permitted loan and security baskets. This is one of the top issues for investors in the market now.
There are still non-defaulted covenant-lite loans in the market, whereby people speculate that the first default may be one of payment or bankruptcy.
In these loans the lenders are a long way from the traditional position of being the first creditors to engage in discussions with borrowers in a downturn. Financial covenant definitions, the setting of headroom of those covenants and equity cure provisions are tightening significantly. The ‘mulligan’, whereby a quarterly financial covenant breech could be cured by a successive compliant one, has vanished. The scope of equity cures is, for example, being heavily curtailed in more recent deals, with more limited cure rights and equity being required to reduce debt rather than counted as an addition to earnings before interest, depreciation and amortisation (Ebitda).
Another area that in the past has afforded sponsors much financial covenant flexibility is anticipated synergies through acquisitions, without any lender consent or independent certification, which again is coming under more debate in the current market.
The downside protection provisions come into their own in restructurings.
Two key areas are voting and the structure of the security package. Voting can become such a key area in the restructuring context that these provisions need rethinking. Out-of-court restructurings remain prevalent in Europe.
Although schemes of arrangement and other European procedures designed to bind minorities are useful in effecting out-of-court restructurings, they are cumbersome and expensive. Some out-of-court restructurings will falter because ‘all-lender’ consent is required. A slightly lower threshold for key economic changes would be controversial, but it would eliminate hold-outs.
A mechanism for dealing with crossover holdings for voters holding both senior and junior debt should also be discussed.
The security package has been eroded by ‘agreed security principles’, which have, in broad terms, allowed all administratively complex or expensive security to be excluded. A full security package need not be taken in all countries over all assets, but two key items are important: a secured ‘going concern’ sale should always be possible, requiring security over a single holding company’s shares and downstream loans; and there should not be significantly unencumbered assets over which third-party creditors can effectively take a super senior position ahead of the main financing.
Finally, the home truths. On complex deals the intercreditor agreement is key – in the restructuring world, intercreditor glitches are manna to distressed investors. There have recently been standstills that expire on the commencement of a debt restructuring; release provisions that leave junior borrowings in place on a senior enforcement; and consent cram-down provisions that apply to the junior loan as well as to shareholder and intercompany debt. The new Loan Market Association standard form intercreditor may start to reduce the risk of intercreditor snags, but these documents need much more focus.
Also, there is little room for implied duties or construction under English law, so if provisions are unclear or contradictory it will again create leverage in a restructuring. And finally, in a world of decreasing complexity, if you are the draftsperson and do not understand it, then the chances are that neither will a judge.
James Chesterman is a banking partner at Latham & Watkins