24 September 2007
In late June, just as the financial community had begun to slow down for its traditional summer break, a sudden collapse in confidence brought turmoil to credit markets around the globe. The trigger was the US sub-prime mortgage market, which had turned sour due to borrowers with poor credit struggling to meet payments as interest rates rose – and the implications were global.
The credit crunch
The catalyst of the credit crunch was a sharp rise in the number of US home loan defaults that caused financial institutions to rethink their attitudes to risk, becoming unwilling to lend for fear of not getting their money back. As a result, the market ground to a halt. Panic quickly spread beyond US shores because instead of holding loans on their balance sheets, US lending banks had been offloading them to investors.
These high-risk loans had been repackaged along with higher quality loans into collateralised debt obligations, which were then given higher credit ratings from agencies and sold on to investors looking for attractive returns.
The reasoning behind this was that by dispersing the risk, it was much less likely for one institution to become the victim of bad debts, in turn providing the financial system with more stability.
However, what became apparent as subprime defaults increased was that investors were finding themselves open and unprotected to losses hidden in what they thought were low-risk investments.
Many disparate views on the root causes of the turbulence have been aired, with some being rather alarmist. What there has been less discussion of is what the future holds.
The future of the leveraged finance market depends on the outcome of three important categories of deals, all of which we have seen present in the US market. First, there are a number of lending commitments that were entered into prior to the credit crunch that have yet to pass through the market.
At the time, these deals entered a robust market where even very aggressive terms such as covenant-lite and payment in kind-toggle features would sell, meaning that the banks that had committed to these deals had no reason to think that anything unusual would occur.
However, all of a sudden in late June deals started running into trouble in the market. These deals are still subject to ongoing negotiations between the banks and the sponsors.
The main focus of these negotiations is the terms employed and whether they should remain as they were prior to the credit crunch or whether they should be modified to take into account recent market conditions. Some of these deals have closed, but they have struggled in the market because the terms incorporated prior to the credit crunch prevent them from being sold at par.
There are a number of very large deals looming and all eyes will be on whether the terms of these deals will be modified or whether they will go to market on the terms originally agreed to and if so, how big a hit the banks that are committed to those deals will take.
The second category of deals consists of those that have closed between when the credit crunch began and now. These deals have received funding, but they have not yet been syndicated and the banks currently holding them on their books are sitting on billions of dollars of debt. The question here is whether the deals will be sold into the market now at a discount, therefore taking a loss, or whether the banks will hold on to the debt hoping for the market to rectify itself so that they will be able to sell the debt at, or close to, par.
The final category of deals includes those lying just under the surface. New deals are beginning to percolate through, showing future signs of life for the market, despite it currently being in a state of shutdown. What will be most defining for the future of the leveraged finance market will be the terms that are agreed between sponsors and lead arrangers on these new deals. Sponsors want to continue to do deals but the question is on what terms the banks will commit to these new deals and this will be determined over the next several months.
It is still unknown what the outcome of these deals will be, although what is certain is that a more cautious approach will permeate the markets in the future, at least for the mid-term, with a return to tighter credit and market risk management. A reduced risk appetite will lead to materially more conservative leveraged debt structures, more in line with pre-2004 trends when banks were the dominant lenders, and less market risk for lead arrangers with expanded market-flex features.
What is definite is that the days of covenantlite, payment in kind-toggles and bank-style equity bridges are long gone in the private equity world. In addition, there is likely to be an initial delay in new leveraged deals coming to market while major banks that were left holding as much as $360bn (£180.26bn) of underwritten but as yet unsyndicated debt over the summer seek to clear their balance sheets.
Despite this waiting game, it is inevitable that the market will bounce back, although the pace of the recovery will depend to some degree on how quickly the banks can push the backlog of loans into the market and at what price.
When it does, deals will most definitely be on more traditional credit, leverage, covenant and pricing terms. Private equity firms are awash with cash to invest and sponsors are already starting to look around for new deals, even though leveraged financings are not currently clearing the market at par.
There are still no signs of the brakes being applied to global economic growth. The global outlook remains broadly positive, with interest rates and global demand not changing dramatically. Corporate profitability remains sound and default rates are at an all-time low, so it is unlikely that we will see leveraged defaults and restructurings in the short-term, particularly in light of fewer amortising pieces of debt in current structures and seemingly a freeze on the upward trend in interest rates.
For now the future of the leveraged finance market seems to be very much a waiting game, with the financial community’s attention focusing on the terms that will emerge from deal negotiations. One thing that has become clear is that once activity recommences, it will be the banks that hold the upper hand when it comes to negotiating terms.
David Koschik is a New York-based finance partner at White & Case