Mark Campbell, head of global finance, Clifford Chance
For the past few years lawyers acting for lenders and borrowers alike in the larger leveraged finance transactions have had to cope with a rapidly developing market. Private equity firms have been able to dictate terms to their bankers to such an extent that it seemed as if there would be no end to the concessions that the banks were willing to make.
The fact that huge amounts of institutional money have been available to invest in these loan transactions has meant that demand has exceeded supply.
The banks arranging the transactions have not had to worry too much about the terms they were able to negotiate with the private equity firms since, seemingly, there has always been someone willing to buy into the loans no matter how weak the terms.
The high (or low, depending on your viewpoint) watermark of this trend is the so-called 'covenant lite loan', which has hit the headlines in the national press and even been the subject of questions in Parliament.
In the covenant lite loan the key protection afforded to banks in leveraged finance deals - the requirement that the borrower continues to meet certain financial ratios - is jettisoned in favour of 'incurrence' tests (imported from the US high-yield market).
However, some investors in both the US and Europe have started to question whether this trend is in their interests, and this, when allied with rising interest rates and a feeling that the top of the market may have been reached, means that the short-lived craze for covenant lite deals is starting to run out of steam. Banks are reverting to using the traditional financial ratio maintenance covenants.
While there is a number of covenant lite deals still in the market that will no doubt go through, we will likely be seeing far fewer of them. The bubble may not have burst, but it is certainly deflating slowly and quietly.
If it proves to be the case that the market retreats from covenant lite deals, private equity firms and their lawyers should not be too concerned. They have won concessions over the past few years that are far more important than the covenant lite fad. These include:
•moving away from fixed pricing for every leveraged deal; •dispensing with the need to amortise the loans over a seven-year period, instead only being required to repay after eight or nine years - and if this is the case, then the need for a cashflow cover ratio test disappears anyway; •effectively removing the obligation to repay lenders from excess cashflow (the 'cash sweep'); •building in protections, including equity cure provisions, that allow the private equity house to fix the breaches of financial ratio covenants before they become a problem; •changing the definitions used in the ratios so that they are unlikely to be breached anyway; •including so many exceptions to the other restrictions in the loan documentation that they are far less troublesome; and •if all else fails, allowing waivers of breaches of the covenants to proceed much more smoothly (through use of 'yank the bank' and 'snooze and lose' provisions).
These changes to the market produce a 'covenant-loose' loan document, which will achieve 99 per cent of what the private equity houses are seeking, while not causing the angst that the discussions surrounding covenant lite have produced.
My suspicion is that loose rather than lite will be the flavour of the next few months. There is a shift in the balance of power in leveraged finance transactions.