3 July 2006
The European loans market has undergone significant changes in recent years. All-time low default rates in the past couple of years have pushed non-bank financial institutions into new areas in order to extract value during a period of excess cash and low returns. This in turn has enabled arranging banks to structure ever bigger and more complicated debt packages comprising tranches of senior debt, second lien, mezzanine and sometimes junior mezzanine.
The composition of creditors participating in these debt packages is changing rapidly as the traditional line between banks, hedge funds and other asset managers blurs - a trend that is set to continue. Hedge funds and collateralised loan obligation (CLO) and collateralised debt obligation (CDO) vehicles, traditionally investing in second lien and mezzanine tranches, are now investing in senior tranches of leveraged deals and are actively looking to participate in investment grade loans, an arena which has in the past been dominated by the commercial banks.
While non-bank financial institutions continue to make inroads into the primary markets, the European secondary markets have continued to grow significantly year-on-year for the past five years. The majority of this growth has come from the buy side - US hedge funds attracted by the relatively higher returns in the Euro markets. This increased liquidity in both the primary and secondary markets has been a contributing factor to the low default rates, as corporates that may have been ripe for workouts are able to find new money to refinance existing indebtedness.
Most commentators believe, however, that a combination of higher interest rates, higher commodity prices, weakening consumer demand and wage inflation in emerging markets, such as the People's Republic of China, may lead to a credit crunch in the next 12-18 months, with the automotive, transportation and utility industries most at risk. If this were to occur, a number of highly leveraged corporates may find themselves facing a workout or, even worse, an insolvency process.
The increased number and differing composition of creditors participating in debt packages is set to change the face of future workouts.
Many wonder whether non-bank financial institutions will have the appetite for a workout. Second lien creditors are an unknown quantity when it comes to restructurings. Will their interests be aligned or opposed to those of the senior creditors, which have traditionally been the dominant force in restructurings? Or will their interests be very different? There is a consensus among restructuring and insolvency professionals that the multiplicity of stakeholder positions and the diverse agendas pursued by the broad range of institutional and private investor classes will unquestionably complicate turnarounds and restructurings in the coming months and years.
Given the possible complexity and time-consuming nature of future workouts and the uncertainty of the return, certain stakeholders may choose to sell their positions to specialist distressed investors. The strength and depth of the secondary markets has given stakeholders a variety of exit options. Through the use of sub-participations and credit default swaps, stakeholders can effectively transfer the economic ownership/interest in any particular position while still remaining a lender of record. This will in turn present turnaround professionals with new classes of stakeholders, whose interests may be very different to that of traditional senior lenders.
In the current market, cautious sponsors are trying to exert some control over the composition of syndicates by restricting sub-participations or altering the unanimous decisions clauses so that minority senior lenders cannot exert a disproportionate amount of control over any potential restructuring plans agreed by the majority. Borrower-drafted term sheets are starting to emerge with so-called 'yank the bank' clauses (allowing the borrower to replace a minority non-consenting bank) and 'snooze and lose' clauses (to stop banks effectively rejecting a proposal by not responding). These provisions may give comfort to sponsors.
The above notwithstanding, many experts believe that it will be increasingly difficulty to achieve a harmonised approach to a restructuring, reflecting the logistical hurdles in coordinating and communicating diverse strategies among a myriad of stakeholder positions.
Many have also predicted that there will be an increase in the number of hold-out lawyers, who try to improve their clients' short-term positions by threatening to pull down the entire restructuring. In the process the entity may survive, but the underlying businesses will lose a great deal of value. Furthermore, most experts believe that the process of achieving consensus among a multitude of stakeholders, each having diverse interests, will lead to weakened capital structures for corporates exiting a restructuring.
It is also likely that the level of workout failures will increase, leading to formal insolvencies and a race to the courts by various interested parties to maximise their positions. Cross- border securities and insolvency laws have struggled to keep apace with the development and an increased internationalisation of business and trade. On new assignments, restructuring teams will have to negotiate legislative discrepancies and anomalies in various jurisdictions, some of which are debtor-friendly and some of which are creditor-friendly.
The United Nations Commission on International Trade Law (Uncitral) has attempted to increase the level of cooperation between different national courts exercising insolvency jurisdiction by reference to a Model Law. Last year, the US incorporated the Uncitral Model Law through a new chapter in its Bankruptcy Code (Chapter 15). In Europe (with the exception of Denmark), Regulations on Insolvency Proceedings (Council Regulation No. 1346/2000) have been in place for three years now, which have attempted to improve the efficiency and effectiveness of cross-border insolvency proceedings.
However, there has been some evidence of judicial friction between courts of member states, for example, in the case of Parmalat and its Irish subsidiary Eurofoods, which demonstrates an emerging battleground for jurisdictional prominence as opposed to a forum for cooperation between courts and relevant national officeholders. Despite the attempts to increase cooperation between different national courts, the lack of a uniform insolvency regime throughout the EU will entail a greater degree of forum shopping to reflect an acute jurisdictional awareness among the myriad of creditor groups. The practicalities of cooperation and communication between restructuring professionals in a number of jurisdictions needed to undertake cross-border deals will come under the microscope as a greater number of complicated workouts come on stream.
Future workouts will be more complex, time consuming, costly and, ultimately, they may be more susceptible to legal challenge. Break-ups of corporate groups into their respective component parts, mainly along national lines, may well be the resulting trend. Another expected trend will be the increase in stakeholders trading their debt on the secondary market to ensure timely returns to traditional investors. While European corporates may benefit from increased liquidity in the market currently, a change in the economic cycle may ultimately result in loss of value for some.
Swati Patel and Mark Fennessy are partners at Hunton & Williams