With banks putting double knots on the purse strings, Jack Kantrowitz and Jamie Knox examine the rise in mid-cap businesses turning to the debt capital markets
In the wake of the global financial crisis, significant shifts have occurred in corporate finance markets. Many of these changes, including the decreased availability of certain structured finance products and senior lender concerns regarding high levels of leverage, have made traditional bank financing less available, especially for certain mid-market corporate borrowers.
These circumstances have posed challenges for finance directors who have traditionally used bank financing as their primary source of debt financing. Unlike large European corporations or mid-sized companies in the US, which have long financed growth with capital markets debt, these borrowers have had limited access to debt capital markets. In addition, many financial institutions in Europe, unlike their counterparts in the US, historically have not targeted mid-sized corporate borrowers as potential clients for this kind of financing.
However, help may be on the way. Sustained growth in the high-yield bond market over the past 18 months appears to be a harbinger of expanded use of capital markets debt as a financing alternative for mid-sized companies. Factors that have contributed to the recent growth include investors’ search for yield in a sustained low interest rate environment driving substantial inflows to high-yield bond funds and reluctance on the part of traditional bank lenders to lend on the same terms or in the same amounts as they did previously.
Last year was a record year for high-yield bond issuance in both the UK and Europe. As notable as the recent growth in the size of the market has been, the growth in the range of companies for whom high-yield bonds are an available financing alternative has been even more remarkable. Issuers with lower credit ratings and those seeking to place smaller high-yield offerings have found greater acceptance in the market. Many of these recent offerings have seen high-yield bonds assume a position in the capital structure that was once unthinkable – as a primary long-term secured senior debt obligation ranking equally with all other senior indebtedness and behind traditional bank debt only in respect of security.
High-yield bonds were largely a creation of the investment banking participants in the US debt capital markets, and the US high-yield market remains the world leader. In addition, the approach, terms and conditions and documentation of US offerings have provided a widely accepted model as the international market has moved towards high-yield bonds.
Customary US high-yield transaction structures and processes that have been gaining traction in the UK and European markets include a US-style indenture and covenant package, and disclosure that includes such US-style components as an MD&A (Management’s Discussion and Analysis of results of operations and financial condition).
Such convergence will continue and this will require the participation of lawyers and investment bankers with compatible experience. For companies that are financially or organisationally unprepared to provide the documentation the high-yield market demands, increased access to the US private placement market (dominated by US insurance companies), with its traditionally more limited documentation and greater structural flexibility, offers an alternative source of funding.
Corporate directors and their stockholders in the UK and Europe have their own history and requirements, and our markets have their own dynamics. Therefore, we believe that, to be successful in the longer term, exposure to historical practices in the UK and Europe will be essential for lawyers and bankers who wish to participate in the growth of our debt capital markets. Only those teams that bring real expertise and understanding of financing patterns and practices will be able to meet the needs of borrowers and the demands of investors.
Therefore, while we believe certain US-style practices will continue to take hold, a sustainable UK and European high-yield market must also be sensitive to our distinct tax and security regimes, and emphasise particular strengths. These include the ability of UK issuers with global operations, unlike their US counterparts, to customarily provide guarantees and collaterals from all material subsidiaries, regardless of their jurisdiction of formation. This enhances the relative credit quality of the UK offering, and may add to investor interest in the US for UK and European offerings.
The growth in debt capital markets accessibility for UK and European issuers should continue, although at a more measured pace than in the past 18 months. A virtuous circle could even develop in which issuance costs, including legal fees and spreads, decline.
As this happens, the market will become increasingly accessible to smaller issuers, which will drive further growth. The growing market also deepens the pool of experienced talent at law firms and investment banks who can work effectively in this product space and drive further efficiencies in deal execution.
Adapt and advise
For corporate borrowers, therefore, the high-yield market will provide an alternative source of long-term fixed rate debt. For legal and financial advisers to corporate borrowers, understanding the pros and cons of this altered landscape is crucial to providing effective advice. Borrowers will increasingly seek out advisers who have adapted to this landscape and can assist them in evaluating the benefits and costs of each financing option.
For more and more companies, these options will include issuances into the high-yield bond market and accessing the US private placement market as well as traditional bank debts governed by Loan Market Association documentation.
Jack Kantrowitz and Jamie Knox are partners at DLA Piper