Market conditions have changed since the onset of the credit crunch, resulting in a widely reported shift in the balance of power when negotiating facility documentation.
While there has been an increase in the time taken to do deals and a decrease in overall deal flow, an analysis of mid-market transactions in the £50m to £500m range over the past two years reveals some surprises and suggests that while facility terms are more ‘lender-friendly’ in the credit crunch era when compared with the credit boom era, the changes are not as dramatic as anticipated.
For the purposes of this discussion, we have analysed 30 facilities in the year leading up to 1 September 2007 (a line in the sand that we regard as marking the beginning of the credit crunch) and 30 facilities in the year following that date.
One would expect facility terms in the credit crunch era to be more lender-friendly than in the credit boom era and in many cases the results of the analysis have borne out that expectation. For example, margins have risen and monitoring and agency fees are higher. In terms of financial covenants, leverage multiples are lower and financial covenant testing holidays are shorter. With regard to syndication, loan transfer restrictions are less stringent, minimum holds are lower, and ‘yank the bank’ and ‘snooze you lose’ provisions are less widely seen. In terms of repayment, excess cash sweep is more common and amortisation start dates occur sooner. Finally, inclusion of the material adverse change event of default is more common and clean-up periods tend to be shorter.
On some counts, the results are the opposite to what one might expect. In terms of repayment, we have seen a lower proportion of amortising facilities in the credit crunch era and the amount of cash swept as a percentage of overall excess cash is less. Furthermore, call protection is more common, meaning that although the resulting prepayment fees are higher, the net effect is that borrowers are discouraged from prepaying voluntarily. On financial covenants, the incidence of equity cure has increased significantly, albeit with some tightening up on its usage.
The trend in the credit crunch era can be characterised as a tightening up of facility terms rather than a paradigm shift. Notwithstanding the urban myths about borrowers in the credit boom being able to get away with anything, this was not generally the case. In the credit boom, and with notable exceptions, facility documentation was typically still very lender-friendly, as the standard Loan Market Association facility agreement shows. This is because legal risk was just as much of an issue in the credit boom era as it is in the credit crunch era and this was reflected in the pre-credit crunch documentation.
For this reason, the scope for tightening facility terms in the credit crunch era is not perhaps as great as the myth would imply. The changes we have seen in facility documentation are important, but they cannot in themselves improve the borrower’s cash flow or prevent a crisis in the money markets.
The paradigm shift has occurred not so much in lenders’ attitudes to legal risk (legality and documentation) but rather to market risk (fluctuations in prices and rates), liquidity risk (trading in the money market) and credit risk (the borrower’s ability to repay).
Given this shift of attitude, one might expect lenders to encourage prepayment and insist on facilities amortising rather bullet repayments, since from a basic credit perspective ;a lender’s exposure, and therefore risk, is lowered if it is repaid early. These results do not support this expectation. On the contrary, it is clear that lenders want to maintain their stakes in the deals that they do actually approve and will penalise prepayment.
This is because lenders are taking more time to conduct careful due diligence on deals before investing and, as a result, when they do invest they are likely to have more confidence in the creditworthiness of the deal than they did during the credit boom era when the time available to conduct such due diligence was less.
As credit becomes increasingly difficult to obtain, for those deals that are approved we expect the trends to continue: higher fees, higher margins, tighter covenants, more stringent events of default and lower leverage multiples. We would also expect to see a rise in the inclusion, and likely exercise, of market flex provisions – pricing flex, structural flex and even documentation flex.
What will be more interesting is whether we see a greater appetite for amortising rather than bullet repayment facilities. It will also be interesting to see whether the incidence of equity cure will continue to increase, since this will be indicative of whether lenders regard it as a borrower-friendly or a lender-friendly concept.
David Boyd is a partner and Nicholas Joyce an associate at Eversheds