BNA s Banking Report

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1 BNA s Banking Report Reproduced with permission from BNA s Banking Report, 104 BBR 34, 1/6/15, 01/06/2015. Copyright 2015 by The Bureau of National Affairs, Inc. ( ) OUTLOOK 2015 Credit Markets The U.S. Leveraged Loan Market: A Cautious Outlook for 2015 Alexandra Margolis is a partner in Nixon Peabody s New York office and a member of the firm s Banking & Finance department. She represents corporate borrowers, financial institutions, private equity sponsors, strategic investors and investment funds in a wide range of domestic and international financing transactions and can be contacted at amargolis@nixonpeabody.com. The author would like to acknowledge the assistance of her colleague Jinho Alex Yim in preparing this article. BY ALEXANDRA MARGOLIS T he U.S. leveraged loan market enters 2015 cautiously as the market adjusts to a more difficult regulatory environment. Increased regulatory scrutiny of leveraged loan underwriting standards and impending risk retention rules are widely predicted to dampen leveraged loan issuance this year. These headwinds combined with a continuing investor exodus from mutual funds and an uncertain interest rate environment are expected to drive down new loan deal issuance in 2015 by up to 15 percent from 2014, according to a November report from Standard & Poor s. 1 As of late December, S&P Capital IQ Leveraged Commentary & Data (LCD) projected a 24 percent to 34 percent new loan issuance decrease in S&P Capital IQ tracked $529 billion of leveraged loan volume for 2014, down 12.7 percent from 2013 s alltime high of $607 billion. 3 Contributing to favorable market conditions throughout most of 2014 was the strong demand for loans by collateralized loan obligation funds (CLOs), which account for two-thirds of leveraged loan investments. CLOs purchase the noninvestment grade loans and package them into securities of varying risk and return. As of late December, CLO issuance was a record $123 billion in 2014, surpassing the previous record of $97 billion set in 2006, according to LCD. 4 Market participants predict CLO issuance to decline in 2015 (with most estimates ranging between $70 billion and $90 billion), 5 as the market adjusts to risk retention rules that will go into effect in late Retail investors fled from mutual funds in 2014 and the ongoing exodus of mutual funds from the leveraged loan market likely will continue in 2015 assuming interest rates remain low, according to Standard & Poor s. 6 While positive loan market conditions existed throughout most of 2014, leveraged loan volume plunged in the fourth quarter as new-issue yields reached two-year highs. 7 With yields rising, refinancing and dividend recap activity slowed significantly in the final months of The last several years of refinanc- 1 S&P, Nov. 13, 2014: Leveraged Lending Market Outlook for 2015: Has the Loan Market Run Out of Steam? 2 LCD, Dec. 22, 2014: Limping to the finish line: Loan volume plunges to 3-year low in 4Q. 3 Id. 4 LCD, Dec. 19, 2014: 2014 Loan Investor Market: CLOs dominate as retail bid, banks fade. 5 Id. 6 S&P, n.1. 7 LCD, n.2. COPYRIGHT 2015 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN

2 2 ing activity have pushed out the maturity wall to 2017 and beyond, with loans due through year-end 2016 limited to 2.8 percent of outstanding performing loans, down from 9.1 percent at the end of An encouraging sign in 2014 was the increase in M&A related lending. Approaching year end, a total of $254 billion of loans for acquisitions and leveraged buyouts had been issued in 2014, the highest volume since Entering 2015, arrangers expect the first quarter to resemble the fourth quarter of 2014, with little refinancing and dividend recap activity and modest volume driven by M&A related loans. 10 Trends in Loan Documentation Terms Leveraged loan terms in 2014 reflected a continuation of key trends from 2013 as borrowers and sponsors continued to push for maximum operational and financial flexibility in covenant packages and structure. The leveraged loan market continues to diverge from the investment grade loan market, where relationship lenders expect to hold their loans and have ongoing exposure to the borrower. CLOs, hedge funds and other institutional investors now dominate the U.S. leveraged loan market and are focused on investment yield rather than a continuing relationship with the borrower. These investors are less concerned about deleveraging over time or financial covenants. The dominance of institutional investors has made the leveraged loan market more closely resemble the high-yield bond market, and the increased convergence of terms in these two traditionally separate markets frequently has been noted. Issuer negotiations have been influenced to a large degree by private equity sponsors seeking maximum flexibility for their portfolio companies. As a result of these market dynamics, covenants and other structural terms of leveraged loan agreements, especially for institutional tranches, or term loan B s, have become more borrower friendly in recent years. Some of the more recent trends in terms and structure of institutional loan documentation are discussed below. Although these trends are widely seen in the large corporate market, the middle market has shown resistance to looser structures and middle market loan terms reflect less uniformity. Acceptance in the middle market of borrower favorable terms generally is limited to the sponsored higher middle market, and we do not expect that to change in Covenant-Lite Loans One feature that traditionally has distinguished loans from bonds was the presence of quarterly-tested financial maintenance covenants in loan agreements, such as maximum leverage and minimum interest coverage ratios. After disappearing for several years during the credit crisis, covenant-lite loans reemerged in 2011 and now are prevalent in the large cap market. In a covenant-lite structure, maintenance covenants are replaced with incurrence covenants that permit borrowers and restricted subsidiaries to incur debt, make investments or restricted payments or take other actions if specified financial ratios are met. Many loan agreements with a revolving credit facility contain a springing financial maintenance covenant solely for the benefit of the revolving lenders, which is tested only when the borrower s utilization of the revolving commitments exceeds a threshold level, usually 25 percent to 35 percent. Financial maintenance covenants (when in effect) customarily are subject to equity cure provisions in large cap sponsored facilities. Equity owners may make cash contributions through the purchase of qualified equity to cure a financial covenant default, with such cures generally permitted to be exercised twice in any consecutive four quarter period and a maximum of five times over the term of the loan. Contributed cash is then used solely to cure the covenant default usually by increasing EBITDA by the amount necessary to cure the default, and is not utilized for calculating any other ratios or baskets. Equity cures sometimes are included in sponsored middle market deals, but may be subject to tighter restrictions on the ability to exercise. Term loan B facilities have adopted certain borrower favorable mechanisms used in calculating both maintenance and incurrence financial ratios. Leverage ratios commonly are now calculated on a net debt basis by reducing total debt by the amount of the borrower s unrestricted cash and cash equivalents (sometimes capped but more frequently uncapped). In addition, the definition of EBITDA (the denominator of any leverage ratio and the numerator of any coverage ratio) frequently includes generous add-backs for items such as projected cost savings and synergies, including those relating to actions expected to be taken within 12 to 24 months (sometimes capped at a percentage of EBITDA). Approaching year end 2014, more than 60 percent of outstanding S&P/LSTA loans were covenant-lite. 11 While covenant-lite acceptance is broad in the large cap institutional market familiar with the incurrence world of high-yield bonds, the traditional middle market has resisted covenant-lite structures and middle market covenant-lite issuance for the most part is limited to the sponsored upper end. For borrowers generating $50 million of annual EBITDA or less, middle market covenant-lite volume in 2014 was just $2.7 billion through the third quarter. 12 The traditional middle market probably will continue to resist the covenant-lite structure in Flexibility in Connection with Acquisitions In 2014 the ongoing trend of borrowers and sponsors negotiating to structure loan agreements as flexible documents designed to accommodate acquisitions has continued and appears in several different forms. Many large cap loan agreements now contain limited condition acquisition provisions which limit transaction risk in connection with an acquisition not conditioned on third party financing. These provisions enable a borrower that has committed to an acquisition without a financing condition (a limited condition acquisition ) to elect the date of the acquisition agreement as the relevant date (the LCA test date ) for testing whether debt and lien incurrence and the taking of certain other actions (such as investments, restricted payments, dis- 8 LCD, Dec. 12, 2014: Default survey results show optimistic outlook for leveraged loans. 9 LCD, n LCD, n LCD, Dec. 2, 2014: Covenant-relief activity picks up in November, while A-to-E slows. 12 LCD, Dec. 3, 2014: Middle Market: Covenant-lite recedes from fourth-quarter deals COPYRIGHT 2015 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBR ISSN

3 3 positions or fundamental changes or designation of unrestricted subsidiaries) are permitted. If the borrower so elects in connection with a limited condition acquisition, until the earlier of consummation of the acquisition or termination of the acquisition agreement, the measurement of ratios and baskets relating to debt or lien incurrence or the taking of other actions, as well as the existence of any default or event of default, is determined as of the LCA test date. These provisions provide borrowers and sponsors with certainty when committing to an acquisition that an EBITDA decrease, default or other adverse event occurring between the date of the acquisition agreement and consummation of the deal will not impair the ability to raise debt or take other actions if conditions were met on the date of the acquisition agreement. In addition, flexibility to incur debt for acquisitions sometimes is provided in a debt covenant basket that permits acquisition financing to be incurred subject to either satisfaction of a specified leverage or fixed charge coverage ratio or (using the high-yield construct) on a pro forma basis such ratio is not worse than it was immediately before the transaction. Further, negative covenant grower baskets utilizing the greater of a fixed dollar amount or specified percentages of EBITDA or total assets have become customary in the large cap market. Unlike fixed dollar baskets that still are more common in the middle market, grower baskets enable the borrower and restricted subsidiaries to grow their businesses through strategic acquisitions and retain flexibility without having to obtain lender consent to amend covenants. Incremental Facilities Incremental provisions that permit the incurrence of additional loans if lenders are willing to provide them are invariably included in large cap deals. These provisions enable the borrower to incur, subject to specified terms and conditions, additional term and/or revolving loans that constitute obligations under the existing loan agreement. Until recently, the borrower s capacity to incur debt under an incremental or uncommitted facility was capped at a maximum dollar amount and pro forma compliance with a financial ratio test was required. Incremental capacity in large cap facilities now frequently is based on a free and clear or freebie maximum dollar amount plus unlimited debt subject to pro forma compliance with a maximum leverage ratio. Many provisions increase the incremental capacity by the amount of prior voluntary term loan prepayments and permanent revolver commitment reductions. Until recently, the free and clear portion of incremental capacity was utilized before the ratio-based portion. In 2014, the borrower in many large cap deals can elect to utilize either the free and clear basket or the ratiobased basket, with the borrower in some deals being permitted to later redesignate debt incurred under the free and clear basket as ratio-based debt (if an increase in EBITDA enables satisfaction of the ratio). Alternatively, the ratio-based capacity may be deemed to be used before, or together with, the free and clear basket (in which case amounts incurred under the free and clear basket are not counted in calculating leverage). A recent iteration appearing in a few large deals further expands the free and clear basket by capping the amount at the greater of a fixed dollar amount or LTM EBITDA. Although this development may not be significant for lenders in the near term, it could expose lenders to a larger free and clear incremental basket in the future. Incremental free and clear baskets may meet resistance in 2015 due to the repayment requirements of leveraged lending guidance... Traditionally, the conditions to incurrence of incremental financing have included the absence of a default or event of default, material accuracy of representations and warranties and satisfaction of the leverage ratio (to the extent applicable), tested as of the closing date for the incremental loans. To obviate any financing risk arising from changes between the date of signing an acquisition agreement and closing, borrowers and sponsors recently have succeeded in limiting conditions for incremental loans incurred primarily to finance acquisitions to so-called Sungard conditionality (in some cases subject to the agreement of the lenders providing the incremental financing). Under typical Sungard standards the absence of payment or bankruptcy default (rather than all defaults), and the accuracy of only certain specified representations (rather than all representations) 13 is required. As noted above, financing risk recently has been limited further in agreements which permit the borrower to elect the LCA test date as the relevant date of testing ratios and absence of default (and sometimes accuracy of representations) for incremental financing incurred for limited condition acquisitions. Generally, incremental term loans must have the same terms as the original loans, but for pricing, tenor and amortization, and cannot have a maturity earlier or average weighted life shorter than that of the existing term loans. In order to protect existing lenders from incremental term loans being priced substantially higher than the existing term loans, most favored nation (MFN) pricing provisions usually apply to pari passu incremental term loans to prevent higher pricing for the incremental term loans without increasing the interest rate on the existing term loans (in most cases subject to a permitted differential of 50 basis points). The MFN usually applies to all-in-yield including interest rate margin and floors, upfront or similar fees and original issue discount, but not arrangement, structuring or other fees not payable to all lenders. Borrowers seek to limit MFN protection by having it sunset after a period of time, typically one year (or 18 months), after the closing date of the existing term loans. Lenders frequently push back on MFN sunsets and it is not unusual 13 Standard Sungard representations are limited to (i) those in the acquisition agreement relating to the target that are material to the lenders interests and would entitle the buyer to terminate or not close if not accurate and (ii) certain fundamental representations (e.g., valid existence; requisite power and authority; due authorization, execution, delivery and enforceability; no conflicts with organizational documents and material laws; governmental approvals; Federal Reserve margin regulations; Investment Company Act; solvency; status as senior debt; OFAC; Patriot Act; FCPA and collateral (subject to specified limitations)). BANKING REPORT ISSN BNA

4 4 for sunsets to be dropped during syndication. Another exception borrowers lately have negotiated for to a limited extent is to restrict application of MFN protection only to incremental term loans incurred in reliance on the ratio-based basket and exclude those incurred in reliance on the free and clear basket from the MFN. Borrowers have continued to negotiate for flexibility in the form of incremental equivalent debt. Historically, incremental facilities were limited to additional term loans or revolving commitment increases under the loan agreement, however, incremental equivalent debt now frequently is permitted in large cap loans. Incremental equivalent debt is incurred under a sidecar debt basket which shares the facility s incremental capacity but such debt is incurred outside the loan facility. Incremental equivalent debt may consist of pari passu secured notes, junior lien loans or notes or unsecured loans or notes, and in some cases pari passu secured loans also are permitted. MFN protections usually do not apply to incremental equivalent debt, except that the MFN sometimes applies to pari passu sidecar loans (but not to pari passu notes). Although incremental provisions appear in some middle market deals, middle market incremental capacity usually is limited to a dollar cap rather than permitting an unlimited leverage based amount. Middle market incremental provisions also commonly require pro forma compliance with a ratio-based incurrence test, frequently tied to the financial maintenance covenant in the agreement but sometimes a more restrictive test applies. Also, middle market incremental provisions may limit the number of times that incremental loans may be incurred. Incremental free and clear baskets may meet resistance in 2015 due to the repayment requirements of leveraged lending guidance (ability to repay 50 percent of total debt or 100 percent of senior debt within seven years), which has forced arrangers to ensure that borrowers can repay incremental debt incurred in reliance on a free and clear basket that does not result in additional EBITDA, for example by using the proceeds to pay a dividend. 14 As a result, there may be some pressure this year to limit the size of the free and clear basket and to restrict the use of the proceeds of free and clear incremental tranches. 14 LCD, n.2. Debt Incurrence Large cap loan agreements invariably contain numerous provisions enabling the borrower to change its capital structure and incur additional debt. This flexibility is provided through incremental facilities, refinancing facilities, amend and extend provisions, ratio debt, acquisition debt and other debt baskets, both under and outside the loan facility. Ratio debt has long been a feature of bond indentures which allow the incurrence of unsecured debt subject to a minimum fixed charge coverage ratio. In recent years ratio-based baskets have appeared in term loan B agreements, permitting unlimited debt incurrence subject to a maximum leverage ratio. Some term loan B agreements have adopted a bond-like test permitting debt incurrence based on pro forma satisfaction of a minimum fixed charge coverage ratio, usually 2.00:1.00. Secured debt, however, usually still is subject to pro forma compliance with a maximum first lien leverage ratio for first lien debt and a maximum secured leverage ratio for junior lien debt. Another concept commonly seen in bond indentures which sponsors have negotiated for in some term loan B facilities is contribution debt, which allows the incurrence of debt in the same amount as qualified equity contributions to the borrower. As noted above, a ratiobased basket for acquisition debt that is conditioned on either satisfaction of a specified leverage or fixed charge coverage ratio or such ratio not worsening on a pro forma basis from the ratio immediately before the transaction has appeared in some large cap deals. In addition, reclassification provisions permitting the borrower to reclassify debt, so that debt initially incurred under a fixed dollar amount basket when leverage is high can be later reclassified (in whole or in part) as ratio debt when leverage improves (thereby refreshing fixed dollar baskets), have been gaining acceptance in the term loan B market. Restricted Payments and Investments Many large cap credit agreements have included an available amount, cumulative credit or builder basket that can be used for restricted payments, investments and subordinated debt prepayments. In loan agreements, the builder basket traditionally began with a fixed dollar amount and increased as retained excess cash flow (plus contributed equity, returns on investments, declined mandatory prepayments and other items) accumulated. Satisfaction of a pro forma leverage test usually has been required to permit usage. More recently, builder baskets have trended towards the formulation included in high-yield indentures by building the basket based on 50 percent of consolidated net income ( CNI ) rather than retained excess cash flow and, in some cases, replacing the leverage ratio test with a fixed charge coverage ratio test. This provides borrowers with greater flexibility because a CNI basket typically is larger than a retained excess cash flow basket, and a coverage ratio condition often is easier to satisfy than a leverage ratio condition. Some deals have given the borrower the option to measure the basket based on the greater of retained excess cash flow or 50 percent of CNI. Regulators are particularly concerned with a borrower s ability to fully amortize all of its senior secured debt or to repay half of its total debt within five to seven years from base cash flows. Restricted payment covenants have become increasingly permissive. In addition to builder baskets, many large cap deals contain freebie baskets permitting restricted payments in a fixed dollar amount (or in some cases the greater of a fixed dollar amount and a specified percentage of EBITDA or total assets), subject only to the absence of an event of default. In addition, some recent large cap deals permit unlimited restricted payments subject only to pro forma compliance with a specified leverage ratio (typically tighter than the ratio COPYRIGHT 2015 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBR ISSN

5 5 for incurring debt) and the absence of an event of default. Mandatory Prepayments Asset sale and excess cash flow prepayment provisions continued to be diluted during Asset sale prepayment provisions now exclude certain dispositions, contain individual transaction (or series of transactions) and aggregate proceeds thresholds below which prepayment requirements do not apply and are subject to reinvestment rights over 12 to 18 month periods. Further, asset sale net proceeds are not required to be applied solely to repay the term loans but can be used to prepay ratably other pari passu secured debt that also requires prepayment. The calculation of excess cash flow to be swept typically is subject to broad deductions, including for certain restricted payments and other debt prepayments, and sometimes for anticipated expenditures to be made between the end of the calculation period and the prepayment date. Lenders usually may reject their mandatory prepayments, making the prepayment provision similar to the customary offer to repurchase in high-yield bonds. Disqualified Lenders Disqualified lender lists ( DQ lists ), by which the borrower excludes certain entities from holding its debt, are now common in large cap deals. Under disqualified lender provisions, a disqualified institution is (a) an entity designated by the borrower prior to the date of the loan agreement (or the date of the commitment letter in some cases), (b) any competitor of the borrower or its subsidiaries designated from time to time by the borrower and (c) any clearly identifiable affiliate of any of the foregoing. The DQ list enables the borrower to avoid assignments and participations of loans to competitors and to institutions reputed to be demanding in debt restructurings. DQ lists have become common in syndicated deals and this trend is expected to continue, despite investors view that such lists impair liquidity. Regulatory Constraints Federal bank regulators have made clear their intent to carefully scrutinize leveraged lending practices. The Federal Reserve, the FDIC and the Office of the Comptroller of the Currency, in announcing results of their annual Shared National Credits ( SNC ) review in early November, said they would increase their scrutiny of leveraged loans, citing serious deficiencies in underwriting standards and risk management of leveraged loans. The agencies said that the SNC review showed that a third of leveraged loans failed to adhere to the Leveraged Lending Guidance ( Guidance ) issued in March Regulators are particularly concerned with a borrower s ability to fully amortize all of its senior secured debt or to repay half of its total debt within five to seven years from base cash flows. The agencies noted four other areas of concern: underwriting standards, leverage, enterprise valuations, and risk management. Along with the SNC review results, regulators provided supplementary commentary on the Guidance and a set of answers to frequently asked questions ( FAQ ) in an attempt to help banks reduce noncompliant loan issuances. The agencies said that some of the more severe requirements of the Guidance, such as the limit of total debt to EBITDA of not more than 6 times or that a company be able to repay at least half of its total debt within five to seven years, are not a bright line, so long as other compensating factors make up for the weakness. Although bankers may be relieved that these factors are not a bright line test, the FAQ did not provide any clear guidance for determining how to evaluate and weigh which factors would be compensating. The regulators concluded that banks unwilling or unable to implement strong risk management processes will incur significant risks and should cease their participation in this type of lending until their processes improve sufficiently, 15 warning that the regulators would increase the frequency of their reviews. The OCC reiterated similar concerns about aggressive loan underwriting in an annual survey released in December, stating that underwriting standards have returned to risk levels seen before the 2008 credit crisis. 16 In late October, six federal agencies released their final risk retention rules which require CLO managers as sponsors to purchase and retain a 5 percent stake in the fair value of the liabilities of the CLO, in the form of a vertical pro rata share of the notes, a horizontal residual interest in the equity, or combined vertical and horizontal interests. The risk retention rules go into effect on Dec. 24, 2016 and the CLO market is expected to engage in exploring structural solutions in The Loan Syndications & Trading Association (LSTA) does not believe that risk retention rules are workable for much of the CLO market and has filed suit against the SEC and the Fed to seek a reasonable solution. The regulators concluded that banks unwilling or unable to implement strong risk management processes will incur significant risks and should cease their participation in this type of lending until their processes improve sufficiently... Looking Ahead in 2015 U.S. loan market fundamentals present a mixed picture for Improved economic fundamentals and high interest coverage ratios support a stable outlook for leveraged loans in the next 12 months, with default levels expected to remain low. At the same time, leverage levels have been rising, and documentation and credit quality have been deteriorating. The U.S. leveraged loan market likely will be less robust than in 2013 and 2014, with a greater portion of volume driven by merger and acquisition activity. An expected decrease in demand from CLOs and mutual funds may cause a rise in borrowing costs, and transaction conditions in 2015 may be less favorable for borrowers than in Increased regulatory scrutiny likely will lead to a greater unwillingness of regulated banks to participate 15 Shared National Credits Program 2014 Leveraged Loans Supplement, November 2014, pg Bloomberg, Dec. 16, 2014: Big Banks Return to Pre-Crisis Lending Standards, Regulator Says. BANKING REPORT ISSN BNA

6 6 in riskier deals. In adjusting to regulatory restrictions, private equity firms now reach out to more banks when seeking financing, knowing that some may find the structure or terms too risky, and are marketing loans directly to other investors. 17 Banks share of nonarranger allocations fell to a record low of 10.4 percent in 2014, 18 and banks share of the loan market likely 17 The Wall Street Journal, Dec. 3, 2014: Private-Equity Firms Adapt to Regulatory Clampdown. 18 LCD, n.4. will continue to erode in As fewer regulated entities are able to participate in more leveraged riskier deals, the trend that has existed for the last few years of unregulated, or less regulated, financing providers garnering a greater share of the leveraged loan market should continue. With regulatory concerns at the forefront and projected lower demand in 2015, borrowers and sponsors could face stronger investor opposition to aggressive loan terms and structure in the coming year COPYRIGHT 2015 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBR ISSN