May 22, 2023 - On May 18th, the LSTA and LMA jointly hosted their New York City Conference. Speaking to a packed audience, LSTA’s Executive Director, Lee Shaiman, launched the day with his opening remarks noting that although the leveraged finance market is a bit bruised, it is far from beaten. Secondary loan prices are up, and the Morningstar/LSTA Index has been modestly positive for this year. Amidst recessionary fears, downgrades, and an uptick in defaults, he found the silver lining behind the data — financial leverage for newly underwritten loans, as measured by the ratio of debt-to-EBITDA, has fallen below 5x for the first time in seven years.
LMA’s Head of Legal, Amelia Slocombe, then shared updates about the LMA’s latest projects. With more ESG regulation in Europe expected, the work to continue the alignment of ESG standards was critical, and the LMA is currently drafting a mandate letter for the Sustainability Coordinator role in ESG loans. The LMA also is currently drafting a new corporate lending document and a new credit risk insurance product policy document which will serve as a means to diversify risk rather than serve soley as a credit risk mitigant. Their continued work on LMA Automate was driven by strong member demand for technological advancements in the loan market. Sovereign debt, restructurings and a KYC checklist to standardize what borrowers should provide their syndicate are other LMA areas of interest.
Chief US Economist of BNP Paribas, Carl Riccadonna, presented on the economic challenges for the loan market. The level of US growth rate in 2021 had not been seen in the US since the 1950s; however, a more normalised growth rate of 1-2% is better for the eoncomy as whole. A 1% contraction in the economy combined with a 1% increase in unemployment (the unemployment rate is currently at 3.4%) would be ideal. The consensus is that we will enter a recession, but it need not be one that resembles the Global Financial Crisis. Rather it could look more like the 1990 recession when Former Chair of the Federal Reserve, Alan Greenspan, raised rates and induced a recession. The economy has run too hot for too long and with inflation at 5%, the Fed’s goal of a 2% inflation rate means that the Fed needs to let the recession smoulder, and, therefore, we should be prepared for worsening labor market conditions over the coming months. Rising unemployment without a recession is extremely rare. To date inflation deceleration has been driven by goods. To see downward pressure on services we need labor costs to drop and thus need the unemployment rate to increase above the current 3.4% level. Although the Fed has not used the “R” word, the dial is set for one to occur.
The first panel of the day then compared US and EU deal terms and trends with Amelia Slocombe moderating the panel with Elizabeth Tabas Carson of Sidley, Lewis Grimm of Jones Day, Seth Misshula of Invesco, and Jane Summers of Latham. The focus of the discussion was on liability management transactions. The lexicon had made its way into the loan market a few years ago by providing a way for borrowers to restructure the liabilities on their balance sheets. Common objectives for these types of transactions include seeking additional liquidity, deleveraging, and looking to extend upcoming debt maturities. J Crew blockers, a provision which prevents a borrower from transferring material assets to an unrestricted subsidiary, are now standard in EU credit agreements. Primarily because Europeans are less litigious than their American counterparts, and because European case law is unfavorable in this regard and EU credit agreements generally lack the requisite flexibility for these transactions to be done, parties in Europe who may be seeking to effect such a structuring which results in the abuse of minority lenders were cautioned. Because of the current style of drafting US credit agreements, the buyside community has seen a profound change in the analysis of credit risk – – a potential lender cannot simply analyse the underlying business but must also analye the applicable credit agreement. Understanding the credit documents is key to minimizing the downside. There are many more loopholes in NY law governed credit agreements, with European documents being much cleaner and where credit protection is not in the relevant credit agreement, lenders will pass on the deal and not acquire the loan. Regrettably, the panel concluded by noting that there does not yet seem to be a trend in the US, despite the Serta case, to define “open market purchase” in credit agreements.
Deborah Staudinger of Hogan Lovells then moderated the Private Credit Trends panel with Joshua Groman of MidCap Financial Services, Albert Lee of Crescent Capital Group, and Matthew Schernecke of Hogan Lovells. With the focus on direct lending, the panelists all agreed that direct lenders are benefiting from the slowdown in the BSL market. The primary attraction of executing a deal with direct lenders for borrowers was the better dialogue amongst borrower/sponsor and lenders, allowing lenders to be proactive and have that necessary conversation with the borrower well in advance of any liquidity shortfalls. Private credit has been growing steadily with $1.4 trillion AUM currently; and fortunately, it seems only to have been minimally impacted by the recent bank failures. But some are becoming more aggressive with credit agreement terms, with some deals including the option for borrowers to PIK interest rather than pay cash for interest payments. With some of the direct lending deals having 18-20 lenders, direct lenders may begin to focus more on voting provisions in the credit agreements, and thus it is possible for those provisions to evolve. However, the panelists seemed to think that a secondary market would run counter to the direct lenders value proposition of providing an opportunity for an easy conversation to ensue amongst the parties whenever needed.
The Keynote speaker and geopolitical strategist, David Chmiel of Global Torchlight, then delivered his address, “Any Sign of Light on the Horizon? Geopolitics and the Loan Market”. The war in Ukraine is at a critical period, and although opposition to national military involvement remains very high, people around the world continue to support instead higher energy prices that flow as a result of Russian sanctions. Chmiel identified the emergence of China as a military and political power, its competition with the US, and its deterioration in bilateral relations with other countries around the world as the defining geopolitical issue of the next decade. What is concerning is that the US relationship with China seems to be in free fall now as if policy is being made up on the fly, with no general sense of direction of where things are going and what the parameters will be that define the US – China relationship. There are rising powers that need to be considered as well because of the changing mega trends like changing demographics. Notably, India has recently become the largest country by population on earth. With a young population entering the labor force in India, a democratic country, if its people do not have economic opportunities, they will take it out at the ballot box. Unfortunately, public opinion is rising that things are getting worse and that people cannot provide for their families. Furthermore, there is a disparity in the top earners and the bottom earners and whether they trust institutions. We live in bubbles, and we must still to be aware of the political challenges that may seem unrealistic to us could be very real to others. Finally, Chmiel noted that assumptions about the world in a playbook written 10-20 years have now changed. Whether there is a sign of geopolitical light on the horizon is a complicated questions requiring a nuanced response (although we may think we see what could be a dumpster fire in the next town over). There are glimmers of hope on the horizon, and economic codependency can still act as a break on competition.
The next session, Sustainable Finance: Maintaining Integrity, took a deep dive into the structuring of sustainability-linked loans in the U.S. and Europe. Panelists included Gemma Lawrence Pardew of the LMA and Tess Virmani of the LSTA who have maintained the Sustainability Linked Loan Principles and related guidance since their launch as well as the project counsel for the associations’ inaugural drafting guidance/riders, Sukhvir Basran of Cadwaladers and Bob Lewis of Sidley. To level set, an SLL is any type of loan for which the economic characteristics can vary depending on whether the borrower achieves ambitious, material, and quantifiable predetermined sustainability performance targets. This is typically achieved through annual performance tests which result in a margin discount where met and a margin premium if not (or performance has deteriorated). The panelists highlighted the importance of the SLLP in maintaining the integrity of SLLs and shared how these documents should be used – the SLLP, while voluntary, represents the basic standard for what is categorized as an SLL, where the guidance document is a non-exhaustive practical guide developed from FAQs that arise when applying the SLLP to a transaction. In turning to the LSTA’s Drafting Guidance for SLLs and the LMA’s SLL Riders, the panelists noted the challenge that the broad applicability of SLLs, their bespoke nature and evolving market practice presents for standardizing credit agreement provisions. For this reason, the documents are best seen as educational resources which align with the SLLP and guidance rather than a necessary starting point for drafting in a given transaction.
The last session of the day – “Recoveries and Default Risk” – covered a topic that is coming into keener focus. Monique Mulcare of Mayer Brown, Judah Gross of Fitch Ratings and Melissa Coakley of Clifford Chance highlighted the sectors of concern are Healthcare, Leisure & Entertainment, and Telecommunications, Technology & Media as demonstrated by the Fitch U.S. Leveraged Loan Default Index. As forecasts of the default rate have risen, that is against the backdrop of a more fragile market. Fitch data shows that from December 2021 to January 2023 their ratings portfolio has shown market degradation with the share of CCC and B- both doubling and the share of BB falling to 33% from 52%. Moreover, in 2022, the number of BSL first lien instruments estimated to recover greater than 90% of par fell below the 50% threshold, and all sectors experienced a downward shift in recovery expectations. That should be compared to the historical average recovery rate of 76% and a median of 95%. Picking up on the topic of liability management transactions (LMTs), panelists shared that LMT transactions have only deferred bankruptcy filing for those borrowers for a short period so may not be highly effective. From the lender perspective, LMTs have a high deleterious impact on recoveries, particularly for non-participating lenders. From a European perspective, restructuring market has been relatively quiet post-COVID but defaults are starting to tick up so it is a space to watch. With respect to LMTs, as noted earlier in the day Europe’s lack of sufficient credit agreement flexibility and favorable case law means LMTs have been absent. On the other hand, where legislative reform around the U.S. Bankruptcy Code is not expected to result in near-term change, the EU members states have begun implementing the 2019 European Harmonisation Directive relating to restructuring and insolvency. Creditors should be aware of this new legislation and ensure that their expectations continue to hold true.
Click here for the conference slides.