October 25, 2018 - We were delighted to host 1,100 members (and future members) at the LSTA’s Annual Loan Conference on October 24th. As befits the times, the conference focused on Managing Risk (today) and Optimizing the Future. Below, we discuss the themes that surfaced during the day, offer the main takeaways and, of course, thank our attendees and 28 sponsor and exhibitors. Most presentations are available on this presentation page of www.lsta.org.
We started out managing risk from a big picture perspective as Dr. Doug Holtz-Eakin, a noted economist and policy advisor, discussed the state of the economy and outlined looming risks. In the short term, things are good: The economy is strong due partly to the reduced regulatory environment. (Trillions of dollars of GDP had been lost in regulatory capture and have since been released!) Moreover, the tax cuts added 1% to GDP this year and maybe 80 bps next. But…the president’s trade policy is not entirely rationally based, and may be destructive longer term. Moreover, the debt and future liabilities will force a day of reckoning that could be very destructive to the US economy and US prestige.
Risks also exist within loans (newsflash!). The Federal Reserve used the conference to share its “Perspectives on Leveraged Lending”. First, the Fed is not absent. Recent speculation on Leveraged Lending Guidance notwithstanding, the Shared National Credit Review (SNC) still exists, banking regulators still risk rate loans (and underwriting standards), and still have a safety and soundness mandate. Todd Vermilyea, Senior Associate Director at the Fed, noted that they do have risk management concerns, specifically around risk layering through combinations of incrementals, EBITDA addbacks, collateral stripping, reduced subordination and covenant lite-ness. And, rumors notwithstanding, the Fed still tests whether banking practices are safe and sound.
While the Fed discussed some of their documentation and structural concerns, the primary market documentation panel drilled far deeper. Borrowers continue to push the boundaries of credit agreement terms. Today’s borrowers are seeking the right to consent to buyers settling loan trades as participations, but for now are having to settle for merely being notified of new participants. Traditionally, credit agreements have included a change of control provision that triggers an event of default (or may give rise to a mandatory prepayment event) when the borrower is sold to a third party. Increasingly, deals are including a portability of debt provision that permits a sponsor to sell its equity in the borrower without tripping the change of control provision, thus potentially allowing a buyer to maintain the company’s existing capital structure. This potentially reduces transaction costs, uncertainty, and closing times; however, the provision often includes complex technology, which may be difficult to implement. Finally, some borrowers are seeking greater certainty about when they can “cure” a default after a grace period lapses (and before an acceleration).
So what do these document, structural and market changes mean for risk? A panel of leveraged finance experts shared their view. First, wild growth in “leveraged finance” is a myth. LevFin has actually averaged an annual growth rate of just 2.4% over the past four years; this reflects a combination of shrinking HY bond outstandings (-0.9% p.a.) and growing loan outstandings (+7.1% p.a.). Why is loans’ share growing? Because there is more M&A and LBOs, and the funding increasingly is coming just from loans. While risks indubitably are increasing – there is more debt, fewer covenants, looser docs and less subordination – there are few potential triggers for defaults. In turn, it is possible that defaults remain benign for years to come. And when the pendulum does swing, it will be a downturn, not a credit crisis – and most likely will look like a shallower version of the 2001-2003 TMT default cycle.
Of course, default is not the only risk out there. For instance, after default, there is bankruptcy. Today there is a question on whether bankruptcy is “fair” (and, if not, should senior lenders be penalized?) This is a provocative thesis of an academic that posits that bankruptcy is not fair, that secured creditors exert too much control and that “involuntary” participants, like tort claimants, get the short end of the stick in bankruptcy. A bankruptcy practitioner countered that not only is the current process efficient, other solutions seeking “fairness” are impractical. (Plus, proposed changes presumably would not be good for loan recoveries.) On the issue of involuntary participants, all sympathized that they are overlooked in the bankruptcy process but that an easy solution is elusive.
Focusing on managing risk in today’s market, a modestly optimistic outlook pervaded the secondary panel; while stocks traded down more than 4% this month, the loan market delivered a positive return and substantially outpaced fixed income. Why? As interest rates have moved higher, demand for loans has increased substantially – thus allowing the loan market to outperform during a period of growth. Looking forward, panelists see a 50% chance of a recession in the next two years. While it likely will not be soon, when defaults do come, recoveries may be lower and more dispersed. In turn, secondary prices will naturally trend lower while the cost of credit increases – a natural occurrence at the tail end of any credit cycle.
While the sellside panels were cautiously optimistic on credit risk, the buyside panels were trying to mitigate supply risk, manage challenging arbitrage and keep their documents as firm as possible. The CLO panel saw risk retention as conceptually counterproductive, but perhaps somewhat beneficial as it opened many investors’ eyes to the attractive risk-reward profile of CLOs. Still, after going strong this year, CLO forecasts have been trimmed, as the arbitrage becomes even more challenging. While supply of loans is a constraint, panelists were not overly concerned about ratings migrations or defaults – the structure of CLOs handles these reasonably well and CLOs often can be buyers in downturns. After all, the best performing CLO vintage was 2007.
At the lower end of the market – the direct lenders – concerns circled around sufficient supply of deals and maintaining solid standards in underwriting. Capital formation remains robust, but slower than in recent years. Terms of financing structures like unitranches are becoming increasingly stretched. On the flip side, though, direct lenders eat their own cooking and are incented to ensure credit remains sound.
Optimizing the Future
While half of the conference was about managing risk, the other half focused on optimizing the future – sometimes in challenging situations.
First place to optimize? The regulatory and legislative world. Former Senator John Sununu reminisced about managing risk through TARP (largely successful) and optimizing the (regulatory) future through Dodd-Frank (not successful; every imaginable idea got thrown into that legislation with profound unintended consequences). To optimize our own regulatory future, Senator Sununu also counseled the LSTA and its members to continue engaging on Capitol Hill and with the regulators. While the regulatory environment is relatively benign now, the coming midterm elections or exogenous events may lead to dramatic changes.
While DC is changing in unrecognizable ways, so is the world. And, many times, this is for the better. Guest speaker, April Rinne, discussed the “Sharing Economy“ and explained that the on-demand, freelance, and collaborative economies all describe different parts of today’s sharing economy, with companies such as Uber, AirBnb, and Rent the Runway perhaps its most recognizable names today. However, it is not just transportation, real estate, and retail that are being impacted by the sharing economy; the healthcare, energy, and insurance industries also are having to adapt. As consumers shift from valuing ownership of goods to seeking access to goods, companies will need to embrace both owned and shared options. Importantly, it will be the insurance industry that will be the enabler of this new way of doing business. The sharing economy is a global phenomenon, with South Korea including it in their schools’ curriculum, the UK building it into their nation’s GDP projections, and China declaring it to be a national priority. So what does this mean for the loan market? When evaluating potential corporate borrowers, lenders will need to assess whether the company has factored in the impat of the sharing economy on its own business model and how its industry will be reshaped by the sharing economy in the years ahead and positioned itself accordingly.
In a somewhat similar vein, the loan market is going green(ish) and sustainable(ish). 2018 has seen the first green loans and sustainability-linked loans hit the U.S. The market has seen only a smattering so far, with about $2.2 billion of YTD activity in the Americas, but interest both from borrowers and investors is building. The investor push will be an important contributor to the growth and that demand will not be only ESG investors. Increasingly, institutional investors are seeking to incorporate ESG considerations in their mainstream investment frameworks. Green and sustainability-linked loans are just one step in meeting this demand. Much is unknown but this is certainly a space to watch.
There is another sustainable effort underway in our loan market – the development of a more sustainable (potentially better?) reference rate for loans. Sandie O’Connor, JP Morgan’s Chief Regulatory Officer, Chair of the ARRC and sixth most powerful woman in banking, explained why moving from (rickety) LIBOR to (robust) SOFR is not just an in invention born out of necessity, but also a step in the right direction. Less than $1 billion of daily USD-based LIBOR “trades” underpin a whopping $200 trillion of USD-based LIBOR contracts. Moving to SOFR, which counts around $800 billion in daily trades, would stabilize the reference rates edifice considerably.
Drilling down again to loans, we’re making progress sustaining delayed compensation as well. In fact, we asked whether Primary Delayed Compensation was “To Be, or Not To Be”. Happily, the resounding answer was “To Be!” The protocol was unanimously approved by the LSTA Board on Tuesday. In turn, on Wednesday, we discussed the benefits, rules and exceptions of the standard, while fully appreciating that it is borne of compromise between the banks and the buy-side investors. All predicted that implementation will be accompanied by positive change in practices and behavior such that not only primary, but also secondary settlement times, will be reduced.
The LSTA would like to thank the 1,100 attendees at the conference as well as our Sponsors (S&P/LCD, ThomsonReuters/Refinitiv, Cortland, Fitch Ratings, HIS Markit, Bloomberg, Finastra, Virtus, BNY Mellon, US Bank, Advantage Data, Ipreo Debtdomain, Deutsche Bank, Wilmington Trust, Moody’s, Market Axess, Winston & Strawn, Alston & Bird, Proskauer Rose, Richards Kibbe & Orbe, DLA Piper, Allen & Overy, Seward & Kissel, Katten Munchin, Alcentra and Sidley Austin) and Exhibitors (FIS Global, Wells Fargo, Black Mountain, Xtract Research, Debt Xchange, ClearStructure, Loan Ecosystem Online, S&P Ratings, S&P Cusip and HashLynx).