The US loan market has proven resilient over the past year despite many challenges. Its course since the beginning of 2011 has been marked by numerous short, steep cycles and sudden twists and reversals in response to broad macroeconomic concerns and the continuing reverberations and after-effects – both economic and regulatory – of the credit crisis that began in 2007. Large volumes have at times masked a shortage of 'new money' financings, as borrowers took advantage of significant liquidity to refinance existing facilities and extend nearing maturities. Demand for new loans often – though not always – exceeded supply and, with LIBOR and other relevant indices remaining low, corporate loan pricing and terms have generally remained attractive to borrowers. With low default rates and the continued re-emergence of 'CLO' lenders, the US loan and credit environments have generally remained open and active.
Lenders generally prefer stability to uncertainty; the past year has provided an abundance of the latter. At the time of writing this, banks and non-bank lenders alike are confronting, among other things, the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, including the much-discussed 'Volcker Rule' and risk-retention ('skin-in-the-game') requirements for loan buyers; the new capital and liquidity requirements of the 'Basel III' accords; and increasingly plausible scenarios for the break-up of the Eurozone. Dodd-Frank compliance and Basel III will almost certainly impair the profitability of some lending activities by affected institutions, though the exact effect will not be clear until regulators agree on and impose final rules and the banks and other lenders test them in practice. Risk retention and similar requirements may well have a disproportionate effect on CLOs and similar market participants, who may be required to retain a larger participation in the assets they acquire than they have in the past. Concerns for the future of the Eurozone – setting aside the larger economic concerns about recession – have similarly chilled activity in affected regions.
Add to these regulatory and legal matters persistent worldwide economic questions: in the United States, concerns about the sustainability of public debt levels and uncertainty about the approaching national elections; in the European Union, serious recessions, sovereign debt crises and continuing debates over the economic best-way-forward in several of its member states; and in large developing market economies – particularly but not exclusively China – anxieties about whether each slowdown is a short-term retrenching or the beginning of a more fundamental change. All considered, the most noteworthy point might be that the loan markets have remained as healthy as they have.
Loan market activity in 2011 and early 2012 illustrates the correlation between market liquidity and financing terms. The first half of 2011, extending the borrower-positive trends from late 2010, was characterized by a high volume of refinancings, amend-and-extends, dividend recapitalizations and increasingly aggressive structures, including higher leverage levels, covenant-lite facilities, tightening of pricing (including through reduction of original issue discount), and weakening or even disappearance of call protection. In the late summer, however, heightened visibility and anxiety over many of the factors listed above – including the perception of US political deadlock and the downgrade of US treasuries – brought the loan markets to a virtual standstill despite low default rates and strong credit fundamentals. This slowdown, combined with a crowded pipeline of large committed acquisition financing transactions, including several significant LBOs (Blackboard, KCI, Go Daddy’s, BJs, Emdeon), created a significant demand/supply imbalance. The near-term impact of this imbalance was dramatic. Secondary prices fell, triggering a corresponding increase in pricing and/or original issue discount demanded by lenders (sometimes beyond flex caps, to the dismay of committed arrangers). The required amount of equity contributions in LBOs increased and maximum leverage levels correspondingly decreased. Call premiums re-emerged. Underwritten covenant-lite loans temporarily disappeared. As inventory cleared and conditions stabilized in October and November, we saw a return to more aggressive structures, producing a strong overall performance for 2011. Volatility in the loan market and corresponding volatility in loan terms may be indicative of the increasing importance of institutional or relative value investors, who move in and out of markets and between investment products more readily and are more heavily influenced by macro-economic trends such as those described above.
While the paired movement of liquidity and certain aggressive loan terms is an important theme of the non-investment-grade loan market in recent years, some trends seem to have become more permanent. One example of this is financing flexibility. During the credit crisis and its immediate aftermath, many borrowers sought ways to extend loan maturities, effect below-par repurchases in the open market or through modified Dutch auctions, or refinance existing pieces of multi-tranche facilities through longer-term facilities with less restrictive or no financial maintenance covenants. Because many then-existing agreements did not contemplate those arrangements, borrowers have now begun to seek pre-wired financing flexibility, including language in facilities that permit loan buy-backs or affiliate purchases, 'amend-to-extends' (allowing extensions of maturity with the consent of extending lenders only) and 'refinancing facilities' that allow, for example, the refinancing of a particular term tranche within a credit facility either within or sometimes alongside other tranches of that credit facility but with shared collateral, all without a separate required-lender approval. Incremental facilities allowing increased size with just the consent of new lenders – sometimes called accordions – have also become very common in leveraged facilities, though the amounts and terms, including of 'most-favored-nation' price protection, are often heavily negotiated.
The continuing availability of covenant-lite loans – loans with no financial maintenance covenants – is another noteworthy feature of US loan markets, one that distinguishes it from the European loan market at least in degree. After being pronounced dead by some during the financial crisis, covenant-lite began its comeback in 2010 and has since become fairly common, at least in stronger periods, in sponsor-backed leveraged financings. Although it is still rare to see a non-investment-grade revolver without a financial covenant, a covenant-lite term loan is often combined with revolving credit facilities (including asset-based revolving credit facilities) that contain 'springing' financial covenants that only apply upon meeting certain utilization or excess availability thresholds.
Going Forward During 2012
Overall loan volume in the first quarter of 2012 was down significantly from the first quarter of 2011. And activity has centered on refinancing and dividend recaps, with less, at least in the non-investment-grade arena, driven by mergers and acquisitions and other new-money events. The troubles of the European banks may, however, present opportunities for US banks, as several European borrowers (including Ineos, Taminco, UPC and Formula One) have looked to the US loan market for financing. This has drawn attention to the differences between practice in English/European and New York loan documentation, practices and legal regimes. In addition, there has been a material increase in new CLO issuances. And there is an interesting trend towards creating short dated term B loans (with pricing and maturity somewhere between a term A loan and a true term B loan) designed to take maximum advantage of CLOs that are nearing the end of their lives. This all suggests that despite a challenging environment and the likelihood of continuing volatility, attractive opportunities will continue to exist in the US loan market for borrowers, arrangers and lenders alike.