Documentary developments in more difficult times | White & Case srl
Key points to remember
The risks posed by rising inflation, worries about a global recession and the lingering impact of war in Ukraine are seeing lenders and investors start to cut back on the soft, borrower-friendly terms that have characterized the documentation of loans in recent years.
According to Debtwire Par, covenant-lite loans still accounted for 84% of institutional loan issuance in the year to the end of June 2022 (just 2% lower than what was seen in the 2021 bull market and equal or higher than any other year dating back to 2013), but a tougher syndication market is prompting borrowers to change the terms for closing deals.
Covenant Review’s analysis, which rates the strength of loan document covenants on a scale of 1 (most protective) to 5 (least protective), provides evidence that lenders get more protection in the documents. In May, the score for loans reviewed by Covenant Review rose to 3.39, representing the most protective score since August 2020. This compares to scores earlier in the year of 4.14 in February and 3, 93 in March.
Covenant-lite loans accounted for 84% of institutional loan issuance in H1 2022
Lenders’ pushback on the documentation, however, has not been massive. High-quality credits and private equity (PE) backed deals are always able to secure borrower-friendly features such as unlimited sub-conditions and generous producer baskets built into the loan documentation. (Producer Baskets – generally structured as the greater of a fixed dollar amount and an equivalent percentage of EBITDA at the closing date – allow borrowers to incur additional debt or take certain other actions, which would otherwise be restricted by lenders, within a set limit or percentage of earnings.)
Borrowers may not be pushing for loose documentation with the same intensity seen last year, but high quality loans backed by regular blue chip sponsors continue to enjoy favorable terms.
For regular private equity issuers, there has been more flexibility on the lender side. According to Covenant Review, equity-backed loans were able to obtain more lending terms than other issuers, with a score of 3.51 on the Covenant Review scale in May 2022.
For this select group of issuers, concessions have been on the edges, with borrowers only ceding ground on some points rather than a general pullback.
For now, flexible covenants that allow borrowers to exclude certain liabilities from leverage calculations are still available, as is additional flexibility on baskets, which gives borrowers the ability to spend thresholds higher income in dividends or other investments.
Leading direct lenders
Borrowers have also benefited from a convergence between the conditions of the syndicated loan and direct loan markets, with the traditionally better documented direct loan offering approaching the approach of the syndicated loan market.
With trade execution risk and pricing flexibility being more of a concern in the current environment, direct lenders have been able to compete with the syndication market by holding credit on their own books and offering borrowers flexible terms.
Some direct lenders offer debt on a cov-lite basis, a change from the status quo where they would require a financial commitment test at the end of each quarter. Cov-lite agreements include a spring-loaded financial covenant – usually a leverage test – which only becomes effective when a borrower draws on a revolving credit facility above a set threshold, including letters of credit that have been issued.
For financial sponsors borrowing to finance purchase and construction strategies, direct lenders have provided deferred term loans, which provide borrowers with a line of credit that can be drawn down over an extended period when it is necessary to finance complementary agreements.
The syndicated market will also offer the flexibility of a deferred draw term loan, but the commitment fees charged by direct lenders are generally much lower and it is also easier for borrowers to extend loan termination dates. engagement with direct lenders, if necessary.
Basket sizes, leverage ratio calculations, and additional funding capacity in direct loan documents are also becoming less and less distinct from those of syndicated loans, although direct lenders have begun to retain more ground on conditions lately following the extensive market disruption. syndicated markets, which increased their leverage.
Lenders push up on prices
In addition to reviewing some of the documentation flexibility, lenders have also pushed pricing as a way to mitigate risk. According to Debtwire Par, average spreads on senior institutional term loans reached 4.31% in the second quarter of 2022, well above the first quarter average of 3.96%.
Credit quality has been a key determinant of pricing, with a widening gap between higher and lower rated credits. For higher-rated borrowers with double-B ratings, spreads narrowed in April and May. Lower-rated credits, on the other hand, had a much harder time negotiating syndication and were forced to price debt generously to persuade investors to join. B-rated borrowers saw their spreads climb to almost 5% in the second quarter of 2022, from 4.18% in the first quarter of 2022.
Broader initial issuance discounts (OIDs) also became a standard feature of transactions in the first half of 2022 to compensate investors for increased risk, and they followed lower prices in secondary markets. According to Debtwire Par, haircuts averaged 48 basis points in January 2022, but jumped to 473 basis points in June as the average issue price of new loans fell to 95.27% of par. OIDs continue to deepen, with new issues on the way with OIDs between 80 and 90.
While interest rates are expected to continue to rise, higher prices are already becoming a feature of the market over the medium to long term. Moves towards stricter documentation could follow.