COVID-19 lockdowns sent ripples through the market’s supply-demand dynamics.
Overall leveraged finance issuance (high yield bonds and loans) in North America and Western and Southern Europe fell by a quarter in Q2 2020 to US$368.3 billion from US$493.5 billion in Q1. The drop was even more pronounced in Asia Pacific (excluding Japan), with leveraged finance issuance sliding from US$40.8 billion in Q1 2020 to US$17 billion in Q2 2020.
This fall in demand for new loans and high yield bonds has shifted lender risk appetites and prompted closer lender scrutiny of the borrower-friendly debt structures that were common pre-pandemic. However, lenders in different markets have responded differently to the challenges imposed by COVID-19, with US lenders generally taking a more conservative approach than their colleagues in Europe and Asia.
Protective pricing measures vary by region
The most noticeable shift in documentation relates to pricing, with LIBOR floors—which guarantee a minimum interest rate for lenders when there is a declining interest rate environment—in the US market and increases to original issue discounts (OIDs or discounts offered on the face value of loans to attract lenders) gaining prominence.
The Federal Reserve in the US, the Bank of England, the Bank of Canada, the Bank of Japan and China’s central bank have all cut rates in 2020 to support economies impacted by COVID-19. Australia’s central bank also cut rates to record lows.
A backdrop of falling base rates has resulted in interest rate floors in the US being rebased with a noticeable move toward higher LIBOR floors, according to Debtwire Par. The percentage of deals with 1% LIBOR floors climbed from 12% in Q1 2020 to 47 % in Q3 2020 to date. The percentage of US institutional loans with 0% floors, meanwhile, fell from 86% to 26% in the same period.
Professional services firm Duff & Phelps and Kissner Group, a maker of pool salts and water softeners, are among the loan issuers to include LIBOR floors in documents for loans issued during the pandemic.
In Europe, by contrast, there have been fewer examples of lenders demanding 1% floors, and 0% floors remain a feature of the market.
Original issue discounts more prominent
OIDs may also be widening due to the impact of the pandemic. OIDs have always been a feature of the market and are typically made by borrowers to underwriters, who then typically pass on any discounts to the market.
OIDs were being offered by underwriters to the market pre-COVID-19 but, according to Debtwire Par, more than half (52%) of leveraged institutional loans issued in the US in Q2 2020 were issued at 98 or lower. In Q1 2020, by contrast, 52% of US loans priced at par or above. The merger of casino groups Eldorado Resorts and Caesar’s, for example, saw a US$1.8 billion loan issued to finance the deal offered at 97% of par.
The European market has also seen high profile examples, such as Bain Capital’s refinancing of consumer research agency Kantar in a deal that was offered at 93.5; and a general corporate purpose loan issued by cruise line operator Carnival at 96.
Add-backs in the spotlight
Lenders have also zeroed in on certain borrower-friendly terms that had become regular features in documentation.
For example, lenders have been looking at unrestricted subsidiary structures. These allow borrowers to move assets out of corporate entities against which loans are secured and/or that are subject to restrictive covenants, to other unrestricted entities. This facilitates further borrowing by those unrestricted entities.
Lender pushback on unrestricted subsidiaries has not necessarily been a direct consequence of COVID-19—lenders were already joining forces and pressuring borrowers to unwind unrestricted subsidiary transactions before the pandemic. However, during the lockdown this remained a focus of concern.
EBITDA add-backs, which are certain categories of expenses and other deductions, as well as certain pro forma adjustments, that are permitted to be added back to EBITDA, have also become subject to greater scrutiny. Lenders are paying close attention to the rationales for adjustments to earnings, which can make earnings appear artificially high and delay defaults and restructurings.
There are still examples of borrowers examining loan documents to see if any COVID-19 costs and financial impacts can be included in adjusted EBITDA numbers to prevent tripping a covenant. Lenders, however, are being careful to ensure reduced revenue is not covered (in a second wave of the pandemic, for example).
Attitudes toward covenant-lite loan issuance have not changed much during the pandemic. According to Debtwire Par, 91% of European institutional loans issued in H1 2020 were cov-lite, with 81% of US loans agreed on a cov-lite basis over the same period.
The slowdown in M&A and leveraged finance activity means there have not been enough deals to confirm a definite trend, but the fact that deals like Eldorado/Caesar are being done on a cov-lite basis indicates that lenders are more focused on other terms in the documentation.
Regional nuances are also at play. In Asia’s bank-led market, for example, there has never been much cov-lite issuance. Since the start of the pandemic, lenders in the region have focused on credit quality rather than trying to drive tighter terms. As in other regions, EBITDA add-backs continue to be a focus but bank lenders remain supportive of the market, while keeping a cautious eye on credits that might be overly affected by China-US trade tensions or supply chain disruptions.
Indeed, credit quality is a theme across all jurisdictions. Attractive credits will continue to secure financing on good terms, but lenders are holding their ground in certain areas.