The distressed funds drowning in froth

Any private debt investor nursing a cappuccino in a cafe in London’s West End, as they informally discuss a potential deal with a private equity sponsor, will notice – if they think about it at all – that the froth on the coffee is pretty much the same as it was in the cafe round the corner where they had their last meeting.

By contrast, the froth that investors complain about in Europe’s private debt market – the bidding down of lender returns and terms caused by the imbalance between supply and demand – will notice that it takes many different forms.

One of its most common manifestations – and one of the most worrying to some observers – is the growth of stricter restrictions than before, imposed by the borrower, on the transfer of ownership of the loan.

As Annette Kurdian, banking and finance partner at Linklaters, the law firm, in London, puts it: “The market at the moment is awash with very borrower-friendly terms and this is just one part of it, but it’s one important part of it.”

Investors and industry experts worry that such restrictions could reduce liquidity in the market.

Any assignment of loans typically requires the prior written consent of the borrower. Although consent may not be “unreasonably withheld”, many lenders are unwilling to rely on this, not least because the burden of proof lies on the lender to show that the borrower is being unreasonable.

For this reason, many have long inserted into loan agreements a “whitelist”: a rollcall of companies to whom the loans can be assigned without borrower consent. The list often runs to more than 100 firms, whose business model is based on investing in debt at par or close to it, and patiently waiting for scheduled interest payments and eventual repayment of principal.

It is becoming increasingly difficult for firms outside this list to take on the debt.

“The starting point is common sense from the point of view of the sponsor,” says Pierre Maugüé, London-based finance partner at Debevoise & Plimpton, an international law firm. “Ideally you would like your loans to be held by a group of lenders who are supportive of the business.” Among other things, “as a borrower, you want to know that, if the business starts underperforming, your lenders will listen to you with a sympathetic ear”.

This has given rise to one of two alternatives, intended to protect the borrower. One approach is a generic exclusion of investors deemed to follow the more aggressive model favoured by distressed and special situations funds, which is likely to include aggressive restructuring of debts or a strategy of “loan to own”. The other approach is to devise a “blacklist” of named firms regarded as unattractive investors. In many cases there is also a prohibition for a borrower’s trade competitors, to prevent them accessing commercially sensitive information as debtholders.

Everybody out

Prohibitions on transfer to distressed investors and competitors has reached “almost 100%” take-up for large-cap sponsored deals, according to Kurdian.

Sponsors these days tend to favour the generic exclusion approach. Alan Davies, finance partner and colleague of Maugüé at Debevoise & Plimpton in London, says this is “partly because if you have a blacklist you might miss somebody, and partly because, as an equity sponsor, you don’t want to be passing around the market a list of your Public Enemies Numbers One to One Hundred”. He explains: “If you put some well-known big funds on your blacklist, and they get to hear about this, they might not want to do any business with you in the future.”

In the old days these restrictions used to fall away in certain circumstances. “The traditional market standard used to be that once a default occurred, all bets were off, and the lenders didn’t have to worry about the whitelist any more,” says Maugüé. “They could transfer their loans to other lenders without seeking consent from the borrower.” However, in the early 2000s this began to tighten up from “any event of default” to “a serious event of default”, such as a missed payment or outright bankruptcy.

Restrictions have become a lot stricter more recently. Debt Explained, a data provider, has charted the trend. In 2016 23 percent of deals on its database of European leveraged loans, almost all of them for sponsored deals, gave the borrower complete discretion to withhold consent to a transfer to a distressed debt fund. By 2017 this had risen to 29 percent, and in mid-2018 it is running at 47 percent, of which three-quarters allow the borrower complete discretion to refuse consent even after a default.

Many lenders are highly concerned about this trend towards prohibition, in many cases on very circumscribed terms.

“It makes it more difficult for the special situations and distressed funds to participate in the broadest array of loan opportunities,” says Anthony Robertson, head of the Strategic Value Credit group at Cheyne Capital, the alternative asset manager, in London. Moreover, “it’s disadvantageous to the institutional loan community” – par lenders in the primary market – “because their ability to exit based on some future credit impairment is going to be substantially diminished”.

Asked what these greater restrictions will mean when the credit market downturn increases the number of borrowers in distress, Robertson predicts: “I suspect that institutional loan funds looking to sell loans will be limited in their ability to do so, and will suffer mark-to-market declines, which will hurt the performance of the funds.” He also thinks these clauses could work against the interests of the sponsor-led companies, by postponing necessary restructuring.

Par for the course

In theory the presence of long whitelists should make it easy to find a buyer for debt that the original lender wants to offload. However, Stephen Mostyn-Williams, chairman of Debt Explained in London, disagrees. A whitelist does little to help a par lender offload their debt in the event of a payment default, he says, because it consists of other par lenders that will have limited interest in such debt by this stage. He describes the recent tightening of transfer restrictions as “dangerous for investors”.

Given these constraints, it is not surprising that potential lenders are perusing this closely before signing deals. “Par lenders are very focused on this – it’s one of the first things they look at: ‘What is the situation in which we can sell out?’” says Kurdian.

However, market observers think this greater strictness is cyclical rather than permanent. Davies of Debevoise & Plimpton concludes: “Eventually, “when the market turns and debt becomes harder to obtain, some of the new provisions, such as those which allow the borrower to retain consent rights over an assignment of loans after a default, will probably disappear.”

Peter Bate, director of debt advisory at KPMG in London, also predicts that lenders will eventually have more power to fight back against restrictions on loan transfers. “We are in a world where sponsor terms are to die for at the moment, and this is just one of the pieces sponsors will push, because they can,” he says.

However, “for 2,000 years we’ve lived in a boom and bust economy, so terms will tighten at some point.” As the pushback gathers pace, “some lenders will focus more on these terms, and others on some other part of the documentation”.