This article is an extract from GTDT Loans & Secured Financing 2023. Click here for the full guide.
The leveraged lending markets, both in the US and Europe, had a banner year in 2021, continuing to build on the recovery that began in the second half of 2020 after the initial slow-down in these markets resulting primarily from the covid-19 pandemic. A number of factors drove these record results including continued fiscal stimulus measures in a number of jurisdictions to bolster their respective economies to counteract the impact of the covid-19 pandemic on the global economy and continued low interest rates at or near historical lows. In addition to these macroeconomic factors, 2021 was also a record-breaking year for collateralised loan obligations (CLO) issuance, which is the dominant source of demand for leveraged loans, and a robust M&A market, driven in part by a significant increase in the number of SPAC IPOs and de-SPAC transactions; these were also significant catalysts for the growth seen in the leveraged lending market in 2021. Other factors contributing to the increased demand for leveraged loans in 2021 include a significant increase in the volume of dividend recapitalisation transactions, which more than doubled in 2021 when compared to 2020 and the significant decrease in the number and volume of defaulted loans during the year. Defaulted loan volume fell to approximately US$9.7 billion in 2021 a decrease of over 80 per cent from the end of 2020, leaving the default rate at 0.6 per cent at the end of 2021 compared to 4.5 per cent at the end of 2020.
Refinitiv LPC’s leveraged volumes hit $1.3 trillion in 2021, an increase of 84 per cent over 2020 volumes. According to Standard and Poor’s Leveraged Commentary and Data (S&P LCD), total leveraged loan volume increased significantly in 2021 versus 2020 in both the US and Europe almost doubling in each of those markets. Volumes increased to approximately $790 billion in the US in 2021 compared to approximately $395 billion in 2020 and increased to approximately €130 billion in Europe in 2021 compared to approximately €65 billion in 2020. Total institutional loan volume in the US for 2021 was approximately $615 billion compared to $288 billion in 2020 and surpassed the prior annual high of $503 billion set in 2017. Although not nearly the size of the first lien loan market, there was also a significant rise in second lien loan issuances in 2021 when compared to 2020 and 2019.
As noted above, CLOs, which are the predominant buyer of leveraged loans, had a record-breaking year for issuances in 2021, which issuances more than doubled the issuance levels during 2020 and were up approximately 45 per cent from the previous record set in 2018.
Investment-grade lending transactions were also at record levels of approximately $1.2 trillion, an increase of approximately 60 per cent over 2020 volumes, as many companies that would have refinanced their debt earlier decided to delay transactions in 2020 due to higher borrowing costs as a result in large part to the covid-19 pandemic. The market for high-grade issuances (excluding sovereign, preferred and hybrid deals) also had a stellar year of approximately $1.4 trillion (the second-highest level ever) compared to approximately $1.7 trillion in 2020 (the highest level ever). The high-yield bond market also continued on its torrid pace in 2021, coming in at $461 billion compared to approximately $435 billion for 2020, which was itself a record high, and $253 billion in 2019 according to S&P LCD.
As institutional investors make up more of the leveraged loan market and the demand for leveraged loans is high, the use of covenant-lite loans, which do not contain financial maintenance covenants and have flexible operating covenants similar to those contained in high-yield bond covenant packages, have continued to flourish and become a more significant portion of the leveraged lending market. This increase has been driven, in large part, by private equity groups performing leveraged buyouts and a borrower-friendly loan market. Given the market dynamics described above, including the robust demand for leveraged loans and high yield bonds, these trends continued in 2021. Many of these covenant-lite leveraged loans have covenant packages that are substantially the same as the covenant packages for high-yield bonds including incurrence-based covenants, baskets for unlimited dispositions and acquisitions and greater flexibility for restricted payments and junior debt prepayments. Although covenant-lite loans are more likely to have a greater risk of loss after a default, with covenant-lite loans in many instances the first default is often a payment default, which generally would occur long after there would have been a breach of a financial maintenance covenant. Commonly negotiated points in covenant-lite loans include permissive cost savings and revenue synergy adjustments to EBITDA, as well as more flexible incremental debt provisions (including financial ratio-based baskets, the ability to incur side-car facilities (which are stand-alone credit facilities secured on a pari passu basis with the existing credit facility) and acquisition debt carve-outs to the limitations on incremental facility pricing and maturities).
Private equity sponsors have driven much of the volume of leveraged loans and have continued to exercise their power and leverage to push the market toward more borrower-friendly terms. As part of that, as described above, a larger proportion of the leverage loan market now is comprised of covenant-lite loans and credit agreement covenant packages that afford borrowers much more flexibility than what was historically the norm. Examples of this increased flexibility include the ability for the borrower to designate certain subsidiaries as ‘unrestricted subsidiaries’ with limited lender protections, which unrestricted subsidiaries will not be required to provide guaranties and liens on their assets to support the loan nor be subject to the representations and warranties, covenants (including the ability to incur debt and liens) and events of default provisions in a credit agreement, although the EBITDA of such unrestricted subsidiaries will not be included in the EBITDA for the borrower for covenant calculation purposes, grower baskets based on EBITDA for most, if not all, dollar basket exceptions in the covenants and the increased use of an ‘available amount’ basket (which often has a starter basket and also increase generally through retained excess cash flow or a percentage of the borrower’s cumulative net income), which can be used to make investments, restricted payments and prepayments of junior debt as well as, in certain cases, to incur debt and liens. Credit facilities have also become more borrower-friendly in their ability to incur incremental debt under such facilities without obtaining required lender approval. Incremental facility provisions have expanded recently and become more flexible including the ability to use the general debt basket exception to incur incremental debt under the credit facility, increased flexibility to reclassify debt that was incurred under the ‘free and clear’ basket exception that is not tied to satisfying a leverage-based test to move automatically to a ratio-based test once such test can be satisfied, and the weakening of inside maturity date and most favoured nations yield protections customarily found in incremental facility provisions.
In addition, investment-grade covenant packages have recently become increasingly available to select issuers that are close to investment-grade ratings. Typically, investment-grade issuers have only been subject to a narrow set of covenants (usually, limits on lien incurrence, sale-leaseback transactions, mergers and changes of control) compared to issuers of high-yield debt that are customarily subject to a significantly broader set of restrictions (including incurrences of debt and dividends and other restricted payments).
To fill the void in the leveraged loan market left by the partial departure of traditional banks as a result of regulatory pressures and other considerations, investors have continued to turn to non-bank financial institutions or ‘direct lenders’, which are largely unregulated. During 2021, direct lenders continued to increase their overall market share of leveraged loan transactions. When compared to the syndicated loan market, direct lending solutions are often viewed as having advantages of speed of execution (as there is no requirement to have the borrower and loans rated by any rating agency and no syndication period is required) and to have a greater certainty of terms without the risk of the arrangers of a syndicated facility exercising market flex provisions. In the past, direct lending transactions were often for smaller more difficult transactions to finance. However, as the number of direct lenders increased and the size of the pools of capital that have become available to direct lenders has meaningfully increased, that distinction has been changing over the past few years and further accelerated. Certain direct lenders, especially those that are competing with syndicated lenders in the upper middle market and large-cap space, are able to provide covenant-lite loans that have pricing and terms that are competitive with those provided in a syndicated lending solution. For instance, during 2021, the market saw a significant increase in the number of billion-dollar plus financings (including some that were over $2 billion and even $3 billion) provided by direct lenders, either individually or in clubbed deals and, given the significant amount of capital that is being raised by direct lending funds, this trend is expected to continue. Additionally, direct lenders are able to provide sponsors and other borrowers with recurring revenue financings, which is popular for acquisitions in the technology space for businesses that are in the early stages of development and high growth potential but currently have low or negative EBITDA, which technique generally cannot be provided in syndicated financings.
There also was a significant focus in 2021 on adjusting provisions related to LIBOR and LIBOR transition provisions. In late 2020, US banking regulators had issued a statement urging banks to cease entering into new LIBOR contracts as soon as possible but no later than 31 December 2021. In October 2021, US banking regulators further clarified that a new LIBOR contract would include any agreement that creates additional LIBOR exposure or extends the term of an existing LIBOR contract. Accordingly, and in response to these regulatory pressures, US lenders began documenting a larger number of new loans with alternative rates to LIBOR with most lenders electing to use the Secured Overnight Financing Rate (SOFR) as the preferred alternative benchmark. In addition, regulators also continued to stress that loan agreements entered into before the end of 2021 that used LIBOR as their benchmark rate should have adequate fallback provisions that provide for a clear path for implementing alternative interest rate benchmark provisions after LIBOR is discontinued. In March 2021, the Alternative Reference Rates Committee provided additional guidance and supplemental provisions for a ‘hardwired’ fallback to a couple of SOFR-based rates (term SOFR and daily simple SOFR).
Following the extremely robust 2021, the general expectation was that 2022 would be a slower, albeit a still busy year. However, the unexpected geopolitical events in Europe and resulting increasing oil prices, coupled with already existing inflationary pressures and persisting supply chain issues, have caused a significant slowdown in the leveraged lending and high-yield markets during the first half of 2022. According to Refinitiv, the US leveraged loan issuance in the first quarter of 2022 was down 52 per cent in comparison to the first quarter of 2021. The US high-yield issuance during the same period was down a staggering 70 per cent, caused in large part by the rising interest rate environment. Similar trends were happening in Europe. It remains to be seen what will happen during the remainder of 2022 amid the continuing geopolitical uncertainty and mounting recessionary fears.
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