The world of broadly syndicated lending faces unique challenges in periods of distress. These challenges can arise when corporate borrowers face liquidity issues affecting their ability to meet the provisions of loan agreements or make payments. They can also emerge more systemically in the case of macroeconomic turbulence that affects spending or credit markets.
While COVID-19 may have seemed a harbinger of distress, we found that other less intuitive trends took hold in loan markets. Here’s our view on the highest impact trends in complex bank loan financings that will persist into coming quarters. We also explain the role of an Independent Loan Agent in helping lenders navigate them.
Setting the Context
Generally speaking, the larger a loan package is, the more likely it is to include more participants in a loan syndicate, involve multiple currencies and tranches, and see higher volumes of trading activity.
The trend of larger and larger M&A financing capital structures has only further fueled complexity, with more lenders, including non-bank lenders, playing a part. Loan Agent capabilities and activities have scaled to meet this demand, with most loans including several hundred syndicate participants.
COVID-19: The Loan Market Turbulence That Wasn’t
The global scope and impact of COVID-19 became apparent in the first quarter of 2020. Many loan market observers and participants began to consider the potential for a rapid and severe spike in loan defaults, perhaps even at the scale of the global financial crisis of 2008.
Conditions were ripe for a widespread liquidity crisis constraining borrowers’ ability to repay debt. Many borrowers felt the impact of an immediate drop in consumer spending, leisure, and business travel. Layoffs, furloughs, and remote work arrangements left workplaces and city centers nearly empty.
Nonetheless, the expected surge in COVID-19 defaults did not happen, not across the board. While the pandemic exposed or exacerbated balance sheet weaknesses with specific borrowers, several factors prevented the spread of defaults into the credit market as a whole.
Some borrowers had enough sources of liquidity to weather the storm. In addition, governments took rapid action with a range of forbearance schemes and liquidity programs, many of which remain in effect today. Beyond those programs, some lenders were willing to agree to short-term forbearance in the interest of the long-term viability of borrowers. Finally, equities markets quickly recovered and then surged.
What Actually Happened
In addition to defaults and foreclosures, we saw more adjustments to credit terms in line with a shorter-term liquidity situation. When lenders believe that a borrower’s underlying business is sound and that its leadership team is well equipped to navigate choppy waters, they are more inclined to work with the borrower.
As a result, we saw an increase in amendments and waivers over the past year and more. When lenders and borrowers find realistic terms for temporary forbearance, Loan Agents can adjust accordingly, acting as a fair representative of what credit agreements allow and then carrying out the lenders’ decisions.
In some situations, borrowers or sponsors have sought to layer an additional tranche of debt onto their balance sheets either when covenants allow it or as a separate facility that requires consent from existing lenders. The new debt gives them liquidity in the short run and helps prevent default on existing debt. As Independent Loan Agents, we have supported clients in both such scenarios.
We also saw situations where lenders agreed to out-of-court restructurings. Private lenders often have more flexibility to take this tack as a way to provide the company with a longer runway. They typically have a very different agenda to that of banks lending at par, with fewer strictures. As a result, they frequently offer more borrower-friendly terms from the outset than banks, given the amount of capital they have to deploy and their appetite for risk.
The Impact on CLOs
CLOs were inundated in 2021 by an unprecedented number of leveraged-loan downgrades, causing them to exceed triple C-rated loan buckets, triggering haircuts, and resulting in breached coverage tests. This turbulence temporarily turned off cash flows to equity investors or first-loss bondholders in some securities. It also led to a swath of ratings downgrades on the CLOs themselves in the first few months of the pandemic. CLO managers traded out of distressed credit, resulting in permanent par hits.
Still, as with the broader loan market, fewer loans defaulted than expected. In the current market, downgrades of both loans and CLO bonds have subsided and are even being upgraded.
We have also found it reassuring to see that the loan market united around recent pain points and trends that hurt recoveries for CLOs during restructuring and workouts. Many investors have responded to pandemic stresses recognizing the need for more flexibility. They have displayed a willingness to provide more options to CLO managers to operate successfully in today’s distressed debt market while maintaining reasonable guardrails for investor protection, which will result in greater CLO resiliency both now and through the next economic storm.
A Tale of Two Markets
Looking forward, in the U.S., the worst of the pandemic seems past, and we do not anticipate a pent-up wave of restructuring in the world of complex transactions. What we observed during the pandemic will remain largely valid. Borrowers with underlying balance sheet weaknesses may suffer if they cannot quickly recover revenues, but those who do not will benefit from the broader macroeconomic recovery. Some facilities may continue to flex and bend with short-term conditions rather than breaking down into foreclosure. The pace of restructuring has already slowed dramatically.
In the UK and Europe, chances are higher that restructurings will pick up the pace heading into the second half of 2021 and beyond. Robust relief and recovery programs have created an artificial firewall for forbearance to help stave off defaults. With prospects for a follow-up wave of stimulus low, many loan market stakeholders we speak with anticipate challenges to arise. Investors and lenders may take a second look at their portfolios as these two situations converge.
The Trend Behind the Turbulence
Both before and after COVID-19, we believe collateral shifts are a core distressed debt trend to watch in the U.S. market. While commonly accepted document conventions make EU and UK credit agreements more rigid, credit agreements in the U.S. may include more ambiguity around what the borrower can do with underlying collateral. Sometimes, private lenders accept this ambiguity intentionally to keep future options open for both parties to the loan. In other cases, the ambiguity is unintentional.
Taking advantage of perceived or actual loopholes, borrowers or private equity sponsors make structural changes such as creating unrestricted subsidiaries and then move collateral into them to the detriment of the lenders. They can then sell this collateral to get liquidity or take on new debt on top of it. Such shifts can happen when borrowers choose to adjust their strategy, even without distress or debt refinancing as the market traditionally understands these ideas.
Regardless of their reason, these efforts strip collateral out from under existing lenders and leave them in a less secure position with respect to their debt. As a result, conflicts between borrowers and lenders emerge because they have different interpretations of the credit agreement and borrowers’ rights.
Once borrowers want to carve off or sell collateral in ways that conflict with lenders’ understanding of the loan documents, it exposes ambiguities in documentation and risks leaving the loan under-collateralized. It can also drive out CLO managers because non-CLO lenders propose alternatives that preclude CLOs from participating.
Acting in Lenders’ True Best Interest
These differing interpretations have a direct impact on the role of the Loan Agent. From Wilmington Trust’s vantage point as an Independent Loan Agent, we believe vigilance, communication, and experience are critical.
In distressed situations, lenders become increasingly concerned and may attempt to pursue aggressive remedies outside the terms of the loan documentation. Two things become essential as a result. First, Loan Agents must make a commitment to act in the best interests of the lenders and take direction from required lenders. Independence from arrangers and sponsors gives agents an advantage in holding firm to their commitment to the lender.
Second, and equally important, the agent must offer an unbiased perspective on what is possible within the terms of the loan and what is not. This objectivity is essential to acting in the true best interests of the borrower and lender.
Moreover, fidelity to the documentation mitigates the risks of departing from the role of a neutral agent. Putting through trades and payments that favor the lender in the short term may be challenged and may ultimately need to be reversed or reconciled, making for much more complex litigation for all parties. It also opens the door to deeper trouble for the lenders down the road.
Succeeding with Successors
Agent independence can also be advantageous when lenders decide to replace agents with ties to the borrower or sponsor. Similarly, initial agents may choose to relinquish their role in a distressed loan if there are conflicts of interest across the various tranches in the capital structure.
The move to a successor must happen quickly—the faster, the better. In the case of complex transactions, this transition entails bringing on hundreds of existing lender positions and processing a backlog of hundreds of trades. During the transition, loan trades and payments become frozen at the very time when original lenders are more likely to trade out and when distressed investors are more likely to be looking for ways to get into the syndicate.
Speed and complexity, in turn, raise the bar for execution. In our experience, timely and accurate execution makes an enormous difference to lenders by helping get the transaction back on track with as quick a transition as possible.
In distressed scenarios, what constitutes fidelity to the lenders’ interest and the broader loan documentation can also be a quickly moving target while lenders renegotiate terms with borrowers. At this critical time, we think it is essential for lenders to review what they want carefully and test their wishes against the reality of the situation. At the same time, lenders who are at par will drive for different outcomes than those sought by lenders who bought into the syndicate at a discount or by CLOs.
Loan Agents, given their intimate operational familiarity with loan documents and their implications, can be a highly valuable source of information in this process, helping creditors and their counsel achieve the best outcomes in the situation. When coming into a transaction, we tend to ask extensive questions about the deal, the documents, the collateral, and the lender goals, precisely so that we can identify what is possible.
The syndicated loan market has become increasingly complex over time. In placid economic periods, complexity can go somewhat unnoticed, as all parties within the market flex and adjust to accommodate new structures and new participants. The flood of private credit hungry for return has helped fuel that complexity.
While COVID-19 has not triggered a wave of restructurings or a broader credit markets crisis, it has shed light on some of the underlying complexity of the loan markets. Complexity occurs not only from loan to loan but within them. When restructurings occur or when borrowers make moves such as shifting collateral to protect against them, documentation can provide a sense of stability while everything else is in flux. Independent Loan Agents can support lenders best when they remain objective rather than creating additional turbulence at times of stress.