In general, it has been a stable year so far for financial markets. The syndicated loan markets have been buoyant, with practitioners reporting that “demand exceeds supply” and data indicating that the global syndicated leveraged loan market grew 2 per cent in the first half of 2018 alone. The US retains its position as the largest market with $1.5 trillion in loans, followed by the UK with $94.8 billion in loans. M&A-related financing has followed a similar path so far, seeing a global record of $486.4 billion in financing in the first half of 2018.
Below we delve into some of the most prominent trends driving this growth in loan markets, namely the convergence of high-yield bond and term loan features, their impact, their future consequences and how they intersect with the work of legal practitioners. Financial regulations are another prominent source of work for legal practitioners who specialise in the area, and MiFID II and other regulatory regimes are still making their presence felt in the markets. It is also apparent that finance work is dominated by a few top firms in the market, which is starting to cause frustration among other practitioners we spoke to.
One of the most significant driving factors causing growth in the syndicated loan markets has been what sources described to us as “Frankenstein products”: loans whose terms have been influenced by “a convergence of high-yield bonds and term loan financing requirements” in both the US and the UK, a trend that has been in play for nearly a decade. These are now desirable and prominent loan products for a variety of reasons.
First, in comparison to the resource heavy financial covenants and amortised payments of traditional term loans, these Term Loan Bs (TLBs) and covenant-lite loans offer simpler and fewer incurrence covenants. This translates into greater flexibility of terms, minimal lender interference, cost saving in operating these loans and ultimately gives greater access to credit. In a market with excessive demand, it is no surprise that these are now ubiquitous products that account for 60-65 per cent of the US loan market.
Second, the unseating of traditional banks by institutional and private equity investors in the leveraged finance market should also be considered a factor in the rise of these “Frankenstein products”. These new players in the market do not wish to expend the resources to enforce traditional covenant structures, which has accelerated the loosening of covenant structures and the rise of these converged products in the international syndicated loan market. A fundamental change in investor mentality in the market can also be attributed to this trend, where a shift from a “lend-and-hold” model of business to an “originate-and-sell” mentality means that more flexible loan terms are favoured, as loans can be quickly approved and sold on.
Finally, a range of macroeconomic factors have helped to foster this convergence trend. The global financial crisis created a low-interest environment which simultaneously increased risk appetite among investors as well as putting pressure on them to secure portfolio profitability. It also produced new financial regulation that forced banks to downsize their loan books, and institutional investors to diversify their portfolios. This meant that banks left a vacuum for institutional investors to step into in their search for yield.
Perhaps the two most significant consequences of the convergence are as follows: firstly, the pricing spreads between Frankenstein products and high bond yields have reduced in the last decade. This feeds into the second point, that the use of TLBs or covenant-lite term loans has now surged in popularity for leveraged buyout financing. Furthermore, the more flexible covenant-lite stipulations have given less creditworthy firms access to the international loan market. Overall, this has contributed to the emergence of a loan market that legal practitioners describe as “heated, and extremely borrower-friendly, with lenders becoming more aggressive in their approach”. Evidence of this can be seen in the record leveraged finance deal done this year by Blackstone, valued at $13.5 billion. Indeed, even with the increased flexibility now offered by these new covenant-lite products, sources told us that they “are not making a dent in the amount of liquidity there is in markets to invest”. As such, there are practitioners “questioning how long the market can remain in this state, especially with increasing interest rates and large leverage margins”. It isn’t just legal specialists who see clouds on the horizon for global markets. Moody’s have warned that this convergence sets the stage for much more difficult recoveries if there is a downturn in the global economy.
At a more micro-level, several sources also highlighted to us the problems created by the convergence of high-yield bond and term loan features. For one, the more flexible covenant-lite stipulations have given less creditworthy firms access to the international loan market, which poses the risk of more frequent defaults. Furthermore, the market is now reportedly seeing “deals where borrowers have a wide variety of ways to incur additional debt, which creates a dangerous, kicking-the-can mentality in the market”. This is worsened by the reduced oversight offered by covenant-lite terms, where lenders lose the early warning notification of default offered by traditional covenants.
Another point of concern regarding covenant-lite products arises with their stance on “unrestricted subsidiaries” in their terms. Unrestricted subsidies are entities that are not factored into a Frankenstein product’s terms, which gives lenders less control over the borrower and their subsidies, and thus reduces their security in the event of a default. This may also increase the frequency of defaults, as borrowers know their other subsidiaries are protected. Perhaps the UK market is now waking up to the lack of viability in these loans, with a 23 per cent decline in the syndicated loan market seen in the first half of 2018.
Regulations are the other formative force on the market that institutions, businesses and legal practitioners have to contend with and adapt to. In this regard, MiFID II regulation is “still having an impact in Europe, as its implementation efforts continue”. For example, the requirement that financial institutions be transparent about trades made off their own books only began its period of enforcement in August 2018. Furthermore, it is not clear to what degree MiFID II will remain in force in certain jurisdictions given events like Brexit. In the UK, secession from the EU has sparked a degree of anxiety in the market as its regulatory future becomes less clear. Legal specialists are reporting an increase in work “advising institutional clients on planning for a hard-Brexit”. MiFID II has impacted the financial markets in other ways. With the loss of banking secrecy, in jurisdictions like Switzerland sources report “a lot of banks selling their portfolios and restructuring” in order to become compliant.
In such a strong finance market with plenty of work to go around, it is perhaps intuitive to envisage that there might also be a diverse legal market. However, many sources report that the space is increasingly dominated by large firms who “want to act for everyone”. This has engendered “one of the big dynamics of the legal market”, where law firms are pitching themselves to private equity sponsors. This is having the effect of “excluding other firms in an unbalanced and monopolistic way which should be regulated against”. An area of finance practice that is decidedly under-exploited by law firms is, reportedly, in the prudential end of the market. Sources report that “lawyers shun this area as they can’t see how they can monetise it, as it is traditionally the province of accountants”. Additionally, it is an area massively impacted by regulatory change, with impending changes in EU prudential regulation via CRD5 legislation. For those legal practitioners who do step into this highly technical field though, the rewards have been great. As has been well publicised, anti-money laundering efforts by regulators continue apace with increased aggression, as demonstrated by the high-profile undisclosed wealth orders now being served in the UK, and significant trans-Atlantic sanctions and money-laundering investigations.
It remains to be seen whether the global syndicated loan and M&A markets will continue their record-breaking growth in a volatile political and economic environment of rising interest rates and the prevalence of “Frankenstein products” that pose clear risks to the stability of the market. Regulatory changes will continue to cause change in the market as financial institutions and legal practitioners are forced to adapt to them. As far as the legal market goes, the domination of large firms at the top end of the market is a difficult position for smaller firms to assault, but perhaps a change in the market landscape will bring new opportunities.