This article is sponsored by Proskauer.
Deal terms have been loosening on both sides of the Atlantic, but lenders are pushing back. Stephen Boyko, partner and co-head of the private credit and finance groups with Proskauer in New York, and Faisal Ramzan, partner and member of the private credit and finance groups in London, look at the sectors and geographies holding promise.
With so much debt fund capital available, what has happened to deal terms in the US?
Stephen Boyko: In the US a tremendous amount of capital is available. There are literally hundreds of funds seeking deals, so there is an enormous amount of supply. This makes the markets incredibly competitive, so for the right management team, or the right private equity sponsor, terms are very attractive.
How about Europe?
Faisal Ramzan: Sentiment in Europe has many similarities with the US, as there is also a lot of liquidity in Europe on the supply side. But there are some nuances, because Europe consists of distinct regional markets. To an extent, it is possible to divide Europe into certain categories. In the UK, France, Benelux and the Nordics, private debt is now a well-established product – something that sponsors are very comfortable with. Consequently, in these jurisdictions there is an immense amount of supply.
How has supply in Europe affected deals?
FR: Leverage levels have crept up a little, so deals that might have had leverage of 4.5x EBITDA might now have up to 5.5x. When it comes to pricing, spreads above LIBOR might have fallen for some deals, but only by 25 basis points or so – certainly not to the point where lenders start thinking that it will threaten the hurdle rate for their funds.
What has happened to financial covenants in Europe?
FR: Since the financial crisis, large-cap deals have had fewer covenants, but historically, documents in the middle market would have a full suite of financial covenants: the standard four of leverage, cashflow cover, interest cover and maximum capital expenditure. That has largely fallen by the wayside. In our experience, almost all middle market European deals are now down to one covenant: usually leverage, though it might instead be cashflow cover, and, more rarely, interest cover. However, I think we have only seen one debt fund in Europe that has done deals on a cov-lite basis.
How about financial covenants in the US?
SB: We are seeing a similar weakening in financial covenants in the US, but just as in Europe, this depends on the size of deal. In the lower middle market, convenant packages tend to be more robust, and even EBITDA definitions tend to be stricter. But once EBITDA rises into the teens – $15 million of EBITDA or so – covenants tend to be looser. For example, there are more addbacks, and addbacks may be uncapped. The flexibility gets more pronounced as EBITDA increases to $50 million or more. If it is a very competitive situation the covenant package and greater strictness on addback terms get swept out with the tide of the market.
When it comes to the important details of documentation, what is up for negotiation?
SB: In the US, a primary focus for borrowers has been the ability to incur additional debt, after the deal closes – often all the way back to closing leverage, and sometimes even above closing leverage. There is also a lot of negotiation around free-and-clear baskets, that might allow three-quarters or even a full turn of additional leverage without any leverage governors.
We are also seeing lenders commit to delayed draw loans right up front to fund acquisitions and capital spending – we saw this last year for about one-third of the transactions we did in the US. Another focus of negotiation is flexibility around restricted payments: borrowers are seeking to lessen restrictions on their ability to take dividends.
FR: In Europe too, the ability to take on additional debt has been a primary focus for sponsors. There has been a gradual erosion of protections for lenders in this area.
Which market has looser documentation terms these days: Europe or the US?
FR: There is no doubt in my mind that documentation terms in the US are looser. This is not altogether surprising, because innovations in private credit usually start in the US, then make their way across to the UK, next spill out across mainland Europe, and finally maybe pass into the rest of the world. This means that the US is ahead in the trend towards looser documentation. The trend in the US is transmitted to Europe by big US fund managers that have significant operations in Europe too. They are familiar with US terms, so are prepared to do deals on these terms in Europe as well in order to compete.
SB: The US is ahead in looser documentation probably because of the volume: it is a very large market, with a tremendous number of private equity sponsors.
But which market has higher headline leverage these days: Europe or the US?
SB: In direct lending, data for Proskauer deals shows that last year average leverage in the US and Europe was identical, at 5.2x EBITDA. While this may seem surprising at first, it makes sense to us, because members of the investment committee of a big global fund will usually take a house view on what leverage they are willing to accept, whether in the US or Europe.
Returning to documentation, is there not any pushback against these more liberal terms?
SB: In the US, our clients are becoming more cautious, and pushing back in some areas. It may be because they believe that we are late in the cycle. The US recovery has gone on for more than 10 years, so there are some concerns.
FR: In Europe, the picture is complex. Lenders’ willingness to accept loose terms depends partly on their assessment of the economic backdrop. Concern about Brexit has affected sentiment for UK deals, and lenders are aware that in the eurozone the downturn will come sooner or later, but it is hard to generalise: lender behaviour depends on differing microeconomic and macroeconomic factors in different pockets.
What kind of pushback are you tending to see, and what is it actually achieving?
SB: In the US, a key area of focus is leakage. For example, there has been increased attention to terms allowing the transfer of assets to an unrestricted subsidiary – a subsidiary that is not restricted by the covenants in the loan agreement and can therefore borrow as much as it likes from other lenders. This might well be a company owned by the borrower, or a foreign subsidiary. The flexibility that borrowers have to move assets around is causing concern with lenders in the US, particularly after the media attention high stakes asset transfers have attracted.
We can contrast this lack of protection with some of the protections in the European markets. European deals generally have a guarantor coverage test, which throws a net over 80-85 percent or so of the earnings of the entire enterprise. We do not have a similar concept yet in the United States, and this lack of structural protection is causing some of the leakage.
While lenders are focused on limiting leakage, it is a very competitive market. Lenders are often chasing a deal with three to five of their toughest competitors nipping at their heels, so although there is a progressively louder chorus among lenders calling for greater restrictions on leakage, in other respects documentation remains very flexible.
FR: In Europe, it is hard to say whether documentation terms have reached their peak of looseness. One loan document with loose terms often serves as a precedent for the next one. However, there has certainly been a little bit more pushback among banks and private debt investors in large-cap deals.
How is Brexit affecting dealflow?
FR: Historically, when we look at deals done by Proskauer in London, between two-thirds and three-quarters of deals have involved UK businesses, with the rest covering businesses elsewhere in Europe. However, last year that balance shifted to about 50-50. The uncertainty around Brexit has impacted the number of deals in the UK.
On the other side of the coin, have any developments made doing deals more attractive in other European countries?
FR: In the past, private debt funds were unable to provide loans in certain countries where these restrictions have now been amended or lifted altogether. Germany is a classic example. In 2015 the German regulator decided to loosen the prohibition on lending by private debt funds, and since then direct lending has taken off like a rocket. Debt funds now account for about 30 or 40 percent of deals in the middle market, filling a gap left by the banks, which are pretty short of capital.
There are other jurisdictions where there is no regulatory restriction on lending, but the bankruptcy regime has not been attractive for lenders. This is changing: certain debtor-friendly jurisdictions are updating their bankruptcy legislation to create greater balance. These jurisdictions include Spain, the Netherlands and Italy. In Italy we have seen a bit of an uptick in deal activity in a market that was previously a no-go area for debt funds, with Proskauer advising on three or four deals last year.
Which business sectors are seeing the greatest private debt fund deal activity?
SB: In the US, last year manufacturing became the biggest sector for Proskauer deals involving private debt funds, for the first time since we started adding up the numbers in 2012. The sector has benefited from a big push on the regulatory and tax sides by the Trump administration to encourage domestic output. Moreover, manufacturing clients have been prudently diversifying their sources for input materials bought outside the US, in response to trade tensions. In addition, their ability to sell within the US might actually increase if tariffs make goods produced outside the US more expensive.
Aside from manufacturing, software and technology was the second most popular sector last year, with reasonable interest in healthcare, business services, and retail.
Are there any sectors in Europe which lenders are tending to avoid?
FR: In the UK, debt funds are being more cautious about retail and casual dining, which has been hit by Brexit and by rises in business rates and the minimum wage. Some household name retailers, such as House of Fraser, have gone into administration. They are cautious elsewhere in Europe too about bricks and mortar retail, which has been hit by e-commerce.
When it comes to sectors they like, anything that tends to have a lot of recurring revenue, such as large parts of software and technology, is tremendously attractive to a lender. However, this tends to make them hotly contested assets, which brings us round again to sharp competition and the resulting problem of loose documentation.