2022 – Leveraged Finance - Year in Review: The Year that was Everything Everywhere All at Once

The Year that was Everything Everywhere All at Once

Well it’s a good thing we make our coin as lawyers and not as forecasters. We published our 2021 review on 22^nd February of this year with a relatively positive outlook.  We were excited to talk to our clients (who were interested) and our friends (who were not) about the developing Australian TLB market and its implications for the leveraged loan market.

2 days later Russia invaded Ukraine and as the year heads to a close, 2022 feels like Everything Everywhere All at Once[1] - with a war in Europe, COVID’s umpteenth variant, global energy/supply side crises, heightened East-West geopolitical tensions, unprecedented central bank monetary tightening, runaway inflation in many Western democracies, continued labour shortages, highly frothy and then dislocated debt markets, significant elections in many countries, a fascinating takeover of Twitter and a fascinatingly unpredictable soccer World Cup to boot!

Despite the turmoil, KWM was pleased to support our sponsor, corporate and lender clients on many of the landmark transactions for 2022, including BGH’s takeover of Virtus Health, EQT’s acquisition of Stockland Retirement Living, Apax’s acquisition of Pickles, refinancing of KKR/Australian Venue Co’s facilities and advising underwriters/lenders to the Infotrack and ATI Software term loan B financings, Greencross’s cov-lite unitranche, TPG/iNova and PAG/Patties & Vesco Foods.

Relative Value

Macquarie Dictionary has gone with ‘Teal’[2] as their word of the year (we were more partial to Orange Gamble referring to the reliability of your average Jetstar flight from the Deniliquin Dictionary[3]).

In our world though, the word (phrase?) of the year has been ‘Relative Value’ – or for those with too little time for 5 syllables (all of us presumably) ‘RelVal’.

Relative value/RelVal encapsulates the issue facing investors looking at new money deals:

Assuming a roughly equivalent credit, if the debt of the existing financing deal is trading at a substantial discount to par, then for a new credit to be at least as attractive for a debt investor, the risk-adjusted return on the new deal needs to match that of the existing deal.

There are of course qualifiers:

(a)  Sponsor relationships – at times, notwithstanding the RelVal of a deal, it’s important for a lender to maintain a sponsor relationship or to maintain their relevance/standing in debt markets (and from an absolute value perspective the deal still makes sense)

(b)  Availability of the equivalent alternative deal – given the relative lack of liquidity in the Australian secondary market (vs the US TLB market) there isn’t always an equivalent deal to buy – for lenders sitting on funds to deploy, you can’t hold out forever for that ideal secondary trade.

(c)  Apples and Oranges – ie deal teams convincing Investment/Credit Committees that the RelVal argument is not valid because there is no equivalent deal – eg because:

(i)   you can’t compare across markets (ie an Australian/Asia-Pac deal can’t be compared to a European deal because Australian/Asia-Pac exposure to the Ukraine conflict/European energy crisis is more contained); or

(ii)   you have been able to improve structuring/terms from a lender perspective.

Direct credit – on the up (sub text, TLBs on the way down)

We’ve mentioned before the considerations that had been driving Sponsors towards TLB and unitranche solutions – a short refresher

At the start of the year, TLB’s were coming out ahead of the unitranche on all-in pricing (even if Sponsors assumed their deal would be fully flexed – which was theoretical or minor).

So what’s happened?

In the US there were some very high profile deals where underwriters were (or so far have been) unable to sell the debt even at the fully flexed price (or even at a further discount eating into the underwriters economics (see the note on flex below)) – the most prominent include:

• Twitter
• Citrix
• Nielsen

In the Australian TLB market, the underwriters worked hard to sell the Virtus Health and LaTrobe TLBs financings but in a sign of maturity and differentiation of our market and our investors, managed to clear these successfully.

However, the prolonged market dislocation since June/July 2022 meant that underwriters are either “risk off” (obviously not wanting to be a bullet point in the list of famous hung deals in our 2023 Leveraged Finance Year in Review) or have increased flex terms materially (sponsors/borrowers unsurprisingly flinched at the prospect of being flexed to 10% upfront fees) such that the unitranche became more attractive again.

All this has been music to the ears of direct credit providers who aren’t looking to syndicate (if they can get past the RelVal considerations discussed above).

Traditional bank debt – back in vogue

Or, as the banks would say, we never went away!  Indeed, bank debt continued to be very strong in the midmarket space and is increasingly popular in the larger-cap space again.  In a time of dislocated debt markets, traditional banks come into their own.

Although less aggressive on overall leverage (compared to a unitranche/Term Loan B), we expect this trend towards using more bank debt on larger deals to continue given:

• it’s relatively cheap (by comparison)
• banks have flexibility to underwrite, join a club on a take-&-hold basis or do a bit of both
• bank debt can work well in combination with other structures also now coming back in vogue (eg Holdco or Opco mezz structures – see below)
• banks have also come a long way on providing more flexibility on terms given the competitive lending environment in the last few years. There is much more willingness to consider appropriate/different structures and permissions/carveouts/covenants to enable borrowers to execute their growth plan / investment thesis. 

Holdco and Opco mezz – a revival?

Post GFC but pre 2017, Mezz deals were a common pathway for sponsors to achieve an additional 1x-2x leverage above what they could achieve in the bank market.  To recap:

• Holdco Mezz debt usually features PIK-only interest (ie capitalising rather than cash-pay interest) and being structurally subordinated to Senior Debt, is relatively easy to execute without a need to negotiate an intercreditor with senior lenders.
• Opco Mezz debt usually features a combination of cash pay and PIK interest (or gives the borrower the ability to elect to pay PIK rather than cash – known as a PIK toggle). Opco Mezz is contractually subordinated to senior debt, and has the same guarantor/security provider group as senior lenders, meaning an intercreditor agreement between senior lenders and opco mezz lenders is needed.

Holdco and Opco mezz structures fell out of fashion somewhat post-2017 when Borrowers were able to achieve equivalent leverage via TLB/unitranche structures for a lower all-in cost. 

However interest on TLBs and unitranches is 100% cash pay.  This was fine when base rates were near zero and all-in cash interest costs were still in the single digits.  But with Australian base rates now exceeding 300bps (and still rising) and material increases in institutional debt pricing (RelVal etc), the cash burden from all-in debt servicing costs is proving to be challenging.  It is not surprising therefore that some borrowers concerned about that significant cash drain are considering alternative capital structures which pair a lower levered senior bank debt package with Holdco or Opco Mezz debt as a new (/old) way to push leverage without increasing cash servicing costs.

Flex

In a turbulent market, Borrowers who want the certainty of an underwritten deal will increasingly have to live with flex.

“Flex” refers to the ability of an underwriter to change the terms of a deal unilaterally (within agreed parameters) to make it more attractive to debt investors and enable the underwriter to achieve a successful selldown of the debt.

Historically in bank deals, flex has been limited to increases in economics (which can be taken as an increase in the margin and/or an increase in the upfront fee).  TLBs and, to a lesser extent, underwritten unitranche deals, will typically have both pricing flex and terms flex.

Some normal TLB terms flex items include:

• extending or removing the sunset on the pricing ‘most favoured nation’ in favour of existing lenders that applies to incremental debt
• reducing or removing the ‘free and clear’ dollar basket that applies to incremental loans
• requiring additional deleveraging before unlimited distributions can be made.

For a Borrower, some factors which mitigate the impact of terms flex include:

• the documentation will typically require the underwriters to test the market before exercising flex (however, TLB deals do not typically have a pay-away requirement requiring the underwriter to offer some of their underwriting fee to the market before exercising flex)
• in most cases terms flex will affect Borrower upside rather than affecting economics
• knowing that they have flex to remove or amend a term gives underwriters confidence to try and market what would otherwise be challenging terms – so borrowers may get more attractive terms on a deal with flex than one without it.

Structure flex (eg reallocating debt between 1L and 2L) is another form of flex which is more material (and therefore less common) as it changes the capital structure when compared to terms flex.

Base rate

The immediate impact on existing transactions is on cashflow coverage ratios such as the Interest Cover Ratio or, for those deals that still have it, Debt Service Cover Ratios – especially for lowly hedged or unhedged borrowers.

We’re already seeing some covenant waivers for those covenants (rather than the Leverage Ratio as has typically been the case).  Financial covenants are often an early indicator of distress.  So, as the real cash cost of base rate increases is being felt (in combination with rising input prices), actual serviceability could become an issue for some over-levered borrowers.

In response, mandatory minimum prescribed hedging is now back on the table as a discussion topic.  Time will tell whether it is a transitory or more permanent feature – a typical Borrower response would be that they have sufficiently experienced treasury teams to implement a hedging strategy without having it legislated in their financing documents. 

Terms

Pricing has increased materially in recent deals, including for RelVal reasons (particularly for global private credit funds vs regional/local credit funds and banks).

Some lenders have also seized the opportunity to turn the tide on years of “terms creep” by sponsors/borrowers by pushing back on some terms in favour of lenders.  The counterpoint to this is competition between lenders for a very limited number of quality new deals.  And so, overall terms have not become materially more Lender friendly.

ESG – continue the trend of implementing SLLs

It wouldn’t be a year in review without discussion of how ESG considerations are continuing to reshape the loan market.

We think it’s fair to say that 2022 was a maturation year for how local markets are dealing with ESG.  More sustainability-linked/green leveraged loans have come onto the market, with social loans now becoming more prominent rather than just the more traditional “environmental” KPI focussed loans.  In terms of execution challenges, ESG-loans are still more common in refinancings than in time-pressured LBOs deals as Sponsors need time to bed down the business before turning their minds to ESG KPIs.

Outlook

Let’s just say new deal activity in the September 2022 quarter was pretty dead.  It’s been many years since we’ve seen so many bankers and lawyers (present company included) pounding the pavements, having coffees/drinks/lunches and giving back to the COVID-hit restaurants/pubs industry.

Will this result in more deals going into 2023?

We certainly hope so – and (deep breath) will finish off with some predictions for the year ahead: 

• certain sectors will continue to be strong and attract interest eg health, infrastructure (and “infrastructure”), infrastructure services, energy transition, SAAS and cyber/digital
• more P2Ps/divisional carveouts
• more distress in the system generally – leading to more restructures/loan-to-own deals and special situations/M&A opportunities
• the backlog of hung deals in offshore markets clearing (hopefully with no more major casualties) and demand side pressure returning with investors needing to come back “on risk” and restock their books – which should narrow the RelVal spread for new money deals