HEADLINES

• Default levels remain historically low at 1 per cent to 2 per cent
• Prevalence of cov-lite loans in Europe may be concealing some underperformance, but there are no conventional triggers for lenders to act

Despite concerns that the economic cycle is peaking, and the impact of geopolitical and trade volatility on corporate earnings, leveraged finance default rates show little sign of rising during the next 12 months.

According to Debtwire Par, loan buysiders do not expect to see defaults spike as levels hold steady in the historically low 1 per cent to 2 per cent range. With interest rates in the UK and Europe expected to remain low, and more than 90 per cent of European institutional loans issued on cov-lite terms in 2019, lenders have little scope to step in when credits show signs of underperformance. This has resulted in a relative lack of restructuring negotiations regarding leveraged loans and high yield bonds, despite growing macroeconomic concerns and uncertainties around borrowers' ability to refinance loans in the medium to long term.

Restructuring activity has occurred in some sectors, including shipping, retail, casual dining and leisure, but the persistent low interest rate environment has contributed to relatively benign conditions for borrowers.

Signs indicate, however, that more financial distress is creeping into the system, especially in the United States, where developments can foreshadow events for Europe.

Clouds on the horizon?

According to Goldman Sachs, high yield bond defaults topped 5 per cent in 2019, up from just 1.8 per cent a year ago.⁵ Meanwhile, the EY Profit Warning Stress Index, which tracks the number of profit warnings issued by UK-listed companies, recorded 313 profit warnings in 2019, the highest total for profit warnings since 2015. Of the companies tracked, 17.8 per cent issued warnings last year, which represents the highest percentage of businesses to do so in a year since 2008.⁶

Lenders concerned about the health of the credits in their portfolios are forced to adopt a more creative approach when borrowers show signs of distress

The absence of covenants, however, means that borrowers may choose to act only if their loans are approaching maturity or they are running out of cash. As much of the loan and bond issuance from recent years is long-dated, and traditional levers to commence restructuring discussions are often unavailable, lenders concerned about the health of the credits in their portfolios are forced to adopt a more creative approach when borrowers show signs of distress.

Revolving credit may open doors

Revolving credit facilities (RCFs), which have typically retained financial maintenance covenants, are one potential way to exert influence. In practice, RCF covenants will often only come into play on a 'springing' basis, when the RCF has been drawn to a meaningful level. But should the company become more stressed, it is likely to turn to the RCF and other sources of liquidity, and the financial covenant may become relevant.

Other creditors in the company's capital structure may find this comforting, but it is very different from having direct covenants, as would have been the case in previous generations of loan documents. Borrowers often find ways to manipulate their cashflows to avoid tripping the springing covenants, even in relatively distressed circumstances. If they cannot avoid a breach, they may be able to negotiate a separate waiver with the RCF lenders that leaves the term lenders and other creditors on the sidelines.

Degrees of proactivity

Some lenders, absent conventional default triggers, have looked to take steps to challenge directors of distressed borrowers, taking a more interventionist approach if they feel it necessary and reminding directors of their fiduciary duties, as well as querying whether the action being taken is in the best interest of the company's stakeholders.

Not all sponsors and management teams will allow things to go this far, however, and more creative sponsors may look to step in early and work alongside lenders to deliver solutions proactively. This strategy can be very effective in the right climate, as sponsors will typically have considerably more negotiating power as to a portfolio company that is not in breach of its loan documents than they might otherwise have later in the cycle when default is unavoidable or has already arisen.

Factors such as the nature of the capital structure and the mix of creditors, the health of the underlying business and the sponsor's stance will determine a borrower's willingness to come forward. In some cases, a borrower's simple act of commencing a restructuring dialogue with its lenders can act as an unwanted catalyst and precipitate a deterioration in the business, making borrowers and sponsors alike wary of instigating discussions prematurely.

That said, coming to the table early may be the smart course of action and create enough of a runway for the sponsor and the management team to present a turnaround strategy to the lenders and agree on the framework within which it can be realised.

5. 'Rising defaults in high-yield bonds puts this year on track for postcrisis record, warns Goldman Sachs.' Marketwatch. 18 August 2019. Joy Wiltermuth. https://www.marketwatch.com/story/rising-defaults-in-high-yield-bonds-puts-this-year-on-track-for-post-2008-crisis-record-warns-goldman-sachs-2019-08-17
6. EY Profit Warning Stress Index. https://www.ey.com/en_uk/transactions/profit-warnings

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