HEADLINES

• Terms will move back in favour of borrowers/issuers (for now)
• Lenders will hold the line in key areas
• Forecasting and structuring will be a post-COVID-19 challenge
• Pricing will continue to bifurcate by sector and rating
• Competition will encourage private debt and syndicated markets to converge

Although European leveraged loan issuance almost halved in March 2020 month-on-month and high yield bond markets largely shut down that same month, leveraged finance markets regained their stability relatively quickly following the initial shock of COVID-19 lockdowns.

Entering 2021, the underlying drivers—low interest rates and liquidity—remain firmly in place, with lenders eager for yield and any shifts in documentation and terms expected only on the fringes.

Any meaningful documentary changes introduced in 2020 were prompted largely by short-term covenant waivers or followed failed sell-downs. They typically involved the inclusion of liquidity covenants, carve-outs of pandemics from Events of Default or so-called 'EBITDA before Coronavirus' (EBITDAC) add-backs.

What does this mean for businesses, borrowers and lenders for the year ahead? Five key trends will likely shape the market during the next 12 months.

1. Terms will move back in favour of borrowers/issuers (for now)

Lenders have been able to secure some quid pro quo tightening of documents through 2020, due to the many covenant waivers that came around in the first half of the year.

In return for waivers, investors have negotiated items such as liquidity covenants and increased reporting. The UK's digital rail-and-coach ticketing platform, Trainline, along with cinema chain Cineworld and transport group Stagecoach are just a few of many examples. Equally, the muted investor reception to deals that closed prior to the onset of lockdowns meant that pricing widened and covenants were strengthened as these deals struggled to sell.

The waiver changes, however, will soon expire and, as markets normalise, borrowers will likely resist the full extent of these terms on new deals.

Indeed, the terms of financings launched during COVID-19 were little changed from those seen before the market's enforced closure in March, and sustained investor demand for yield was further illustrated when both online classifieds group Adevinta and food ingredients producer Solina reverse-flexed recent loan issues late in 2020.

2. Lenders will hold the line in key areas

Although lenders may make some concessions, they will hold the line in certain areas. Weaknesses in documents that came to light during the pandemic will have to be addressed as borrowers, issuers and lenders take a pragmatic approach to deals with the biggest loopholes.

Debt capacity will be in the spotlight, with restrictions on dilutive and structurally senior capacity—which will include limiting the potential for incurring debt at unrestricted subsidiaries and blocking the transfer of valuable assets, most notably IP, to those entities.

UK sports car maker McLaren, for example, recently saw bondholders mount a successful challenge to stop the company from raising additional capital via an unrestricted subsidiary structure.

Super-senior debt capacity may also now be specifically addressed. While there have been high-profile and contentious fundraisings in the US, European credits have successfully raised super-senior liquidity via existing capacity, consensual amendments or through court-sanctioned schemes of arrangement. Lenders will look to switch off the taps for this capacity or prevent any future misuse of covenant loopholes.

Borrowers and issuers may be encouraged to take a sensible approach, rather than pushing for the most aggressive terms in all areas, accepting more justifiable levels in return for useful flexibility elsewhere.

3. Forecasting and structuring will be a post-COVID-19 challenge

If the market resets in 2021, it will be interesting to see how new deals progress when it has been so difficult to judge creditworthiness on the basis of 2020 earnings figures, particularly for any credits hit by negative rating agency adjustments.

EBITDAC adjustments were a noteworthy feature of loan and high yield bond deals through the year, with many borrowers and issuers relying on historical EBITDA numbers and/or data that excluded the impact of COVID-19.

Blackstone-backed measuring technology business Schenck Process, for example, added €5.4 million back to its profits in 2020 on the basis that it would have realised these profits had COVID-19 not struck.

German beauty retailer Douglas, meanwhile, added back €15 million to its earnings when reporting its second quarter results at the end of March, citing additional costs related to store closures.

The European Leveraged Finance Association (ELFA) has already voiced concerns about how EBITDAC has been applied.⁴ This raises questions about what LTM (last 12 months) numbers will be used, and how and when the market will transition back to standard EBITDA figures. How will dealmakers and lenders forecast and structure new deals? What happens to credits where covenants were waived? These are questions that the markets will be asking for months to come.

4. Pricing will continue to bifurcate by sector and rating

Borrowers in sectors hit particularly hard by lockdown measures—such as leisure, hospitality, aviation and automotive—were able to secure financing during the year, but at higher interest rates than those available to credits in favoured, more resilient sectors.

Cruise liner operator Carnival, for example, had to pay 12% for three-year secured bonds in the spring of 2020. By comparison, market research platform Nielsen launched a European term loan B offer a month later that was priced at just 3.75%.

Carnival announced plans in November 2020 to raise a US$1.6 billion unsecured bond priced at 8%, but this is still more expensive than the options available to companies in sectors like technology and healthcare.

The market also bifurcated when it came to ratings, with more than 90% of leveraged loan and high yield bond issuance coming from credits rated 'B' or above during 2020.

This 'flight to quality' could be the ultimate legacy of COVID-19, as lenders continue to analyse sectors and credits on a very granular basis in order to determine pricing levels and documentary terms.

5. Competition will encourage private debt and syndicated markets to converge

All indications are that high levels of liquidity will remain a feature of capital markets in 2021, which may lead to a wave of opportunistic M&A driven by available cash, as well as investing in distressed assets that are fundamentally sound but require capital. This dynamic is expected to drive up competition for transactions, pushing private debt funds to look at deals with increasingly borrower-friendly terms.

A blurring of lines between traditionally 'tight' private debt terms and 'permissive' distributed debt is on the horizon—with cov-lite possibly becoming the single product being accepted across the majority of the market.

The use of cov-lite and high yield-style incurrence covenants has spread through the large-cap and top-tier syndicated term loan market in the past five years and this product may now push on to cover the mid-cap and private debt market during the year ahead.

_{4 ELFA Insights vol 5. Nov 2020. European Leveraged Finance Association. PDF download.}

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_{This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.}

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