What happens when debt markets diverge?

This week’s Capital Agenda Blog comes from Michael McCartney and Chris Lowe in our Capital & Debt Advisory Team.

Divergence is one of the most influential trends in UK debt markets today. There is an increasing deviation in behaviour, in quality and in companies’ ability to access debt, which – if it continues to play out – will have significant consequences as we move through the next part of the economic cycle.

The music is still playing in most of the market, but the volume is much softer in some corners and this is already giving us some clues about where stress will emerge – and how the next part of the cycle might play out.

Diverging behaviour

One of the most interesting – and we think influential – trends in debt markets at present is the divergence between what we might term ‘conservative’ and ‘leveraged’ credits. Much of what we read in debt market literature now is focused around rising concerns in the leveraged finance market.  There’s good reason for this – as we’ll discuss – but we’re not reading much about what this means for the other side of the market; those companies that utilise more ‘traditional’ funding structures.

If we look across UK companies as a whole, debt – whilst high – isn’t rising as fast as in previous years.  Moreover, the rate of increase in corporate bank credit is much slower than before the crisis and saw a dip in 2018.  Indeed, the latest Bank of England Credit Conditions Survey said that:

“Demand for corporate lending from large PNFCs (Private non-financial companies) was reported to have decreased in Q4 and was expected to decrease significantly in 2019 Q1.”

Bank of England Credit Conditions Survey, Q4 2018

More broadly in this more ‘conservative’ side of the market, we’re seeing reduced M&A deal flow, companies paying down debt, with some using bulging cash balances to undertake share buybacks – what in the context of wider market conditions appear to be more conservative actions.

All of which stands in increasingly sharp contrast to the rise in leverage and fall in creditor protections for ‘leveraged’ (typically PE-backed) credits, where EBITDA multiples on deals approached 6x in 2018 and are as high as they’ve been since 2007.  Moreover, in 2018, 88% of European leverage loans issued were ‘covenant-lite’, compared with 7% before the crisis.  This fact alone guarantees that the next debt markets crisis, when it comes, will be fundamentally different from the last.

Diverging dynamics

What’s driving this divergence? In leveraged finance markets, a low interest rate environment has left investors chasing a considerable distance up the yield curve (and, de facto, down the credit curve).  This behaviour is keeping the higher-risk sub-investment grade end of the market well-supplied from a liquidity standpoint, with fervent competition ensuring lending terms keep moving inexorably in borrowers’ favour. 

Monetary tightening has begun in the US, but the Federal Reserve seems minded to move more slowly in 2019 (as noted last week) and the Bank of England is also speaking in dovish tones. The BoE’s reduction in UK growth forecast (to its lowest level since 2009) and slowing pace of expected interest rate rises was not unexpected, but nevertheless remains instructive as to the direction of broader markets.  When, and to what extent, this starts to materially impact confidence in leveraged finance markets remains to be seen – the buy-side remains alive and kicking for now at least.

In more traditional lending markets, Bank of England Credit Conditions Survey shows the availability of UK bank credit starting to fall from Q3 2018 and dropping especially dramatically in commercial real estate in Q4 2018.

By far and away the biggest contributors to falling availability in 2018, according to the survey, is ‘sector-specific risks’, with little pressure from capital markets or wholesale funding conditions.

We have seen this play out in several financing / refinancing situations in recent months, where even long-standing relationship banks have shown a distinct reluctance to lend to good quality UK borrowers in under-pressure sectors like UK retail, construction, facilities management and business process outsourcing.  

Alternative funding is available in private markets, but typically at a much higher cost and hence are shunned by corporates seeking to keep a lid on interest costs and credit optics (with many being wary of market perceptions if they are seen to be reliant on alternative, i.e. expensive, capital).

Diverging outcomes

Conservatively funded (i.e. non-leveraged) companies now face a classic dilemma.  Do they sit on cash and risk becoming a takeover target; invest or spend on acquisitions – without knowing what shape the economy will be in by April, let alone beyond; or engage in share buybacks and potentially sail into rougher seas without adequate balance sheet buffers – thereby risking a refinancing issue down the line?  As we’ll discuss in the next few weeks, private equity houses – themselves sitting on substantial war chests – are increasingly running their slide rule over ‘undervalued’ quoted companies.

Brexit certainty may raise equity prices in exposed areas and trigger more M&A, making some of the above issues moot.  In the interim uncertainty is spreading stress into new areas, with UK profit warnings hitting a three-year high and those profit warnings triggering record share price falls and driving an up-tick in distressed sales activity.

In leveraged markets, debt availability and commercial terms in ‘difficult’ sectors are tightening, but overall liquidity remains good as lenders compete aggressively for business.  Whilst there have been some missed beats since Autumn 2018, the music still seem to be as loud as ever.

Which brings us to the now oft heard observation: ‘how do companies default when they don’t have covenants?’  Of course, companies will default when they absolutely cannot service their debts (after any relevant cure periods) or when they fail to refinance – but, in a nod to ongoing Brexit negotiations, letting the clock run down this far has consequences.

Different impacts

Standard & Poor’s issued a report this week giving their latest forecast for the average first-lien recovery rates for European debt instruments. This now stands at 58%, well below the long-term historical average of 73%, reflecting their:

…‘continued expectation that recovery rates will decline over the course of the business cycle.’

Updated EMEA Corporate Recovery Calibration: Q1 2019, Standard & Poors, February 2019

Two inter-linked reasons lie behind this statement.  The increase in first-lien debt leverage and the proliferation of covenant-lite deals.

Higher levels of first-lien debt (as opposed to more expensive mezzanine / junior debt) have lowered overall debt costs, which lowers the amount of cash companies need to meet their obligations.  In theory, this makes them less likely to default. But, this also means that companies can survive for a longer time with depressed levels of cash generation (the “zombie company” phenomenon seen since the Lehman crisis, as a result of ultra-low interest rates).  

Add into this a wholesale lack of covenants and we could see declining companies limp on for much longer than in the last credit cycle, eroding significant value before they actually default – resulting in much lower likely value recovery to creditors once an event of default has been triggered. 

Compounding the above issues, there are increasingly smaller cushions of junior capital to protect senior lenders in recent highly leveraged transactions, eroding likely recovery rates (of senior / first-lien debt) even further.

What next?

Default rates are still low and are expected to stay low in 2019, though this reasoning is still highly speculative and subject to myriad macro-economic factors that remain unresolved.  Recovery rates between covenant-lite and more traditionally structured deals have been similar so far, but we’re still in a relatively benign part of the cycle.  What happens when interest rates see a sustained rise and/or economic growth stalls?  This certainly won’t be like last time, when governments and central banks had much more monetary and fiscal policy room for manoeuvre.

The financial system itself has more fire-breaks now than in 2007.  But that doesn’t mean that isolated fires won’t be damaging and have unexpected consequences, some of which could be self-reinforcing.  Alternative lending markets hardly existed in the same form in 2007 and as such remain to be properly tested when waters get more turbulent.  

Today’s market is highly dependent on a seemingly constant influx of fresh money to allow borrowers to refinance, with more and more companies becoming reliant on this capital.  What happens when this influx switches to an exodus?  Voluntary and well-considered actions by capital providers may fast become involuntary and hasty – the exact behaviours that precipitated the last financial crisis – and if there’s one thing that capital providers abhor the most, it’s not having any control when storm clouds gather.  No-one would elect to take to the steering wheel of a car once it has careered off the edge of the cliff – but taking charge before that point is difficult when your legal rights expressly preclude it.

We know next time it will be different, but we’re still working out how.

Edited by Kirsten Tompkins