Background
As interest rates have risen over the past years, lenders' negotiating positions in structuring loan agreements have adjusted accordingly. The tightening up of conditions is most noticeable for companies with a low credit rating, although the changes are also noticeable for companies with a high rating. This is especially the case when it comes to variable-interest financial products (such as leveraged loans or personal loans).
The preference for private loans due to an increasing syndication risk over the past years continues to increase in line with the ever-expanding syndication risk, leading to increasing numbers of borrowers taking out private loans, despite their stricter conditions. Taking the market situation into account, structuring and implementing hedges to reduce exchange rate and interest rate risk is also extremely important, especially when interest rates rise and growth slows.
Contractual conditions: bilateral loans versus syndicated transactions
The conditions initially agreed by the parties are more standardised in syndicated transactions involving several lenders. However, the situation is different with a private loan, which, due to its bilateral nature, allows for closer coordination between borrower and lender. Private lenders can therefore define and incorporate customised conditions and agreements. Tangible assets, receivables or the share capital of operating units offer the most basic protection for corporate lenders. In addition to the possibility of closer coordination between lender and borrower in bilateral loans, the increasing popularity of private lenders is also closely linked to the increased price uncertainty in syndications in today's market. This is due to the lengthy timelines for deal financing, often involving several months between the signing of the agreement and the actual closing of the transaction. For this reason, clauses are included in syndicated loan agreements that give lenders flexibility and allow them to change the spread (interest premium on reference interest rates) or the tranches (credit lines) during syndication in order to take current market prices into account. Syndication risk is therefore a key reason why private lending arrangements are becoming increasingly popular.
In any event, higher interest rates both in the area of bilateral loans and in the area of leveraged loans require more precise contractual documentation between borrower and lender. Clear wording and a high degree of accuracy are required in the documentation in relation to collateral in order to counteract possible legal disputes. One problem which may be encountered is the potential transfer of assets outside the legal entity of the borrower, where such items are required as part of the package for securing the loan.
Use of loan covenants to limit risk by the lender
There are alternative ways for a lender to limit the default risk. By agreeing loan covenants, lenders are able to obtain information at an early stage and options for intervening in the event of unplanned developments on the borrower's side, thereby securing influence over the company under certain conditions. So-called affirmative covenants are common and standardised clauses that oblige the borrower to take measures in connection with the loan (including the payment of interest). Such clauses may also take the form of negative covenants, which relate to the restriction of corporate activities - such as the sale of assets, mergers and acquisitions or dividends. There are two basic forms of negative covenants: Maintenance covenants and Incurrence covenants.
- Maintenance covenants are used to carry out tests on the borrower's financial performance at regular intervals and, in the event of a breach of a maintenance covenant, to grant the lender the right to terminate the loan if no cure options have been included in the contract.
- Incurrence covenants are similar in essence to maintenance covenants but are only checked in the event of certain corporate activities (for example, in the event of a transaction or payment of a dividend) by the borrower.
Such clauses are ultimately intended to ensure that the borrower maintains an adequate operating course and that, conversely, the lender is better protected.
Developments with regard to contractual conditions
In connection with leveraged loans, the term covenant-lite has become established, which could be understood as a neglect of the inclusion of protective measures when granting loans, but rather reflects the institutionalisation of the market and refers to the widespread practice during the last ten years of not including maintenance covenants in leveraged loans, but only incurrence covenants. From the borrower's point of view, these contractual conditions are extremely favourable, as no financial ratios nor compliance with financial ratios is required: covenant-lite loan agreements therefore offer a very positive financing environment.
Furthermore, due to the variable interest rate nature of leveraged loans, many lenders require a certain level of interest rate hedging to ensure debt repayment by borrowers in the form of interest rate caps - ie as insurance against rising reference rates such as SOFR. Foreign currency hedges are becoming increasingly important but are not yet frequently included in loan agreements.
Conclusion
In summary, the negotiating positions of lenders in the structuring of loan agreements and with regards to the contractual terms contained therein have improved in the context of new issues. With rising interest rates, the documentation of credit investments and the tightening up of credit terms for leveraged loans and bilateral loans have become increasingly important, as these products have variable interest rates. The tightening up is particularly noticeable for companies with a low credit rating, but even borrowers with a high credit rating should not lose sight of the contractual terms of loan agreements. Incurrence covenants must be precisely structured and the use of borrowed cash must be restricted. In addition, over the past years, the increased syndication risk has led to more borrowers taking out private loans, which are associated with stricter conditions and better documentation, but also with greater certainty of execution. Currently, syndication risk is still rising, which leads to even more borrowers taking out private loans, which have become established on the international credit market over the past few years. In view of the ongoing market volatility, investors must therefore pay attention to how the loan exposure in their portfolio is structured and to what extent hedges are implemented in the loan agreements in order to minimise the exchange rate and interest rate risk.
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To discuss the issues raised in this article in more detail, please contact a member of our Banking and Finance team in Frankfurt.
