The credit crunch: when will liquidity return to the market?

Research suggests that the illiquidity characterising the international finance markets
looks set to impact deal structures for the foreseeable future, say Tomas Gärdfors and James Dunnett of Norton Rose's European banking practice

Are we seeing the correction that the
European leveraged market was
waiting for, albeit from an
unexpected angle? While many
commentators wondered whether a series of
high profile defaults would have an impact
on the buoyant leveraged finance market, no
one expected that liquidity issues would have
a potentially more significant effect.

The ripple effect of the US sub-prime
mortgage crisis is reaching far and wide. In
Europe, the retreat of some institutional
lenders from the syndication market and a
general lack of liquidity mean that not only
are arrangers reluctant to take on new
leveraged debt, but some seem to have closed
their books entirely.

Borrower terms

In the last couple of years, the European
credit markets have seen a surge in available
liquidity, with lenders conceding ever more
borrower-friendly transaction structures and
documentation: second lien has pushed down
returns on mezzanine lending whilst seeing
increasing risk in the capital structure; prior
to the third quarter of 2007 financial
covenants allowed for more generous cure
rights; and, as lawyers in Iberia will have
seen, in 2007, 'covenant-lite' deals emerged
in Europe.

What changes in transaction structuring
and documentation will now have to be
made to get deals done? To gain an insight,
we interviewed over 100 banks, investment
banks, private equity houses, corporates and
hedge funds active in the leveraged finance
market.

Our survey confirms some expected
views, while also raising other interesting
results. It will come as no surprise that
respondents believe that leverage levels on
deals will come down. Equally, almost 90% of
respondents believe that the current turmoil
will affect the pricing of debt, indicating
higher pricing levels and the disappearance
of 'reverse flex' – the ability of loan
arrangers to reduce lending margins on
syndication.

At present, around two-thirds (68%) of the
respondents believe that it will take more
than nine months for the market to find its
way back to July 2007 activity levels, with
45% specifying twelve months as more likely.
The recovery of the market will see a greater
focus on financial covenants: while over half
(52%) believe covenant cure rights will
remain standard, almost all (92%) are
convinced that covenant-lite clauses will not
return in the foreseeable future, and 85%
believe that financial covenant 'mulligans'
(where a fund may be forgiven its first
default on a financing covenant) are unlikely
to appear in new deals.

Uncertainty

With lenders no longer experiencing the
liquidity they had become used to,
structuring of leveraged deals will be
different. It is also interesting to see that the
inability of lead arrangers to sell down debt
seems to be combined also with a different
concern: whether deals have sufficient credit
quality. Over nine-tenths (91%) of
respondents believe that, when the leveraged
market does pick up again, it will mean a
revival of the amortising A tranche and more
than three-quarters (78%) say that it is likely,
or indeed very likely, that the A tranche will
increase relative to non-amortising B and C
tranches.

In uncertain times, people have less
appetite for riskier debt. More than twothirds
(68%) say that less use of 'payment in
kind' (PIK) loans is likely, or even very likely,
in the immediate future. Equally, with 46% of
the respondents believing that second lien
will still be used in capital structures, it seems
that simpler, more traditional structures will
be preferred.

Leveraged debt will be made available on
certain funds terms in new deals coming to
the market according to 71% of the
respondents. However, the ability of sponsors
to meet tight vendor deadlines is
questionable: 89% of respondents agree that it
is likely, or very likely, that the use of interim
loan agreements and funded term sheets will
decrease or disappear.

The credit crunch is also expected to see
greater focus on the terms of documents: 83%
of respondents believe that we will see less
commoditisation of transactions. As a result,
it looks like clients will be looking
increasingly to bespoke financing
arrangements, and placing greater emphasis
on their lawyers to help them do so.