LMA & LSTA Conference Summary (8 March 2017)

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1 LMA & LSTA Conference Summary (8 March 2017) On 8 March 2017, the LMA and LSTA held their joint annual conference at the offices of Allen & Overy in London. Over 350 industry professionals were joined by 30 senior market experts who delivered sessions covering the current political and economic landscape, a comparison between US and European loan markets, the continued rise of direct lending and the impact of blockchain technology on financial services. Session 1: Global Economic Outlook The outlook for the world economy was positive, with lower oil prices, loose monetary policy and loosening fiscal policy set to make 2017 a good year for global GDP growth. However, it is clear that recovery from the financial crisis is on-going, with sovereign and private debt vulnerabilities in flexibility persisting in developed economies and an ageing population posing challenges for policymakers and financiers alike. This should not dim optimism for the shortrun, since increasing debt is facilitating cross-sector recovery. A general slowdown in productivity related to low trade growth and slower supply chain expansion because of the geopolitical environment has pushed emerging market GDP growth below the long-run average. Despite this, emerging markets are experiencing much needed stability, signalled by the end of recession in Russia and Brazil, improved policy making, low currency volatility and continued growth in India and China. Forecasts expect an upturn in their growth prospects, but lower global trade has caused credit conditions to become tighter as the risk of default on corporate debt increases. Developed economies should forge more trade agreements, help reduce the sovereign debt burden and establish government buffers that can absorb future shocks, in order to relieve some of this risk. The initial impact of Brexit defied the predictions of many economists and UK growth rose to match the % mature economy average, assisted by the real exchange rate depreciation of 16% that boosted exports. Growth is, however, still below the 2.25% long-run average and the full impact of Brexit, once Article 50 has been triggered and negotiations begin, may unhinge the upswing experienced to date. Heightened awareness of political risk in the US, UK, France and Germany, in addition to renewed crises in the Middle East and a potential credit bubble in China, will form the biggest challenges of 2017, but it remains true that macroeconomic signals suggest that the underlying economics is not as bad as many proclaim. Session 2: UK and US Loan Markets: Trends and Deal Terms In recent years, the European and US loan markets have seen a growing trend for sponsors to cherry-pick structures and provisions from both markets, to create a product that best suits their needs. This is best demonstrated by the increasing prevalence of covenant-lite (cov-lite) structures in Europe, which were adopted in just under 50% of new deals in Other trends to note include reduced periods of time for documentation review (both sides of the pond), and the prominence of CLOs, which now account for 60% of purchasing power within the US.

2 A current hot topic in the market concerns transfer restrictions. The European market has seen a recent move towards more restrictive transfer provisions, including consent requirements for sub-participations. This trend is being heralded as a "European phenomenon", not being seen in other loan markets around the world. In addition, there remains uncertainty surrounding the classification of parties which are 'black listed', i.e. cannot take part in the loan going forward. In the US, this issue has been settled by the use of disqualified institution lists (colloquially termed "DQ lists"), whereas European markets are still using a mixture of white lists, black lists and consent rights. A key concern regarding the use of DQ lists is the generic descriptions contained within them, for example, not permitting a loan interest to be transferred to 'distressed investors' or 'industrial competitors'. These non-specific, broad descriptions make it extremely difficult for lenders to judge whether a party is acceptable. Given that the consequences of breaching these restrictions can be severe, and can include disenfranchisement, the requirement for further clarification is of fundamental importance. Session 3: Direct Lending The syndicated loan market remains strong, with Q debt issuance increasing as many borrowers seek to refinance their bond debt as loan debt. Direct lending in particular is experiencing a surge in activity, with US$50bn issued in Europe during 2016, despite increasing political uncertainty in the region. The US direct lending market had a strong 2016, with a multitude of players actively operating and competing in this arena. The European direct lending market shows promising signs of growth. Traditional bank lenders face greater regulatory restrictions and increasingly welcome alternative lenders to assist in financing, rather than compete for the same ancillary business. US direct lending funds tend to encompass a range of structures to increase flexibility in the market, with leveraged unitranche being a popular financing tool. In Europe, direct lending funds are more focused on senior secured lending, with explicit unitranche deals being less common. Direct lending loan terms in 2017 will likely be determined by intense competition, although lenders should remain disciplined and be wary of eroding terms given the volatile macroeconomic and geopolitical environment. European deal sizes are expected to increase but are unlikely to include cov-lite terms anytime soon. For underperforming credits, direct lending funds are much more likely to work through the credit cycle and provide business support services to the borrower rather than restructure because, unlike banks which could cope with taking a loss, fund investors are much more sensitive to being hit by write downs. Long term investors in direct lending funds are also more adverse to aggressive restructuring strategies or taking control of the borrower. Session 4: A Comparison of European and US Intercreditor Arrangements In both US and European restructurings, control of proceedings and the ability to sell the borrower as a going concern are given to senior lenders in order to ensure they can recover their investment in a default scenario, however there are procedural differences. In the US statutory provisions and hierarchy are emphasised in Chapter 11, while in Europe senior secured lenders assume contractual rights via an intercreditor agreement, with Europe consisting of a myriad of insolvency regimes. In Europe, these agreements are usually explicitly governed by English law to avoid local law restructurings and stipulate what can and cannot be done, particularly in the standstill provision applicable to junior creditors. Chapter 11 does not give as much detail as the LMA intercreditor agreement, but provides for a formal court-led process with an automatic stay preventing enforcement action. In the US, parties can also agree to run the process outside of the bankruptcy code via the Article 9 process. Session 5: Key note: Populism and Nationalism A New World Order in the US and Europe? In light of the current economic and political landscape, 'populism' and 'nationalism' have become commonplace terms used to explain a movement driven by public dissatisfaction. In this respect, populism can be defined as a sense of anger and frustration against some form of elite political system, while nationalism can be many things, including the belief that one's nation is inherently superior. It should be noted that populism is by no means a new movement in either Europe or the US, with recent discourse surrounding election results merely its latest revival. Critics of the current movement may be reassured by the historically short-lived nature of populism once it has advanced to the political sphere.

3 Until recently, anti-globalisation has remained outside of the mainstream, with recent political events highlighting heightened geopolitical tensions more generally. However, with referendums being contemplated in 18 of the 27 EU member states, Brexit appears to be only the beginning. In addition, India has stated its intention to allow trade treaties with individual EU-member states to lapse, requiring an EU-wide treaty to be entered into instead. Even in Canada, a jurisdiction viewed as fundamentally liberal, 40% of Canadians, when surveyed, supported increased protectionist measures. This trend is expected to continue throughout 2017, with populist flashpoints including election results in France, Germany and the Netherlands, immigration concerns in Scandinavian countries, and growing frustration with financial institutions in Southern Europe. France, Germany and Italy have recently stated that they would like to increase restrictions and monitoring of inward investment into high-tech sectors. In this respect, free trade in the form of multinational trade deals may be over. The current political landscape suggests that new trade deals will instead be negotiated bilaterally between countries operating on a level playing field. These protectionist measures come alongside an economic landscape in which there is significant populist backlash against pro-business policies. The availability of information and, to some extent, misinformation and the increasing use of social media as a platform for political discussion means that business reputations are continually challenged. Recently, Kraft Heinz notably faced significant backlash following their failed acquisition of Unilever. In this respect, the growing influence of social media and NGOs cannot be underestimated. It has been proposed that one measure in driving change and combating populism is through tackling voter apathy, which may be achieved through government intervention and by facilitating a more rational, informed, and rounded media. Session 6: Blockchain: How will it Change Financial Services? Looking to the future, blockchain technology has the ability to dramatically alter operations and roles within the loan market. Although it remains in early development, with proof of concepts only just emerging, it is important that market participants are aware of its functionality and use cases. Blockchain was formed in 2009 as the infrastructure behind the popular Bitcoin virtual currency network and can be described as a distributed, shared, encrypted database that enables users to access and store information relating to assets or transactions without a single authoritative copy or validation party. Once inputted the information is immutable and secure, creating a trusted universal database that is seen by all users. The blockchain may have a public protocol which allows unrestricted access to viewing and updating data or a private protocol that requires authentication prior to joining the network. Trade finance offers the most developed concepts, since these sectors offer the most extensive potential for cost saving through the automation of current paper-based documentation, transfer activity and security. This does however pose a risk that trade finance becomes concentrated amongst a limited number of banks that have investigated and implemented blockchain. This, in turn, could impact supply capacity and liquidity. Several developers are focusing their efforts on know your customer (KYC) and anti-money laundering (AML) solutions, which have the potential of mutualising the cost of regulation amongst all institutions on the blockchain by reducing their individual requirements to undertake KYC and AML checks. Since blockchain is still a nascent technology, there is natural caution in relation to its development and implementation in the financial sector. It is particularly challenging in the US where technology start-ups require licences from each state they operate in and do not have access to a 'sandbox' to develop financial market technology. In contrast, European regulators have been much more inquisitive and accommodating of the new technology, particularly the UK FCA which has formed a sandbox for start-ups to test new products in a protected environment that prevents undue risk to market security. The loan market will undoubtedly be impacted by the introduction of blockchain technology, which will allow professionals to automate and utilise more creative knowledge to provide the best solutions to their clients. The sooner that use cases are tested and implemented, the quicker that related cost savings will become apparent. More information about blockchain and its financial market use cases can be found on the LMA Loan Operations microsite. Session 7: A Look at Regulatory Guidance for Lending in the US, Europe and UK

4 In order to facilitate a level playing field for financial institutions, the European Central Bank published draft guidance on leveraged transactions in November The underlying regulatory principles remain similar to the equivalent US leveraged lending guidance, which came into effect in However, the ECB guidance contains some key distinctions, which impose stricter requirements on market participants. One key area in which the ECB guidance varies from the US is in the definition of leveraged transaction. Both jurisdictions consider a transaction to be leveraged where the ratio of total debt to EBITDA exceeds 4x, but the ECB definition is extended to cover transactions in which the financial sponsor controls or owns more than 50% of the borrower s equity. The US definition instead comprises four components (including the 4x total debt to EBITDA ratio); however, unlike the ECB guidance, the transaction is not automatically considered to be leveraged if only one element of the definition is met. It should be noted that, in 2016, pro forma leverage remained steady at around 5.6x in the US, with European figures showing a gradual increase in line with US levels. Other areas where the ECB guidance is inconsistent with the US include the calculations for total debt and EBITDA. The US leveraged lending guidance calculates total debt on a gross basis; while the ECB guidance is silent, it is market practice in Europe to calculate total debt on a net basis. The US guidance, unlike the ECB equivalent, also acknowledges adjustments to EBITDA. Given that EBITDA adjustments account for over one turn of leverage, this distinction could have a significant impact on the market. There are further discrepancies which relate to the nature in which troubled credits are dealt with, and the types of transactions excluded from the guidance. Despite these differences, it should be noted that the ECB guidance has not yet been finalised. Given that the consultation period closed on 27 January, it remains to be seen whether comments raised by the market will be incorporated into the final version. Session 8: Brexit Impact on UK Scheme of Arrangement In recent years, there has been a move away from insolvency activity, with the emphasis shifting to pre-insolvency or restructuring procedures. In this respect, schemes of arrangement (SOAs) have become increasingly attractive as they provide a solution for restructuring operating companies in an international group where no local procedures are available, thereby increasing efficiency and predictability in these scenarios. An SOA is seen to be a flexible preinsolvency procedure, which allows a restructuring to take place provided it is approved by 75% of creditors. There is no requirement for unanimity and SOAs are not restricted by the same jurisdictional limitations which attach to formal insolvency proceedings. They can also provide a cheaper alternative to the US Chapter 11 procedure. Following the Brexit referendum, there are some concerns regarding the ongoing recognition of SOAs in European jurisdictions. Whilst recognition is not entirely dependent on EU law, it should be noted that the EU Judgments Regulation will cease to apply to the UK post-brexit. However, there are a number of alternative routes to recognition which the UK may rely on. These include becoming a member of the EFTA, or by means of the Hague Convention, although the latter of these is neither comprehensive nor certain. It may also be possible to adduce expert evidence for the English courts to recognise an SOA. At present, EU member states are responsible for developing their own restructuring frameworks. Moving forward, the European Commission has published a draft Directive for the Harmonisation of Restructuring Laws. The aim of the Directive is to ensure that all EU member states offer certain minimum levels of preventative or pre-insolvency courtsupported restructuring to debtors in each jurisdiction. The Directive also incorporates elements from the US Chapter 11 procedure, including a stay on enforcement during restructuring negotiations, cram down procedures and debtorin-possession (DIP) financing. In light of this changing EU restructuring landscape, there are concerns that UK SOAs may become less attractive. However, given the international reputation of English courts, and the benefits associated with UK SOAs, such as the absence of a moratorium, this risk is likely to be minimal. Session 9: What Comes Next? Politics and Regulatory Reform Following the financial crisis, the market saw the creation of a Financial Advisory Board. In recent years, there has also been significant regulatory change, and compliance with capital requirements has become one of the biggest cost burdens for financial institutions. The introduction of ring-fencing requirements and the new US regulations for intermediate holding companies are just two examples of the heightened regulatory pressure faced by market participants.

5 There has also been significant discussion around taxation reforms, with new legislation relating to the deductibility of interest coming into effect. These reforms could have a significant impact on leveraged loan markets; however, it is anticipated that major taxation reform in the short term is highly unlikely. In the UK, the key issue going forward will be Brexit. Since the referendum result in June, not much has changed. However, the tipping point will be when Article 50 is triggered on 29 March In the UK, market participants should be concerned with whether their institutions are approaching clients in the right way, particularly given the fact that UK Prime Minister, Theresa May, has confirmed that single market access is not expected to continue for the UK post- Brexit. Institutions will react differently depending on their internal structures and own needs, considering questions such as where their head offices should be based, which offices will be market/client facing, etc. Further implications of the referendum result include a heightened 'war for talent' within financial services, and the potential for the UK to become a regulation-lite offshore investment base as suggested by Theresa May should the UK be unable to secure favourable terms throughout exit negotiations. From a European perspective, it has been noted that the EU may also detriment from the absence of the UK's experienced regulatory input. The LMA would like to give special thanks to the speakers who devoted their time to this year s LMA & LSTA Conference. To view the agenda and speakers, please [click here]. To view the conference presentations, please click here.