Who owns your company’s debt? For many entrepreneurs this may be a surprising question. It’s natural to assume that when you agree a debt facility, typically with your high street bank, you will continue to deal with the same lender throughout the life of the loan. You will probably also assume that the bank’s approach and requirements will remain consistent. A decade ago, that would probably have been true; but now it is becoming an increasingly unreliable assumption. And the implications for your business could be significant if not alarming.
The odds have never been higher that during the lifetime of your loan, the ownership of your debt will change hands. The European market for ‘traded corporate debt’ has seen an upsurge over the last decade and demand is still rising. The direction of trading is largely one-way – from the hands of traditional players such as banks and pension funds to institutions such as hedge funds, whose investors are far more aggressive in their pursuit of value than the banks they replace. Frequently their ultimate interest can be ‘loan to own’ – seeking to gain control of a business, using the ownership of debt to force a stressed business to either transact or swap debt for equity.
A decade ago, when the traded debt upsurge started in London and became established in Europe, only debt from larger corporates was normally traded. But as the market has grown, demand has also expanded – fuelled more recently by a high volume of capital thirsty for investment and low interest rates on conventional investment. According to Standard and Poor’s Leverage Commentary, in 2000 hedge funds accounted for just 6.75 per cent of the leverage European Loan Market; they now represent 35 per cent. It’s now not unusual for debt of any middle market company to be traded, and the ‘threshold’ is likely to continue to drop. There is so much liquidity at the moment that most investors of non par debt (i.e. debt traded at below the nominal value) say there is not enough opportunity to meet their needs.
To put this into perspective, debt trading is unlikely to impact on a middle market company which is consistently able to meet or beat its planned targets and doesn’t breach the covenants which will normally form part of its borrowing agreement (to maintain ratios like leverage, net asset value and liquidity).
But should there be a ‘blip’ in the performance of your business or deviation from the initial plans you may find the situation changes quite quickly. The previous regime of visits from the bank’s relationship banker, keen to support your growth with more and more innovative banking products and services, may be replaced by an altogether keener interest, often from a different level of the bank where the debt on the bank’s balance sheet is actually managed.
What you may not see, unless your lending agreement contains a right for you to veto a transferee, is the bank looking to ‘lighten up’ on the debt, either by trading it or by passing on the ‘economic interest’, a process known to bankers as sub-participation.
A bank’s approach to stressed situations is usually supportive and seeks to maintain a good relationship with the corporate whilst protecting value for all the stakeholders. However, it is at this point that who owns your debt can be a very important question. Most banks are likely to consider trading or be approached by a debt trader to sell the debt of a customer that is ‘stressed’ – so that targets are missed or covenants broken. An analyst at Fitch Ratings estimates that hedge funds now own 50-60 per cent of the debt in stressed companies.
So if your business is looking at raising debt financing, what can be done to ensure your debt remains as a debt? The best form of protection is to ensure that the business remains out of trouble, easier said than done, but robust forecasting with sensible covenant headroom is a must. Don’t forecast over-optimistically, and don’t agree to maintain covenant ratios, which you don’t feel confident you can achieve.
Secondly, ensure that your bank understands your business thoroughly and doesn’t misinterpret variations from forecasts. A bank is very unlikely to trade debt in a successful company with the potential to grow even if there are some glitches along the way. If you foresee deviations from your original plans or you decide to enter a new market or provide a new service, make sure the bank understands and agrees well beforehand. If you think you may breach a covenant, open a dialogue with the lender. Like the equity markets, the rule should be ‘no surprises’. As a senior banker I worked with used to say: ‘If you need an answer tomorrow, the answer is “no”’.
Also, have your legal advisers focus on the transferability clauses in the loan facility documents, as although most institutions cannot restrict their right to transfer debt, there may be scope to provide the corporate with a right of veto over the transferee. In reality, however, this right of veto is only cosmetic, as it would not prevent the lender from transferring their economic interest in the debt to another party; but it is still beneficial.
Don’t be over-cautious about using debt. After all, debt is still relatively cheap (especially in the current interest rate environment), relatively available and most importantly it won’t impact the ownership or control of the business – as long as you are able to broadly meet the business plans and financial projections you have constructed.
On the flipside of being the debtor in a stressed environment, we are also seeing some acquisitive companies focusing on acquiring the debt rather than the equity of a target business. When a highly leveraged company becomes stressed the value of the business is likely to be below the equity, making debt the more appropriate entry point into the capital structure. This may ultimately give you better value, greater influence and avoid you being frozen out of negotiations as an ‘out-of-the-money’ shareholder.
Written by David Morris is a director in Ernst & Young’s corporate restructuring team.
This article was originally published in Masterclass magazine.