COVID-19-Related Defaults in European Leveraged Loans Could Create Opportunities for Distressed Investors

Since the last financial crisis, borrowers and private equity sponsors have cut distressed investors out of most European leveraged loan deals. According to Reorg Debt Explained about 66% of European leveraged loans in 2019 restricted transfers to distressed investors.^[1] But the recent economic turmoil created by the COVID-19 pandemic could create opportunities for distressed investors to return to the market. Fitch Ratings recently forecast a 4% default rate for European leveraged loans in 2020 and a 7% default rate in 2020.^[2] In a severe downside scenario, Fitch projected that default rates could reach as high as 14% next year. In some European leveraged loan deals, the transfer restrictions that have kept distressed investors out of lending syndicates may fall away if events of default (or certain specific events of default) occur and continue.

When Problems Create Opportunities

While transfer restrictions vary from deal to deal, a typical European leveraged loan deal will include several transfer restrictions. Generally, the prior written consent of the borrower is required for any assignment, transfer or sub-participation unless: (i) the buyer is a lender or an affiliate or related fund of a lender; (ii) the buyer is included on a list of approved lenders; or (iii) the transaction occurs at a time when a borrower or guarantor has defaulted on its payment obligations or has entered insolvency or insolvency proceedings (or similar events) (a “material event of default”).

Further restrictions are often placed on top of the basic ones discussed above. These can include prohibitions on transactions involving industry competitors, hedge funds, private equity funds, loan to own funds, and distressed investors. In some deals, these prohibitions may also fall away, along with the borrower consent requirement, if a material event of default is continuing (or, in certain deals, if an event of default is continuing). Such scenarios could create openings for distressed investors to participate in European leveraged loan deals that were inaccessible to them just a few weeks ago.

Not all deals eliminate or relax transfer restrictions when a material event of default (or an event of default) occurs and continues. According to Reorg Debt Explained, 58% of loans sold in 2019 imposed restrictions on selling to distressed funds even after certain types of default, compared with just 14% in 2017.^[3] Additionally, there are other jurisdiction-specific restrictions to be aware of. For example, in deals with Swiss borrowers, credit agreements typically cap the number of non-bank lenders under that credit agreement at ten and the aggregate number of non-bank lenders under all outstanding debt at 20 in order to avoid withholding tax on interest payments. These restrictions will very likely stay in place, regardless of whether a default occurs.

When Opportunities Create Problems

As discussed above, it is imperative to thoroughly review the applicable credit documents before entering a trade in which the buyer is a distressed investor that is not already a lender. Parties to a trade should not assume that settlement by sub-participation will be an option if the buyer cannot become a lender of record. European leveraged finance deals frequently apply the same transfer restrictions to sub-participations that apply to assignments and transfers.^[4] Even if sub-participation is an option, parties who check the “Legal Transfer Only” box in an LMA trade confirmation, could inhibit their own ability to settle via sub-participation. There is a common misconception that selecting Legal Transfer Only means that the trade will go away if the buyer cannot become a lender of record. In fact, when parties check the “Legal Transfer Only” box, they are agreeing not to settle the trade by sub-participation if assignment or transfer is not possible, but instead, they are electing to settle “on the basis of an alternative structure or arrangement mutually acceptable to the Seller and the Buyer that provides the Seller and the Buyer with the economic equivalent of the agreed-upon trade.”^[5] There is no standard form for this type of agreement.  

If settlement by sub-participation is an option, the parties should consider settling the trade on a participation agreement adapted from the LSTA form rather than an LMA participation agreement. Under English law, a participation agreement does not effect a true sale of beneficial ownership and the grantor and participant have a debtor and creditor relationship. Under New York law, a participation agreement is viewed to transfer beneficial ownership from the grantor to the participant. This distinction is important because if the grantor becomes insolvent under English law, the participant would only be an unsecured creditor in the insolvency proceedings. Under New York law the participant would have a property interest in the loans and should not be adversely affected by the grantor’s insolvency proceedings. Parties wishing to have a New York law participation as a settlement option should include it as a term of trade and make sure that the trade confirmation is drafted accordingly. But before doing so, the parties should first confirm that such a transaction is permitted under the credit documents. European credit agreements often require that the relationship between the existing lender and the proposed sub‑participant is that of a contractual debtor and creditor (including in the bankruptcy or similar event of the lender or a borrower).

Conclusion

The COVID-19 pandemic may, for the first time in years, allow distressed investors to meaningfully return to the European leveraged loan syndication market. As many par investors look to offload credit risk at the same time, distressed investors could provide an important source of liquidity for CLOs, debt funds and banks. Par investors and distressed investors alike should carefully review credit documents before trading and when they do trade, they should make sure that the trade documentation provides for an acceptable form of settlement if the buyer is unable to become a lender of record.