The credit choice dilemma – navigating the finance options for corporates

The corporate finance landscape has seen a fundamental shift in recent years. In the UK at least we have emerged from the constrained credit environment of the credit crisis.

Assessing the current picture, it is clear that treasurers and finance directors are enjoying the benefits of a range of attractive financing options available to them. But given the possibility of choice, what are the key considerations for treasurers and finance directors when considering a company’s financing strategy?

In this article, we consider the typical questions posed by investment grade corporates when faced with the dilemma of pursuing one or more financing strategies.

What has changed and the reasons for this

Current market conditions may well present a unique opportunity. There is undoubtedly a resurgence of bank lending, assisted by a rejuvenated collateralised loan obligations (CLO) market. At the same time, the low interest environment, as an overhang of the economic stimulus package, makes it attractive to lock in rates for longer-term financing. But most commentators predict that, at least in the UK, rates will only be heading in one direction – and that is up. Views vary on how quickly that is likely to happen, as they do for different countries, regions and sectors.

Corporate credit risk has also, more recently, become a factor in debt and equity market volatility, with continued low commodity prices and persistently low oil prices. Financing decisions have also been affected as a result; for example, as reported by the International Financing Review, international oilfield services firm Schlumberger decided to finance the majority of its US$14.8bn acquisition of Cameron International with stock instead of debt, citing volatility in the financial markets.

With the challenges of the last five years still not forgotten, corporates have begun to access alternative sources of capital. This is evident in the growth of Europe, the Middle East and Africa (EMEA) corporate bond issuances. In the past 18 months, however, there has also been a resurgence in loan market activity, primarily driven through refinancings, but also pre-IPO facilities and some significant M&A activity (for example, the proposed SABMiller/AB InBev transaction). DCM volatility (due to, among other things, the China slowdown, anticipated interest rate rises and a lack of bond market liquidity) has also been a factor in the recent uptick in loan market activity.

Diversification of funding brings with it the benefit of unlocking bank credit lines. Although in the corporate loan markets we are now regularly seeing the pre-crisis “5+1+1” loan tenor structures re-emerging, regulatory capital changes and constrained balance sheets led to tenors of less than five years in the immediate aftermath of the crisis. So, corporates are using short- to medium-term bank facilities to provide more flexible financing for working capital, capex and other expansionary activity such as M&A, and have been turning to the bond markets for longer-term financing requirements (for example, the GDF Suez 20-year bond issued earlier this year, with a record low 1.5 per cent coupon). In fact, the tentative recovery of the M&A market has probably disguised the true extent of recovery of bank balance sheets and appetite for lending. Nevertheless, banks do, of course, continue to be the mainstay of corporate finance for many borrowers.

Key considerations when deciding on a debt solution

To some degree this has always been, and will continue to be, a question of pricing. But corporates are now not only driven by price but also by looking to diversify funding sources and managing refinancing risk by locking in longer tenors. At a recent corporate finance conference, all but one of the topics covered concerned alternative sources of debt, including retail bonds, US and European private placements, Schuldschein and securitisation. Until relatively recently, many corporates would not have been interested in, or seen any need for, such sources of capital.

Therefore, the key considerations are as follows:

Pricing

A number of factors will impact pricing. From a bank lending perspective, this will depend on:

• creditworthiness and sector;
• tenor (which will impact both loan and swap margins) and facility size; and
• lines of ancillary business (which can be used to reduce headline margin costs).

Loan pricing also remains driven by excess liquidity, a continuing demand and supply imbalance, and banks competing against each other to lend.

For a corporate bond, issuer pricing will primarily be determined by:

• credit rating and sector;
• secondary trading of market comparators;
• tenor and features;
• achieving a benchmark public offer issue size (typically viewed as £200m for wholesale bonds) and, conversely, any illiquidity and/or first issue premium;
• in some cases,the depth of sectorspecific private placement markets; and
• general market conditions/ macroeconomic events.

Diversification of funding and managing refinancing risk

Companies with significant or variable working capital or capex requirements will usually turn to the loan markets to cater for these needs. The flexibility (and savings) afforded under a flexible draw revolving facility cannot be matched in the bond markets. Typically, loan facilities will have short- to medium-term maturities. However, the capital markets in many jurisdictions allow much longer-dated debt tenors which are most commonly issued at a fixed rate of interest (with no hedging required). For obvious reasons, a combination of flexible bank debt alongside long-dated bond financing is attractive. Not least, it reduces the level of refinancing risk to which a company is exposed on a three-to-five-year cycle under traditional bank facilities.

Although larger investment grade corporates have operated on the basis of a capital structure comprising both bank and bond financing for many years, it has not always been a viable solution for all. With the advent of smaller issue sizes and alternative bond products (for example, retail bonds or private placements), capital markets have become more accessible to a wider range of companies. The proposed withholding tax exemption on private placements is an example of a government initiative aimed at unlocking “new finance for businesses and infrastructure projects” (Autumn Statement 2014). In the leveraged market, the increased diversification of funding sources has been demonstrated by, for example, the use of super-senior revolving credit facilities alongside a high yield bond issue, or unitranche structures involving direct fund lenders.

Credit terms

Commentary on market standard financing terms is necessarily incomplete without taking into account company, sector and creditworthiness analysis of the relevant borrower. However, in our experience, it is rarely the case that the credit terms alone will drive a financing decision for investment grade corporates. In general, the terms and conditions of a bond tend to provide a less restrictive covenant and event of default package than an equivalent loan. Conversely, it is more difficult (by virtue of the disparate holders and the mechanics of the voting arrangements) to obtain an amendment, waiver or consent in relation to a bond modification, breach or default.

Further down the credit spectrum, the emerging popularity of high yield bond issuance has been an important development. While the scope of credit terms is very similar to those that feature in a leveraged loan (albeit, very differently drafted), the key distinction is that high yield bonds feature incurrence rather than maintenance covenants – in other words, event-driven rather than ongoing performance-based tests.

Other financing products to consider

Although often dependent on the sector in which the corporate operates and/or the credit profile, there are many forms of finance to consider (which may, in some cases, have their origins in traditional bank and bond financing).

For example:

• trade receivables financing;
• borrowing base facilities;
• reserve-based lending;
• lease financings;
• (pre-)export credit finance;
• wholesale versus retail bond issues (e.g. issues listed on the London Stock Exchange’s Order Book for Retail Bonds);
• private placements (including US private placements) which can be issued with much smaller principal amounts compared with public bond offers;
• convertibles (with a right to convert debt securities into equity) and hybrids (e.g. perpetuals);
• high yield bonds for non-investment grade issuers;
• securitisations or other non-recourse financings of eligible assets; and
• equity capital markets.

Practicalities in raising more than one type of finance

As mentioned above, most investment grade corporates have indebtedness outstanding under both debt securities and banking facilities. For investment grade corporates, the respective classes of debt may have very little (if any) interaction between them. Creditors may only become aware of multiple tranches of debt if at any point the borrower suffers financial difficulties. The ability to raise alternative tranches of debt may depend on “Permitted Financial Indebtedness” definitions or negative pledge restrictions. Most investment grade facilities and bonds do not restrict other forms of unsecured indebtedness (although there may be restrictions on the entity which can issue such other debt). However, an investment grade bank facility will normally restrict secured indebtedness (subject to agreed exceptions and baskets). By contrast, the negative pledge in unsecured bonds often only restricts the issuance of secured bonds (as opposed to other secured borrowings) in order to protect against secured/unsecured bond pricing differentials in the secondary bond market. Security and intercreditor arrangements are more likely features for companies that are further down the credit spectrum or that are seeking credit or rating enhancements. A capital structure comprising multiple secured debt layers will inevitably require intercreditor arrangements to be put in place. If, as is the case with small- and mid-sized independent companies acquiring assets being divested by larger companies, there is no strong parent company standing behind the borrower, the lenders will place much more emphasis on security and cross-guarantee structures.

Companies will usually seek to align their covenant and default packages between the respective classes of debt. However, full alignment might not be achievable or in some cases desirable (for example, the documentation for a particular product may be tied to a market standard precedent which may not translate well into other debt products). In such cases, a company must analyse each set of credit terms in order to determine whether an event or activity is prohibited, and consent from one or more affected creditor groups is required.

Timetable and cost implications

A capital markets transaction is generally more expensive at the outset and time-consuming. The minimum time period for an inaugural capital markets transaction for an investment grade corporate is six to eight weeks (although in some cases it will be longer). Most of the additional time will relate to preparing a Prospectus (or other offering document) for the purpose of obtaining a stock exchange listing of the bonds, including the related due diligence of the group as well as the management time required to “roadshow” the bonds. A bank financing can generally be completed in a shorter time-frame.

However, a number of factors mitigate the time and costs involved in a capital markets transaction:

• the transaction costs effectively can be amortised over the longer-dated life of the debt; and
• the establishment of a bond programme will, for subsequent issues, considerably reduce the time period, cost and process of coming to market.

When assessing the correct financing option, the purpose for which the financing is being put in place will often be the deciding factor. The costs, timing and pricing certainty that the bank market affords for event-driven financings cannot be matched by the bond markets. Mechanics, such as “certainty of funds”, which can (depending on the nature of the underlying transaction) be made available through the loan markets, will often drive the borrower towards the loan product in an acquisition scenario. However, increasingly many bank financings (and acquisition facilities in particular) are used effectively to bridge a bond refinancing take-out or disposals programme.

“Further down the credit spectrum, the emerging popularity of high yield bond issuance has been an important development.”

Effects of “typical” covenant structures

Set out below is an indicative range of covenants for respective debt classes. Obviously, the covenants will be negotiated for those appropriate to the borrower, its creditworthiness, as well as its business and sector. The borrower may also have existing financing arrangements in place which will influence the covenants included.

Negotiating flexibility in today’s market.

Most market participants in investment grade financings agree that it is currently more of a borrower’s market. Banks are actively lending and in the capital markets institutional investors are chasing yield. This, coupled with a relative lack of M&A activity, has led to fierce rivalry among financiers to provide competitive pricing, terms and tenors. Other factors, such as renewed CLO activity (allowing quicker recycling of bank balance sheets), more frequent high yield issuance windows and increased European focus of US private placement investors has a significant influence on this dynamic. For corporates lower down the credit spectrum, particularly those operating in more problematic sectors, the ability to achieve favourable terms is less certain. Indeed, the markets for some forms of lending (for example, reserve-based lending) has contracted considerably given current market conditions.

Risks of pricing/costs changing

Other than in underwritten deals, where market flex terms may need to be negotiated for the purposes of syndication, banks are willing to price and hold margin before financial close. The all-in interest rate cost in the loan markets does not tend to be fixed, however, as the banks usually lend on floating rate terms. Even so, bank financing still offers more upfront pricing certainty than an equivalent capital markets transaction. That is because a public bond issue is more sensitive to short-term market movements at the time of pricing (both gilts/treasuries and basis points). In evaluating the pros and cons of raising fixed versus floating rate debt, the true cost is not always apparent at the time of the original financing. Swap mark-tomarkets have left many borrowers out of the money in recent years when paying break costs. That compares to buy-back or make-whole/Spens costs on early redemption of corporate bonds (although such “prepayments” are reasonably infrequent). Although the bank market offers upfront pricing certainty, the level and complexity of bank regulation (Basel III/CRD IV/Dodd–Frank, for example) potentially leaves borrowers exposed to increased costs over the life of the transaction which are difficult to quantify. Issuers in the capital markets do not face the same uncertainty of regulatory capital costs, which is attractive to some corporates.

Investment Grade Credit

Loans	Bonds
Credit support Security: none. Guarantees: position varies but can include parent only, material companies and/or guarantor coverage test	Credit support As for loans.
Mandatory prepayment events Illegality and change of control. If event-driven, position varies, but equity proceeds, other debt and DCM issue proceeds and/or disposal proceeds are common.	Early redemption events Issuer call option for withholding tax reasons at par. Other redemption events may include a change of control put option (generally accompanied by a rating downgrade requirement) or an issuer call option at any time at make-whole or premium (such as 101 per cent). An issuer call option at par at any time during the three-month period prior to maturity (which allows more flexibility when refinancing) is becoming increasingly common.
Representations Package varies, but typically includes status, binding obligations, no conflict, power, validity, governing law, pari passu, tax, no default, no filing or stamp taxes, no misleading information, financial information, MAC, litigation, sanctions.	Representations Similar to loans but extended in favour of Arrangers/Lead Managers only rather than Bondholders. In addition, securities laws and Prospectus-specific representations
Covenants Financing reporting: tends to be annual and semi-annual only. Financial covenants: (if any) tend to be limited, with semi-annual testing on maintenance basis. General undertakings: package varies, but typically includes authorisations, compliance with laws, negative pledge, disposals, subsidiary indebtedness, merger, change of business, sanctions. Depending on credit strength or deal specifics, restrictions on acquisitions may be included.	Covenants Financial covenants: rarely seen in investment grade corporate bonds, although may be included in structured corporate bonds for certain sectors (e.g. infrastructure). Other covenants: status (or pari passu) and negative pledge. Negative pledges in investment grade corporate bonds generally only restrict the granting of security for similar types of debt (i.e. bonds, notes and other tradeable capital markets instruments). Negative pledges that restrict the granting of security for any indebtedness (so-called “all moneys” negative pledges) are rare. If there is a trustee, the trust deed will contain additional covenants by the issuer/guarantor to enable the trustee to perform its functions (provision of financial statements and other information sent to shareholders, maintenance of listing, provision of compliance certificates, access to books of account, etc.).
Events of Default Typical package includes non-payment, breach of financial covenant and other obligations, misrepresentation, cross-default (or cross-acceleration if strong credit), insolvency, creditors’ process, unlawfulness and repudiation, ownership of obligors, MAC.	Events of Default As for loans, except cross-acceleration/payment default is more common than cross-default, MAC generally not included, and there is no misrepresentation default.

Reporting and information covenant requirements

A significant difference between a capital markets transaction and a bank facility is the public-versus-private nature of those financings. The contractual information covenants in a bank facility may be more extensive and may require information to be provided on a more frequent basis than the equivalent provisions in a bond. However, dissemination of information to the public is regulated by legislation in the capital markets. This requires timely publication, not only of ongoing periodic information but also market announcements of any non-public price-sensitive information which could have a significant effect on the price of the bonds. For many first-time issuers, this represents a significant change in a company’s culture regarding information management and public disclosure. Parties to be mandated

Parties to be mandated

For a bank facility, this will usually comprise the arranging bank(s), facility agent, security agent (if security is being provided), lending banks and, if hedging is contemplated, swap counterparties. For certain multi-bank transactions, bookrunners and/or underwriters may also need to be appointed. Unless the facility is self-arranged by the borrower, typically one of the syndicate banks will also be appointed to co-ordinate the process (including documentation). For a capital markets transaction, there are usually more third parties involved, including one or more banks as bookrunners/ underwriters, a trustee, paying agent(s), the rating agencies and perhaps also a ratings adviser.

Management time involved

As with any financing, a significant degree of management time will be involved. For a bank financing, this will be primarily the chief financial officer and group treasurer and, of course, board- and potentially shareholder-level approvals. Preparing a bond Prospectus typically involves a much wider level of participation from the business. This is because the Prospectus must summarise, among other things, all aspects of the business which are relevant to investors. However, if the bank facility transaction is to be syndicated to lenders outside the borrower’s core group of relationship banks, an information memorandum will typically need to be prepared and a “roadshow” process may be required, which will involve more parts of the business. In both cases, senior management will also be expected to participate in the due diligence process.

Provision of financial statements

Any financing will include representation coverage on the preparation and accuracy of financial statements. Whereas the obligation to provide financial statements in a bank facility will be contained in the information undertakings section in the facility document (the frequency of provision of which will vary according to the credit), the obligation for a bond issuer will be driven by market standards, US rules and any relevant listing requirements. In the EU, for example, a bond issuer (or guarantor) must include within its Prospectus two years of audited financial statements in order to obtain a regulated market listing (unless an exemption applies). If consolidated financial statements are prepared, they must be in accordance with International Financial Reporting Standards or an equivalent accounting standard. For transactions marketed to qualified institutional investors in the US, at least three years of financial statements are required and there are requirements regarding how recent financial statements must be to avoid the financial information being “stale”.

Loans	Bonds
Credit support Security: share security and/or full asset security, depending on jurisdiction. Guarantees: comprehensive guarantor coverage test, depending on jurisdiction.	Credit support As for loans
Mandatory prepayment events As per Investment Grade plus, depending on credit and facility purpose, disposal proceeds, insurance proceeds, acquisition proceeds, excess cashflow.	Early redemption events As for investment grade credit. For high yield bonds, issuer call provisions often include: a prohibition on optional redemption by the issuer for an initial period (typically four or five years) unless a substantial redemption premium is paid (thereafter, the premium declines on a sliding scale); change of control put at a premium; a right for the issuer to offer to repurchase a proportion (typically 35–40 per cent) of the bonds (typically at a premium) out of the proceeds of a public equity offering of the issuer’s or its parent’s shares; and an obligation to offer to repurchase the bonds if the group sells assets and does not reinvest the proceeds in the business or use the proceeds to pay down senior debt within a specified period.
Representations As per Investment Grade plus, depending on credit and facility purpose, among others, solvency, environmental laws, anti-corruption, security and financial indebtedness, title to assets, IP, group structure, COMI, pensions.	Representations Similar to loans but, as for investment grade, will not be extended to bondholders
Covenants Financing reporting: comprehensive reporting: annual, quarterly and monthly financial statements, budget, auditor sign-off on annual compliance certificates. Financial covenants: comprehensive financial covenants with quarterly testing on maintenance basis. Where loan sits alongside a high yield bond, incurrence-based covenants are increasingly seen. General undertakings: as per Investment Grade plus, depending on credit and facility purpose, among others, environmental, anti-corruption, tax, JVs, pari passu, loans-out or credit, guarantees, distributions/share issues, insurance, pensions, IP, arm’s length terms, hedging, guarantors.	Covenants Status and negative pledge, commonly “all moneys” rather than capital markets indebtedness only. For high yield bonds and (to a lesser extent) crossover credits, the covenant package will often be complex, although on the whole less restrictive than covenants contained in senior loan facilities. Unlike loans, financial and other covenants will be “incurrence”-based rather than “maintenance” tested. The package will depend on the strength of the credit but typical examples include limitation on incurring indebtedness which would breach fixed charge coverage or leverage ratios (although ordinary course or refinancing generally permitted); limitation on dividends, distributions and other “restricted” payments; limitation on liens; limitation on transactions with affiliates; merger, consolidation or sale of assets; and limitation on disposals. Reporting covenants will be limited to public information including quarterly, semi-annual and annual reporting (e.g. no budgets).
Events of Default As per Investment Grade plus, depending on credit and facility purpose, among others, audit qualification, expropriation, litigation, pensions.	Events of Default As for loans, except cross-acceleration/payment default is more common than cross-default, MAC generally not included, and there is no misrepresentation default.

Tax basics relevant to the various forms of financing

Under UK tax law, a borrower incorporated in the UK is generally required to withhold on payments of interest unless an exemption applies. In relation to a bank financing, the relevant exemptions typically include payments to a UK bank or Treaty Lender (provided, in the latter case, the appropriate treaty directions from the relevant tax authorities have been obtained in advance). A bond issuer will usually rely upon the quoted Eurobond exemption. This provides that interest payments on securities listed on a recognised stock exchange may be paid free of withholding. There is often a gross-up clause included in the terms and conditions to protect certain classes of lenders from any change of law risk (although, typically, this would be accompanied by a right for the issuer to be able to call the bonds at par in such circumstances). In relation to more structured corporate transactions, the level of tax analysis and structuring involved can be more complex (e.g. thin capitalisation rules, transfer pricing, group tax arrangements and securitisation SPV tax treatment).

Conclusion

As this article illustrates, investment grade corporates now have an enviable range of financing products to choose from. But having learned the lessons of the financial crisis, that choice is now being made more carefully. The drive to more diverse and alternative sources of finance is reflective of more sophisticated corporate treasury policies. As for any multiplicity of options, this creates a dilemma. Picking the optimal product(s) and financing window will be the new challenge for treasurers who, until recently, were grappling with very different problems.

This article is part of our sixteenth edition of Ashurst’s EnergySource publication. Click here to view.