Leveraged lenders seek common ground

With some banks pulling back from the leveraged finance market in Australia and those that remain increasingly wary about whom they lend to, it is generally agreed that mezzanine providers are seeing more opportunities. What isn't agreed is whether the market needs a standard set of rules that outline the rights of different lenders involved in a transaction.

Westpac last year put forward a set of intercreditor principles intended to act as a model for how different lenders' interests are managed, including in the event of a dispute with the borrower. The principles reflect the thinking of the Big Four banks - Westpac, National Australia Bank, Commonwealth Bank of Australia and Australia and New Zealand Banking Group - that account for a significant proportion of senior leveraged lending.

Mezzanine lenders were not impressed, arguing that the model serves the senior banks' interests but not those of the subordinated debt providers. Representatives from two of the leading market participants - ICG and Babson Capital - tell AVCJ that, as far as they are concerned, the principles have not been accepted.

On a basic level there is no dispute: subordinated lenders must have rights and be able to act on them. The contentious issue is when and how they can do this. And, more fundamentally, whether a common approach would add depth to a relatively shallow mezzanine market, enabling private equity investors to secure more compelling financing packages.

"What we saw was senior debt constantly being asked to stretch because there was no mezzanine, and it reduced the total debt volume," says Russell Sinclair, director of leverage and acquisition finance at Westpac. "We think we can get better capital structures, boost returns and support acquisition of businesses with higher enterprise valuations."

Minimal mezzanine

Australia's syndicated loan volume reached $108.6 billion in 2011, up 70% year-on-year, and the highest level seen since the heart of the boom period in 2007. However, economic uncertainty at home has prompted several European banks to retreat from the market, while others have tightened up on lending.

Lyndon Hsu, head of leveraged and acquisition finance for Asia Pacific at HSBC, estimates that Australia had the capacity to finance deals of up to $1 billion at the beginning of the year, but this has since fallen to $500-600 million. The mezzanine space doesn't appear to have sufficient capacity to fill the gap. Even in the boom years prior to the global financial crisis, two layers of subordinated debt - one secured and one unsecured - was unusual. With the institutional market showing little appetite for bonds, private equity firms working on high quality deals have turned to solutions such as vendor notes and retail notes.

Market participants say that senior debt generates a return of about 10% and equity delivers 20%. There is room for an intermediate level of capital in between but a common complaint is that mezzanine providers ask for too much. One regional senior debt provider tells AVCJ that he has seen private equity deals with mezzanine quotes in the high teens and early twenties; it made more economic sense for the GPs to push up the senior and equity portions until they met.

According to Shawn Wytenburg, a partner at law firm Corrs who provided input into the Westpac-initiated Big Four proposal, many of the problems stem from a relatively unsophisticated approach to mezzanine before the global financial crisis. Subordinate lenders were granted minimal enforcement rights and this meant many international firms chose not to participate in the market while those willing to lend would only do so at a rate that justified their risk profile.

"Commercial banks operating at the senior level in Australia historically saw mezzanine as a capital layer much closer to equity with the absence of many of the usual triggers to enforce," says Wytenburg. "The intercreditor principles that have been put forward represent a shift locally on the part of the senior lenders to encourage liquidity and appropriate pricing.

History lessons

An appreciation of the history and nuances of Australia's leverage market is also cited as a primary reason for differences between the Westpac proposal and the intercreditor model endorsed by the Loan Market Association (LMA) in London.

The organization was set up in the 1990s to develop best practice and standard documentation for lending in Europe. It introduced an intercreditor agreement in response to concerns that these details were being left to the last minute, as people focused on the front end of deals, and were then holding up the entire process because of disputes over basic principles. When the agreement was first launched in March 2009, mezzanine providers complained that it favored senior lenders and hedge counterparties and a revised version was released eight months later.

"Unlike the LMA, we didn't just get the senior lenders around a table and draw it up," Westpac's Sinclair says, in reference to the initial problems with the LMA document. "It's been very collaborative, involving people active on both sides, including those who work with the sponsors and subordinated financiers."

Wytenburg adds that the Australian approach is a hybrid of the LMA model because the local market should have its own standard in acknowledgment of the fact that it is smaller and less developed than London. Activity is led by banks, with minimal fund participation, and in mid-market transactions commercial lenders often act as arrangers, lenders and hedge counterparties. It might also be argued that giving senior lenders license to allow borrowers more time to sort out their businesses is in keeping with Australian banks' traditionally patient approach.

Theory to practice

Sinclair, Wytenburg and Yuen-Yee Cho, a partner at King & Wood Mallesons who helped the Big Four prepare the intercreditor principles, claim that three recently closed transactions plus a number of well developed packages involving subordinated debt all used the principles as a very strong reference point. They also suggest that subordinated debt pricing has fallen and more parties are coming to participate in the Australian market, in part due to the more consistent approach.

This view is not shared by the incumbent mezzanine providers. "I am not sure that any transactions have been completed using these standard terms," says Adam Wheeler, managing director at Babson Capital. "From what I understand there are some transactions being negotiated that have more in common with the LMA standard."

Discomfort with the Westpac proposal stems from positions on enforcement in the event of default that are perceived to offer an unfair advantage to senior lenders, who control the process. These range from concerns about asset sales being conducted at distressed levels rather than fair value, effectively ensuring that senior money is recovered, to complaints about restrictions on junior lenders' ability to accelerate and enforce.

Under the principles, the length of the standstill period that falls in between a default and the subordinated lender actually being able to take action is conditional on the size of the leverage ratio. If it is above a certain level, the standstill must last at least 360 days; anything below that level and the wait is cut to 180 days.

According to market sources, these thresholds were first seen during negotiations over intercreditor arrangements for KKR's bid for Australian healthcare provider Healthscope in 2010. Even though The Carlyle Group and TPG Capital prevailed in the auction, so KKR's structure was never used, the terms appear to have stuck. Some industry participants say the consensus among mezzanine providers is that they would only be comfortable with a shorter period, perhaps of around 120 days.

The principles also allow the senior lenders greater flexibility to amend loan documents without consent from subordinated parties. Alterations can be made to repayment profiles, cash sweeps, financial covenants and pricing, and the circumstances in which drag-along rights apply to subordinated parties would be narrowed. In short, banks would have more freedom to restructure repayment obligations when they deem it economically sensible. The worry for mezzanine providers is that their interests may run contrary to those of the banks.

"There are many areas of commonality but there are key points where the proposals Westpac put forward represented a significant weakening of the terms from what is currently provided," says one Australian subordinated debt specialist. As an example, he contrasts the LMA and Westpac approaches to drag-alongs. The former says junior creditors can drag along apart from in certain circumstances, while the latter only permits drag-alongs in certain circumstances. The difference is implied rather than clearly prescribed but the impact could be significant.

"There are certainly things that we need to see in these arrangements," adds Babson's Wheeler. "We are a debt provider and we should have rights to enforce and accelerate after a standstill period that is not excessively long."

Much of the debate rests on how crucial the disputed areas turn out to be. It could be argued that just getting industry participants into a discussion about a standardized approach is an achievement in itself. In this context, the principles put forward by the Big Four represent a material step in a process that could lead to a formal arrangement. And given the Big Four banks are present in virtually every transaction, it is appropriate that they should take responsibility for shepherding it.

The document is out in the market, feedback is being offered by industry participants, the standards are holding in deals and the hope is that a final version can be put forward to the Asia Pacific Loan Market Association (APLMA).

Room for negotiation

It is generally accepted that there will always be some element of negotiation over intercreditor arrangements, not least because the size of particular deals and the sector they come from will dictate risk profiles. Some mezzanine providers therefore remain skeptical about an Australia-specific model. The question that always pops up is: If the banks want to attract more international lenders, why didn't they just take the LMA model and let it be shaped to the local market through deal-by-deal negotiation?

Their expectation is whatever emerges from the ensuing consultation process will more closely resemble LMA than the current proposal. Bryan Paisley, a partner with Baker & McKenzie in Sydney, notes that the LMA agreement is by no means a commercial precedent and contains "a great deal of optionality about what is in the standard form." No doubt this freedom is what appeals, and they aren't yet convinced that it will be replicated in Australia.

At the same time, while the LMA's intercreditor arrangement model is seen to reflect the needs of a more sophisticated environment, it is by no means the finished article. It has to respond to changes in the market and Australia is likely to be no different.

"Everyone had disparate arrangements in London and it took them a long time to put a document together - and even now it is undergoing major revisions," says King & Wood Mallesons' Cho. "There is a long way to go in terms of getting a fully drafted intercreditor agreement for the Australian market, and even then it will remain a work in progress."

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• Topics
• Mezzanine
• Australasia
• Financing
• Australia
• New Zealand
• Mezzanine
• HSBC
• Intermediate Capital Asia Pacific
• Leveraged finance