Starting with the leveraged buyout (“LBO”) in Smith v. Van Gorkam, the leveraged loan market has become a popular, albeit risky, way for corporations to finance major transactions.[1] A leveraged loan is a commercial loan provided by a group of lenders.[2] These loans are less expensive and more efficient than traditional loans between one lender and one borrower.[3] Generally, a commercial or investment bank – known as arrangers – will structure the loan for a group of lenders.[4] The loan is then sold to other banks or institutional investors, which in turn are loaned to corporations and other business organizations.[5]
In the past three years, the leveraged loan market in the U.S. has experienced a massive increase in investor participation, reaching a loan issuance of $592 billion in November 2017.[6] The market experienced a drastic increase in loan funding due to the rising interest rates and the floating rate feature of these loans.[7] The floating rate feature allows a lender to recover interest at a rate that changes based on a publicly available short-term interest rate, instead of a fixed rate.[8] Thus, the higher the interest rates, the higher the rate of return for lenders and the higher the supply for leveraged loans. Moreover, in the corporate context, these loans constitute senior secured debt, and will be paid out before other debt and equity sources if a corporation declares bankruptcy or liquidates.
Corporations have positively responded to this increase in supply[9] and most commonly use this type of debt financing in three major transactions: (1) Mergers and Acquisitions, (2) recapitalizations, and (3) refinancing debt. In addition to the infamous leveraged buyout in preventing hostile takeovers, corporations are aggressively using leveraged loans for recapitalizations and refinancing debt. Recapitalizations change the corporation’s balance sheet by either issuing debt to pay a dividend or repurchase stock, or selling new equity to repay debt. Using leveraged loans to finance these transactions is beneficial to corporations because they can borrow capital to increase earnings in the long term, assuming the value of the corporation will increase. Debt is also tax deductible on a corporation’s income statement, unlike equity.
Corporations such as Royal Hotels have used the leveraged loan market to refinance and partially eliminate some existing debt with loans, “taking advantage of lower borrowing costs and lower protection provisions for lenders.”[10] While at first glance this seems like a win-win situation, this increased participation in the leveraged loan market may make lending more precarious and increases risks to shareholders and other investors if a corporation defaults or files for bankruptcy.[11]
First, corporations have taken advantage of this increased supply in the leveraged loan market by issuing covenant-lite loans.[12] Covenant-lite loans are loans that give the borrower more flexibility to take on additional debt, secure less collateral, and create more flexible payment terms.[13] This reduces the capital cushion that normally protects creditors.[14] Consequently, the protection for lenders usually associated with loans has drastically decreased.[15] This dynamic thus increases the volatility of the loan market and creates problems for investors and regulatory agencies.[16] Second, as corporations buy more loans, interest rates on these loans continue to rise, which may decrease leveraged-loan demand[17] –rising interest rates offset a leveraged-loan’s benefits to corporations. The potential for volatility in the leveraged-loan market is already beginning to rear its ugly-head. For example, retailer J. Crew was almost rendered insolvent, because it was unable to keep up with its massive leveraged-loan debt, while Toys ‘R’ Us was forced to file for bankruptcy.[18]
If this dynamic becomes too extreme, numerous legal and financial issues may follow.[19] First, while corporations currently enjoy more control over leveraged-loan provisions, these unpredictable provisions may eventually deter investors from the market and reduce the availability of secure loans. Savvy investors will probably not allow corporations to unilaterally set loan provisions that drastically increase the risk of defaulting on a loan. Second, if corporations incur too much debts as they become due, directors may be held personally liable if a court decides to pierce the corporate veil, which also applies to LLCs. Third, regulators may eventually crack-down, which may create a crowding-out effect in the debt market.[20] While rates of corporate default are currently low, most corporate debt on covenant-lite loans are not due until 2019.[21] Whether this dynamic will result in increased rates of corporate default is debatable.[22] Covenant-lite issuers are generally bigger corporations with better capital structures,[23] and potential losses here will be shared by a larger group of investors.[24] However, for middle-market companies, losses are shared by a smaller groups of investors, where the risks are magnified.[25]
[1] Smith v. Van Gorkam, 488 A.2d 858 (Del. 1985).
[2] Leveraged Loan Primer, S&P Global Market Intell., http://www.leveragedloan.com/primer/#!refigcpbuild-outs.
[3] Id.
[4] Id.
[5] Id.
[6] US Leveraged Loan Market Grows to Record $909B, S&P Global Market Intelligence (June 22, 2017, 8:00 AM), http://www.leveragedloan.com/us-leveraged-loan-market-grows-record-909b/.
[7] Id.
[8] Id.
[9] Hannah Brenton, LPC-Borrowers Scent Opportunity in Leveraged Market, Reuters (June 10, 2016, 10:00 AM), https://www.reuters.com/article/refinancing-loans-leveraged/lpc-borrowers-scent-opportunity-in-leveraged-market-idUSL8N1923E9.
[10] Eric Platt, Companies Bask in Leveraged Loan Advantages, Fin. Times (Nov. 9, 2017), https://www.ft.com/content/2e1ff08a-c506-11e7-a1d2-6786f39ef675.
[11] Stephen Gsandel, Leveraged Loans Face Less Cushion in a Crash, Bloomberg, Business Week (Dec. 20, 2017, 2:42 PM), https://www.bloomberg.com/news/articles/2017-12-20/leveraged-loan-investors-face-less-cushion-in-a-crash.
[12] Nabila Ahmed, Safety Becomes Stigma as Leveraged Loans Cut Out Covenants, Bloomberg Markets (Sept. 21, 2017, 4:04 PM), https://www.bloomberg.com/news/articles/2017-09-21/safety-becomes-stigma-in-loan-market-that-s-ditching-covenants.
[13] See generally, id.
[14] See Stephen Gsandel, supra note 11.
[15] See Lisa Lee & Sally Bakewell, Frothy Leveraged Loans May Get Whipped-Up by Rollback, Bloomberg (Oct. 12, 2017, 1:11 PM), https://www.bloomberg.com/news/articles/2017-10-12/frothy-leveraged-loans-may-get-whipped-up-by-regulatory-rollback.
[16] Lauren Thomas, Bankruptcies will Continue to Rock Retail in 2018: Here’s What You Need to Watch, CNBC (Dec. 13, 2017, 9:15 AM), https://www.cnbc.com/2017/12/13/bankruptcies-will-continue-to-rock-retail-in-2018-watch-these-trends.html.
[17] Jason Giordano, Repricings Remain the Story of the Year for Leveraged Loans, Seeking Alpha, (Dec. 19, 2017, 8:01 AM), https://seekingalpha.com/article/4132670-repricings-remain-story-year-leveraged-loans.
[18] See Lisa Abramowicz, That Junk Loan is Now Basically a Junk Bond, Bloomberg, (Sept. 26, 2017, 10:28 AM); https://www.bloomberg.com/gadfly/articles/2017-09-26/that-high-yield-loan-is-now-basically-just-a-junk-bond; see also Lauren Thomas, supra note 16.
[19] See Christopher Whittall, Leveraged Loans Are Back and on Pace to Top Pre-Financial Crisis Records, Wall Street J. (Sept. 24, 2017, 7:00 AM), https://www.wsj.com/articles/leveraged-loans-are-back-and-on-pace-to-top-pre-financial-crisis-records-1506250800.
[20] See Gillian Tan, Goldman’s Barracuda Role Signals Return of the Big Fish, Bloomberg (Nov. 27, 2017, 9:36 AM), https://www.bloomberg.com/gadfly/articles/2017-11-27/goldman-role-in-barracuda-deal-signals-banks-buyout-return.
[21] See Leveraged Loan Default Rate Falls to 18-Month Low, S&P Global Market Intelligence (Aug. 1, 2017, 3:01 PM), http://www.leveragedloan.com/us-leveraged-loan-default-rate-falls-18-month-low/.
[22] See Ahmed, supra note 12.
[23] Id.
[24] Id.
[25] Id.
