Euro Tranches Increase in a Hot Market for Leveraged Loans

The leveraged loan market has seen a strong start in 2017, with just over $34 billion of institutional issuances in February, following the record breaking volumes in January where total institutional issuances exceeded $77 billion. In comparison to the same two month period in 2016, January and February of 2017 have accounted for an increase of over 370% in institutional leveraged loan activity.

As part of these impressive volumes, which followed a robust 4th quarter in 2016, the institutional leveraged loan market is seeing an increasing number of Euro-denominated loans issued by US borrowers. This is an interesting reversal of the so-called Yankee borrower trend that we saw gain momentum in 2012 and 2013, when non-US companies issued US dollar loans (which hasn’t gone away and is still a sizable piece of the market as a whole). In 2016, for example, total issuances of Euro-denominated loans in the leveraged market by US borrowers topped €14 billion, an increase of over 15% from 2015, and the levels have only increased year over year since 2009 when total issuances of loans of that type was less than €2 billion. This trend for issuances of Euro-denominated loans by US borrowers is expected to continue in 2017.

There are two primary reasons that US borrowers have looked to the European loan market as an attractive alternative to raising debt financing. First, demand from investors has continued to outpace supply of European leveraged loans. Most recent evidence of this has been seen in the repricing trend which continues throughout the European loan market, with some borrowers embarking on second and third repricings in a very short space of time given the widespread demand for loans. This means that the interest rate environment in Europe has been low and is expected to stay low, as compared to the US where interest rates have been low in recent years but are on the rise. US borrowers can simply raise cheaper debt, and with more certainty of maintaining lower rates over the next several years, by going to Europe. This is also bolstered by a robust market for secondary trading for European leveraged loans, which provides borrowers comfort that incremental debt is available or refinancing flexibility is preserved. In fact, recently it has been reported that approximately 70% of European leveraged loans were trading above par, which indicates strong demand, but also attracts borrowers to the marketplace with the promise of cheap and potentially abundant debt financing now and in the future.

Second, US borrowers that generate a significant portion of their cash flow in Euros will use the interest payments on a Euro-denominated tranche as a natural hedge against the risk of currency movements that would otherwise exist if financing costs were payable in US dollars or any other currency.

As one would expect, the same dynamic relating to hedging would generally also be true for Sterling-denominated tranches. However, because the Sterling foreign exchange rate vis-a-vis the US dollar has fallen after the Brexit vote at the end of June 2016, this is currently a less significant factor in influencing borrower’s financing decisions than it might have been a year or two ago. On the other hand, also as a result of a weakened Sterling vis-à-vis the US dollar following the Brexit vote, a rise in Sterling-denominated loans issued by US borrowers can be attributed to financing being raised to fund the acquisition of assets in the UK which have become cheaper and consequently more attractive.

In further support of the increasing trend of US borrowers raising debt in Europe, documentation for Euro and US dollar tranches has become increasingly unified under a common set of loan documents. In fact, especially in larger financings where US borrowers are raising both Euro and US dollar tranches, the terms and conditions for both tranches are most times nearly identical, with the attention of investors only paid to pro rata prepayment provisions across tranches or other similar technical points.  That said, we have seen a certain amount of complexity introduced in the context of applying the MFN pricing provision across both Euro and US dollar tranches where the lenders have required that the Euro and US dollar tranches maintain a fixed pricing spread, as compared to one another, even after giving effect to any MFN adjustment that might apply to either tranche in connection with an incremental debt raise.

Moreover to the main point, however, lenders’ general willingness to accept US-style, New York law governed documentation with very little changes between tranches (other than a relatively short list of certain technical points as discussed) have made the Euro-denominated option a relatively straight forward exercise, and one that looks familiar to US borrowers. However, even where parties have selected European-style, English law governed documentation, the trend has been for more and more lenders to accept a covenant-lite approach to financial maintenance tests, similar to the approach now commonplace in the US markets. Therefore, and to the extent that trend holds, in circumstances where lenders require European-style documentation (with US dollar and Euro tranches governed by a single English law credit agreement, for example), US borrowers can still achieve a relatively familiar looking covenant package.

Based on these factors, and based on the general expectation that the market for leveraged lending will continue to improve throughout 2017, bolstered in part by a forecasted increase in issuances to back M&A activity, the trend for US borrower to incorporate Euro tranches into their capital structure will likely continue.