Banking & Financial Services Law : Canadian and U.S. / Cross-Border Credit Market Lawyers & Attorneys : Osler Hoskin & Harcourt Law Firm

Michael Innes and James Lurie have published the article "High Yield Debt - A New Form of Capital in Canada" in Osler's recent Capital Markets Review.

Here is an excerpt (you can read the full article here):

Prior to 2010, the United States market was virtually the only alternative for Canadian high yield debt issuers, but due to various factors, it appears a nascent high yield market has taken hold in Canada.

Much like the income trust wave of years past, some Canadian issuers are now finding they have access to capital in ways that did not previously exist. This has taken the form of high yield debt. Prior to 2010, the United States market was virtually the only alternative for Canadian high yield debt issuers. Due to various factors, it appears a nascent high yield market has taken hold in Canada. According to one source, 2010 saw $3.5 billion of supply across 14 transactions, a significant increase compared to the $800 million of supply across four transactions in 2009.

High yield debt is essentially non-bank debt that does not carry an investment grade rating and that typically bears interest at a higher rate as compared to investment grade issues (i.e., it is “high yield”). The minimum rating for long term debt to be considered “investment grade” is BBB - for debt rated by S&P, Baa3 for debt rated by Moody’s and BBB (low) for debt rated by DBRS.

In addition to the rating, there are also many features of high yield debt that are typically not associated with investment grade issues. The most significant difference is in the nature of the covenant pattern. Depending on the particular industry of the issuer and the issuer's individual circumstances, investment grade debt typically carries with it very few covenants beyond the covenant to pay back the money borrowed with interest. High yield debt is much different in this regard.  Thus far in the emerging Canadian high yield market, covenant patterns for some issuers have resembled those used in the U.S. high yield market

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I attended a round-table discussion last week in New York that focused on the US asset-based lending (ABL) market.

Observations made during the discussion included:

• the volume of 2010 financings are ¼ of the volume in 2007
• 90% of those financings are amend and extend transactions with some cash flow financings converting to ABL deals
• loan demand is anemic as a result of little capital expenditure (capex) and business expansion
• pricing floors generally have disappeared
• based on 2006/07 experience, the return of a robust M&A market would increase financing volume more than has resulted from the debtor-in-possession/plan of reorganization (DIP/POR) market; the volume of DIP financings expected after the financial crisis hasn't developed
• the institutional second lien facility has generally been replaced with secured bonds (better pricing and more flexibility)
• absent a significant economic shock, the high yield market is expected to be strong until US Thanksgiving
• cyclical industrials, which traditionally have accessed the cash flow lending market, are accessing the ABL market because of the absence of covenants in ABLs
• springing cash management and covenants ( vs. operation from the "get go") are the norm today
• regional banks are the new liquidity providers in the ABL space; finance companies are exiting the ABL platform due to cost of capital and “wind downs”
 

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On April 14, 2010, the New York Times DealBook reported on a survey of 48 top merger and acquisition advisors (including bankers, lawyers and others) published by Brunswick Group LLC. In that survey, 78% of respondents believed that M&A activity would increase for the rest of 2010, given the level of activity in Q1. 22% felt the level of activity would remain the same.

36% of respondents felt that “CEO/Board confidence” was the most important factor in this optimistic market view, outpacing “greater availability of credit and low interest rate environment” at 28%.

The report was published in connection with Tulane University Law School’s annual Corporate Law Institute in New Orleans.
 

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For much of the first quarter of 2009, U.S. credit markets continued to stumble through the aftermath of Lehman Brothers’ bankruptcy, with many segments of the markets effectively still frozen.

Fast forward about a year, and quite a different picture of 2009 emerges - at least in U.S. bond markets. 2009 new issuance activity turned out to be a record-breaker in the U.S. for investment grade bonds, and, depending on sources, at or near record-breaking levels in U.S. high yield bond markets as well. This exceptionally strong performance is all the more remarkable given how slowly 2009 began. U.S. high yield in particular saw a dramatic upsurge in 2009. Markets became frothy enough to produce, toward the end of 2009, the first PIK-toggle deal done since the end of the 2005-2007 credit boom (JohnsonDiversey), several dividend recapitalization financings (e.g. Quintiles) and the (admittedly, muted) return of covenant-lite.

By contrast, an examination of U.S. loan markets activity in 2009 reveals something of a dichotomy. Overall U.S. loan market activity remained largely moribund in 2009, roughly comparable in absolute levels to those last seen in the prior lending downturn of 2000-2001 - notwithstanding the much more significant decline in percentage terms (from a much higher peak during the 2005-2007 credit boom). One bright spot was an upsurge in U.S. institutional leveraged lending toward the end of the year (from an extremely low base), with 4Q2009 representing roughly half of 2009’s overall volume.

Underlying the activity in U.S. credit markets in 2009 were torrential, yield-chasing inflows into bond and loan mutual funds, and an associated dramatic increase in the secondary market prices of bonds and loans. For instance, average leveraged loan prices increased from the low 60s to the high 80s or low 90s. This took the boil off so-called loan buybacks (in which borrowers sought to monetize loan trading discounts), and made new issuance more competitive with decreased secondary market yields.

Interestingly, a closer examination of U.S. loan market statistics in 2009 reveals that a significant portion of the continued weakness in the sector was due to the ongoing freeze in the shadow banking system (CDOs, CLOs, SIVs, hedge funds, REITS, etc.), which at the height of the credit boom in 2007 represented 65-70% of overall U.S. leveraged lending volume. U.S. banks, by contrast, continued lending in 2009, although at significantly lower levels than were seen during the credit boom. Although some pieces of the shadow banking system, such as CDOs and SIVs, may never return, others, such as CLOs and hedge funds, have shown signs of improvement. CLOs in particular have benefited from the dramatic increase in secondary loan market prices, effectively curing existing CLOs’ breached overcollateralization ratios; while paydowns from high yield bonds, asset sales and other sources have provided existing CLOs much needed liquidity. For much of 2009 and until recently, no meaningful new CLO issuance was seen in the U.S. – but that too changed in mid March of 2010, when Citigroup underwrote a US$500 million issuance for a CLO managed by New York-based WCAS Fraser Sullivan Investment Management LLC. This transaction, in part a refinancing of an existing CLO, also increased the size of the CLO’s asset base by more than 50% with the addition of new, widely-syndicated loans – the first time in more than 12 months that a meaningful amount of new syndicated loans had been securitized in the U.S. The transaction was seen as a baby step toward the re-opening of new CLO issuance in the U.S., and may herald further reliquification of U.S. secondary loan markets.
 

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This outlook for the market for asset-based loans in Canada was drafted by Scott Horner in January, 2010.

Canada has experienced some economic turbulence as a result of the recent global economic crisis. However, Canadian banks have not suffered the losses experienced by many of their competitors in the US and European markets and their stability was not an issue during the financial crisis that has occurred in other markets. The reasons for the Canadian banks’ stability in the face of the financial crisis elsewhere are beyond the scope of this article. However, the banks’ stability; demand for the ABL product to fill the void created by cash flow lenders tightening credit availability; some US lenders repatriating some of their resources from the Canadian market in order to focus on resolving problems at home arising from the recent financial crisis there; and the ABL product working well with an active high yield bond market to fulfill issuers’ capital requirements have contributed to steady Canadian asset-based lending activity for lenders in the ABL business.

Factors Driving ABL Employment

One of the significant strengths of the ABL product is that it can withstand earnings volatility. The key to ABL’s employment is that the borrower owns quality current assets. Accordingly, the product works well with capital intensive businesses like retail, distributors and industrial manufacturers regardless of these businesses’ decreased earnings, or even losses, as a result of the recent recessionary period. Another significant strength of the ABL product is the flexibility that it may afford borrowers by way of its “covenant lite” aspect which may be appealing to borrowers whose financial performance has been adversely affected by the recent recession. Recent Canadian consumer surveys have shown consumers are increasingly confident about their employment, specifically, and about economic recovery, generally. We expect demand for the ABL product will further strengthen during the ongoing economic recovery as borrowers build inventory stock to satisfy increasing domestic consumer demand.

Risk Reward Profile of ABL for Borrowers and Lenders; Impact of Legal Developments on Such Profile

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