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US leveraged finance: The road ahead

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What will drive issuance in a post-COVID-19 world?

Foreword

Halfway through 2021, we take stock of leveraged finance in the United States and consider the road ahead for both borrowers and lenders. After more than a year of COVID-19, are things returning to normal? Or are we just starting a whole new journey?

In many ways, COVID-19 had far less of an impact on leveraged finance markets than expected. Activity dropped in the second quarter of 2020, primarily in leveraged loan issuance, but a year later numbers returned to pre-pandemic levels. In fact, leveraged loan and high yield bond values reached record highs by the end of Q1 2021—the highest quarter since Q2 2018 and the second-highest quarter, respectively, on Debtwire Par record going back to 2015.

What drove this relatively high-speed recovery? First, the Coronavirus Aid, Relief and Economic Security (CARES) Act, signed into law in March 2020, protected many businesses from the full brunt of the pandemic. At the same time, many businesses shored up their finances, taking on debt to ensure liquidity as lockdown measures continued to have an impact through the second half of 2020. Issuances rose and that upward trajectory carried on into 2021.

By the end of Q1 2021, the picture had changed once again. Vaccines were being distributed quickly and efficiently, raising hopes for a post-COVID-19 future. The economy was also improving, as various states began to open up and a year of pent-up consumer demand was released. By May, core retail sales in the US had reached levels typically only seen over the Christmas period, according to the National Retail Federation. An air of optimism crept into the market, with lenders increasingly willing to take more risks on borrowers in their pursuit of yield. Financing earmarked for M&A and buyout activity also began to climb, hinting at growth plans for the months ahead. Perhaps most significantly, the low interest rate environment gave businesses an opportunity to reprice and refinance their maturing debt in droves.

What's next for 2021?

While these are all very positive signs for lenders in the leveraged finance space, there are still a few red flags on the horizon. First is inflation—in July, the Bureau of Labor Statistics reported that the US consumer price index had climbed 5.4 percent in the 12 months to June, a level not seen in 13 years. These growing inflationary pressures are part of the rush to reprice and refinance existing debt, as businesses try to avoid any unpleasant surprises if interest rates begin to climb as well.

Second, companies in robust sectors that enjoyed a degree of preferential treatment from lenders during the pandemic may find that sentiment shifting in the months ahead as other sectors begin to recover. The "flight to quality" witnessed in the early days of the pandemic will likely return to a more evenly balanced state of affairs. Documentation may also go through some changes in the coming months, as adjustments brought in during COVID-19 are phased out.

Finally, as the dust settles in debt markets, issues that were gaining ground before the pandemic will return in force, especially environmental, social and governance factors, which continue to take on increasing importance among borrowers and lenders alike.

All of which means the road ahead is not quite as clear as many would like, but there will be fewer obstacles blocking the path.

The US leveraged finance story so far

  • Leveraged loan issuance reached US$763.5 billion in the first half of 2021, up 60 percent from US$478.1 billion in the same period in 2020
  • High yield bond market issuance also rose 22 percent year-on-year, from US$219.6 billion to US$267.1 billion
  • Refinancings and repricing deals accounted for 62 percent of overall loan issuance in H1 2021
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From closing loopholes to rising inflation: Five trends that will drive leveraged finance

  • Leveraged loan and high yield bond markets shrugged off COVID-19 uncertainty to post year-on-year increases in issuance in 2021
  • Features of documents through the COVID-19 period—such as liquidity covenants and EBITDAC metrics—are fading from the market
  • Lenders are increasingly sensitive to the risk of subordination in either right of payment or lien priority
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Fund finance: New ways to harness NAV finance

  • Anecdotal evidence points to a surge in uptake of net asset value finance over the past 12 to 18 months
  • NAV finance is useful for the prevailing longer PE holding periods, which climbed from 3.8 years in 2010 to 5.4 years in 2020
  • Deloitte estimates that the average loan-to-value ratios for NAV facilities sit in the 25% to 30% range
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Downgrades, defaults, distressed debt and refinancing

  • Refinancing and repricing in US leveraged loan markets surged to US$471.7 billion over the first six months of 2021
  • US high yield bond refinancing accounted for 70 percent of total high yield issuance
  • Amend-and-extend deals give borrowers further breathing room
  • The extension of maturities has reduced near-term risk of default and limited the number of borrowers running out of cash and facing bankruptcy
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A more sustainable approach to debt financing

  • Global green bond issuance reached US$305.3 billion in 2020, according to Bloomberg data
  • Ratings agency Standard & Poor's forecasts that global issuance of sustainability-linked debt instruments will exceed US$200 billion in 2021
  • President Biden has pledged to cut US carbon emissions to at least 50 percent below 2005 levels by 2030, advancing the ESG agenda
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Ongoing SPAC surge reshapes capital structures

  • 248 SPACs listed in 2020, raising US$82.6 billion—a more than six-fold rise on 2019 issuance
  • 362 SPAC vehicles raised US$110.2 billion in H1 2021
  • 176 M&A deals worth more than US$386.1 billion have been completed via SPACs in H1 2021
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How distressed companies are avoiding full-blown bankruptcies

  • Announced US corporate bankruptcies climbed to 630 cases in 2020, according to Standard & Poor's—up from 2019 levels, but still lower than expected
  • Bankruptcies ticked higher early in 2021—from 14 cases in January to 23 cases in March, before dropping to 11 in June—but are still well below 2020 levels according to Debtwire Par
  • Covenant relief and uptiering, as well as drop down deals and other liability management structures have offered companies a variety of levers to pull to avoid entering bankruptcy situations
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Energy transition: Financing the race to net zero

  • Green bond issuance climbed 13% in 2020, to US$305.3 billion
  • Global energy investment will have to increase more than three fold to US$5 trillion by 2030 if net-zero carbon emissions are to be achieved by 2050
  • At the start of 2021, renewables accounted for more than 20 percent of total energy generation capacity in the US, surpassing the use of coal
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Direct lending in the US post-COVID-19

  • North American private debt fundraising increased by 15.8 percent in 2020 despite falling fundraising in other jurisdictions
  • The private debt default rate never rose above 2 percent in 2020 and was lower than high yield bond and leveraged loan default rates
  • Current private debt yields of 7 percent are outpacing high yield bonds and leveraged loans
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Conclusion

Refinancing, repricing, M&A and buyout activity all surged in the early months of 2021, but then lenders shifted gears in pursuit of yield and borrowers realized they could tap the market for more than just liquidity. Where will this fork in the road lead for the rest of 2021?

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Wind turbine with flower field

Energy transition: How to finance the race to net-zero

Insight
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5 min read

HEADLINES

  • Green bond issuance climbed 13% in 2020, to US$305.3 billion
  • Global energy investment will have to increase more than three fold to US$5 trillion by 2030 if net-zero carbon emissions are to be achieved by 2050
  • At the start of 2021, renewables accounted for more than 20 percent of total energy generation capacity in the US, surpassing the use of coal

Global momentum behind the fight against climate change has never being stronger, as governments and energy companies around the world make ambitious pledges to reduce carbon emissions to net-zero by 2050.

The US, under the administration of President Joe Biden, has taken a leading role in the race to net-zero by putting an ambitious program in place to facilitate the country's energy transition away from hydrocarbons to renewables.

On his first day in office, President Biden signed the US back on to the Paris Agreement, the international climate change treaty signed in 2016. The Biden administration subsequently outlined targets to deliver a 50 percent to 52 percent reduction in net greenhouse gas emissions from 2005 levels by 2030 and to have a carbon-free power sector by 2035, on the way to achieving net-zero carbon emissions by 2050.

20%
Renewable energy sources now account for more than 20% of the total energy generation capacity in the US

 

Finding finance

The technology required to facilitate energy transition is developing at an accelerating pace, with huge strides in renewables, battery storage, electric vehicles, carbon capture, green hydrogen and energy efficiency technologies. But these technologies require a significant financial outlay to scale at the pace required to meet the net-zero 2050 timetable and retrofit existing hydrocarbon infrastructure to cover demand from renewable sources.

The government balance sheet will be an essential source of funding but given the size of investment required, private investors will have to step in to cover the funding needs.

According to the International Energy Agency (IEA), which outlined a roadmap to achieving net-zero, annual global energy investment will have to reach US$5 trillion by 2030, a more than three-fold increase on the US$1.52 trillion of global energy investment recorded by the IEA in 2020.

For private investors and energy companies, many of which have significant sums of capital locked up in hydrocarbon infrastructure, maintaining market returns while simultaneously reorienting to green energy provision poses a major challenge.

Private markets, driven by investor demand, have already begun to pivot in this direction. The issuance of green bonds raised specifically for climate-related and sustainability projects increased by 13 percent to US$305.3 billion in 2020, according to Bloomberg. In April 2021, ratings agency Standard & Poor's forecasts that issuance of sustainability-linked debt instruments (credit facilities not linked to specific projects, but which incentivize compliance with key performance indicators relating to sustainability) will climb by more than a third in 2021, reaching more than US$200 billion in total.

These already burgeoning markets, however, will have to grow at far faster rates to cover the net-zero fund requirements. What makes this particularly challenging is that much of the investment will have to be in still nascent renewable and carbon-free energy technologies. According to the IEA, by 2050, almost half of the reductions in hydrocarbon usage will have to come from technologies that are still in the early stages of prototype development.

 

Risk and reward

Investors see significant potential for strong returns from investments in renewables and green energy, and commitments to net-zero targets offer opportunities to benefit from these rapidly growing industries.

The expansion of now established renewable energy sources such as solar and wind—both of which are now as competitively priced and commercially viable as hydrocarbon energy—serves as a blueprint for these growth opportunities.

According to a Forbes analysis of the most recent BP Statistical Review of World Energy, the renewable energy sector has quadrupled in size over the past decade and is the only energy vertical to have shown double-digit growth during this period.

Investing in solar or wind is now no riskier than investing in any other energy source, which gives investors comfort and the confidence to deploy.

Investing huge sums of capital upfront in newer technologies and infrastructure, such as hydrogen, however, represents a very different risk-reward dynamic. There are no established customer bases for these energy sources, and they feature long lead times before an investment may start to return capital.

This is where governments have a role to play by investing in upfront R&D to develop proofs-of-concept for new technologies, sharing risk for investment in green energy infrastructure and supporting the formation of new renewables markets through clear policy and regulation.

If their private capital is to be released into the market, developers and investors need a clear long-term policy vision for how the energy transition will progress, as well as the assurance that governments will not change direction.

The US government and regulators have put a variety of measures in place to support renewable energy development and mitigate the risks posed by these projects. These include a federal government renewable portfolio standard, which mandates that a percentage of electric power sales in states come from renewable energy sources; feed-in tariffs, where the government covers any price differentials between new renewable sources of energy and established energy supplies; and renewables R&D grants.

Renewable energy consumption in the US surpassed coal for the first time in 2019, according to the US Energy Information Administration. Early in 2021, the Federal Energy Regulatory Commission reported that renewables now represent more than 20 percent of total energy generation capacity in the US. This demonstrates that governments can play a role in creating new commercially sustainable industries, and corral private sector investment.

Governmental measures will be essential to encourage private sector investment into new renewable energy technologies and projects, and to achieve the ambitious targets for a net-zero future.

 

 

This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
© 2021 White & Case LLP

 

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