What will drive issuance in a post-COVID-19 world?
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
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?
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
From growing concerns around climate change and sustainable consumption to the social and political impact of the Black Lives Matter and gun control movements, environmental, social and governance (ESG) issues are being pushed increasingly into the spotlight for commercial debt investors in the United States.
No longer simply "nice to have," ESG features are increasingly prominent in deals and investments across all asset classes. In a recent study of 50 of the world's largest asset managers, with a combined US$60 trillion of assets under management, shareholder advisory firm SquareWell Partners found that all but one had signed on to the United Nations Principles for Responsible Investment (UNPRI). Of those, 60 percent are using their own ESG ratings systems and 68 percent are publishing reports and materials on ESG topics such as climate change, human capital and biodiversity.
ESG comes to debt markets
The growing investor focus on ESG has filtered into debt markets, with lenders and borrowers looking at how to structure financings in a way that is more sustainable and supports and measures environmental and social objectives and outcomes.
A range of ESG-linked debt products have gained traction. Green bonds (which raise capital specifically for climate-linked and environmental projects) and sustainability-linked bonds and loans (which are not linked to specific green projects but are issued to incentivize sustainability performance objectives) have all seen growing investor interest through the past year.
According to Bloomberg data, total green bond issuances reached US$305.3 billion in 2020, a 13 percent increase on 2019 levels, despite a steep decline in activity during the COVID-19 lockdowns in the first half of 2020. Since 2007, cumulative green bond issuances have climbed to beyond US$1 trillion.
In April 2021, ratings agency Standard & Poor's, meanwhile, forecast that global issuance of sustainability-linked debt instruments will exceed US$200 billion in 2021. According to Bloomberg, sustainability-linked debt issuances reached US$131 billion in 2020, an almost 300 percent increase compared to levels observed just two years prior.
Ratcheting up ESG-linked lending
ESG criteria are also filtering into more "vanilla" debt products. An increasing number of mainstream borrowers are issuing leveraged loans and revolving credit facilities (RCFs) that include ESG-linked margin ratchets in their loan documents. These ratchets are triggered by pre-agreed corporate, social and responsibility metrics and adjusted based on performance against such metrics during the life of the loan. If a company achieves a certain number of these key performance indicators (KPIs), the margin on the loan decreases accordingly, but if criteria are not met, margins tick up and loans become pricier.
According to Bloomberg, Europe leads the way with these types of facilities, driven by European Union regulation and accounting for around 70 percent of the market, but the US is catching up fast. The election of President Biden—who has made climate change a policy priority for his administration and pledged to cut US carbon emissions to at least 50 percent below 2005 levels by 2030—has helped to push ESG up the agenda for US borrowers and issuers.
In April 2021, for example, General Mills renewed its five-year, US$2.7 billion RCF and included a pricing structure tied to environmental impacts through the term of the revolver. The ESG KPI metrics are linked to reductions in greenhouse gas emissions across its operations and use of renewable electricity for global operations. General Mills believes it is the first US consumer packaged goods company to put a sustainability-linked RCF in place.
The world's largest asset manager, BlackRock, meanwhile, recently agreed to a deal with a group of banks linking the costs of a US$4.4 billion credit facility to targets for women in senior leadership positions and increasing the number of Black and Latino employees in its workforce. In addition, BlackRock wants to grow the US$200 billion it has invested in sustainable strategies to US$1 trillion by 2030.
Other esoteric forms of finance, meanwhile, such as subscription line finance, which is used exclusively by private equity (PE) managers to fund deals before making capital calls to investors, have also developed an ESG flavor.
Global PE franchises such as KKR and EQT have agreed to sizable ESG-linked subscription lines in the past year. KKR's Global Impact Fund arranged a US$1.3 billion ESG line in June 2020 and, in November, EQT locked in a similar facility worth €2.7 billion. Much like the loans and credit revolvers with ESG ratchets, these subscription lines have fee or margin incentives and penalties based on achieving ESG KPIs.
As the uptake of sustainability-linked financing products increases, the next challenge for borrowers and issuers will be standardization, to make it possible to compare the value of deals that cover different environmental and social impacts.
Borrowers, lenders and investors are eager to build the credibility of the market, but without standardization, the transparency and verifiability of ESG across products and sectors will remain challenging.
Moves are afoot to use international regulations and environmental conventions as the basis for ESG KPIs, rather than relying on an iterative set of internally generated practices.
The US Loan Syndications and Trading Association, Europe's Loan Market Association and the Asia Pacific Loan Market Association have all published a set of sustainability-linked loan principles, while the International Capital Market Association has issued a similar set of guidelines for sustainability-linked bonds. Ratings agencies Fitch and Standard & Poor's are also now including ESG assessments in their methodologies.
These guidelines are providing a foundation for best practice and control around the issuance of ESG-linked lending and will support a more uniform approach regarding the scrutiny and monitoring expected from borrowers. Standardization will also be driven by disclosure requirements as part of legal and regulatory obligations to reduce emissions and climate change risk or to ensure a responsible and ethical supply chain, for example.
Building a coherent and uniform set of standards will bring further credibility to the market and give borrowers that can demonstrate compliance access to additional pools of liquidity while also reducing financing costs.