Wachtell Lipton: Financing Year in Review: The Tide Turns

2022 brought a halt to a nearly unabated 12-year run of booming credit markets and “lower for longer” interest rates. Rampant inflation, fears of a recession over the horizon, and war in Europe, among other factors, led to a marked contraction in credit availability and a slowdown in deal-making across sectors and credit profiles. U.S. high-yield bond issuances were down approximately three quarters year-over-year – the lowest volume since 2008 – while newly minted leveraged loans fell nearly two-thirds from 2021 levels. Investment-grade bond issuances fared better, but were still down significantly, with new issuances falling roughly 20% year-over-year. At year end, the average price for leveraged loans was just over 92 cents on the dollar, down from 99 at the year’s beginning. And high-yield bond prices fell significantly further – with an average price of 87 cents in December, down from 103 at start of the year. Average yields for single-B bonds rose from under 4.7% on the first trading day of the year to over 9.2% on the last, and average BBB bond yields more than doubled, from 2.7% to 5.8% over the same period.

Looking ahead to 2023, with risk-free rates and credit spreads still elevated and the credit, dealmaking, regulatory and geopolitical environments uncertain, corporate borrowers and sponsors will need to plan rigorously to succeed on levered acquisitions and spin-offs and important refinancings. Obtaining committed financing, in particular, will require both creativity and avoiding the urge to let the perfect become the enemy of the good.

Acquisition Financing Commitments: A Time of Challenge and Creativity

New commitment anxiety

The market and regulatory forces at play in 2022 came together to exact a particularly tough toll on acquisition financing. Over the course of the year, credit markets dramatically weakened and became more volatile. Meanwhile, antitrust regulators in the United States and around the world began scrutinizing M&A deals with new intensity and skepticism, leading to less predictable (and much longer) timelines between signing and closing of acquisitions and, in turn, requiring longer- duration financing commitments. These two factors had a compounding effect that led lenders to become more reticent to provide commitments and to demand greater economics and more onerous flex terms when they did. This makes perfect sense: underwriting lenders promise to provide debt on certain terms and at certain pricing at signing, even though the debt will not be syndicated and funded until the related acquisition actually closes. Longer lead times in falling, volatile markets equate to increased risk that must be compensated.

Case in point, the year’s sharp credit selloff resulted in a series of “hung bridges”; that is, acquisition financing debt that was committed in the frothier markets of 2021 and early 2022 but that could not be syndicated or sold to the market by commitment banks without bearing steep losses when it came time to fund in mid- to- late 2022. By September, the volume of such unsold debt was estimated at over $80 billion. As a result, many traditional banks spent the second half of the year more focused on de-risking existing commitments than on providing new ones.

The results were clear – not only did debt issuance volumes plummet, but so did debt- dependent M&A, particularly private equity buyout activity, which was down approximately 25% by deal value for the year and over 50% for the second half of the year versus the same periods in 2021.

Existing commitment fidelity

As tough as the environment was for obtaining new commitments in 2022, one silver lining for borrowers and sellers was how dependable existing commitments proved to be in the face of hung bridges. In numerous major transactions, including the sales of Twitter, Nielsen, Citrix, and Tenneco, banks followed through on their commitments even when the syndicated markets failed to support the deals – notwithstanding the immediate negative impact of doing so on their own balance sheets. This demonstrated that well-drafted commitment papers – and financing-related provisions in acquisition agreements – remain fit for purpose, even when placed under immense pressure. As we highlighted in our 2020 memo, tight acquisition financing commitments – and financing certainty provisions in M&A agreements – require substantial attention and negotiation. In most scenarios, they end up being an unused insurance policy, but as many of the past year’s largest deals demonstrated, they are invaluable when most needed.

Creative solutions

Despite the year’s challenged debt markets, M&A acquirors – even those unwilling to pay the higher rates of the day – found creative ways to pursue new deals, deploying strategies that include the following:

Buy now, borrow later... Financial buyers who got deals done in 2022 often exhibited significant flexibility – up to and including executing all-equity deals, such as KKR’s buyout of April Group, while waiting for sunnier market conditions to swap in debt. Large equity commitments also appeared in strategic deals in 2022 – for instance, Cigna provided a $2.5 billion preferred equity investment to Walgreens affiliate VillageMD’s $8.9 billion acquisition of Summit Health. And buyouts announced late in the year that did feature leverage often featured uncharacteristically large equity commitments.
...or keep existing target debt on the books? Sponsors in 2022 also pursued bespoke deal structures and terms to allow targets’ existing debt to stay in place post-transaction – for instance, by settling for bare-minority voting stakes with meaningful veto and board appointment rights in order to avoid tripping change-of-control defaults in targets’ existing agreements.
Seller as bank. Some sellers offered financing to prospective purchasers – for example, Global Payments has agreed to provide a substantial amount of first- and second-lien acquisition financing in connection with the pending sale of its Netspend consumer business to affiliates of Rev Partners and Searchlight Capital Partners.
Risk acceptance. Given the pricing of commitments in 2022, some parties to acquisitions – such as those in the sale of Aerojet Rocketdyne to L3 Harris (a large investment grade strategic acquiror) and the take-private of Continental Resources by its then-majority shareholder (which closed within 45 days of signing) – decided to go without financing commitments altogether, accepting financing risk in favor of retaining value. This approach is not for the faint of heart, and is most often available where all parties are confident in the acquiror’s ability to obtain financing at reasonable rates in spite of volatile market conditions (such as where the buyer is a large investment grade strategic company), where the timeline from signing to closing is short (affording greater visibility into the financing markets) and where the seller is in a unique position to evaluate and take on this risk (such as where the seller is a sophisticated financial sponsor).

Risk allocation. Parties can also allocate financing risks in creative ways: During a brief downturn of the credit markets in 2010, for example, PVH (then a high- yield issuer) agreed to close its purchase of Tommy Hilfiger from a large, sophisticated financial sponsor only if PVH obtained financing meeting minimum terms (including weighted average cost of capital) agreed between the parties in the acquisition agreement. It will be interesting to see whether such creativity returns in 2023 after the 12-year bull market.

Direct Lending’s Continued Ascent

As unconstructive syndicated markets failed high-yield issuers in 2022, “direct lenders” partially filled the breach and reached their greatest prominence yet. As mentioned in our 2019 and 2021 memos, direct lending has been on an upward trajectory – the market is estimated to have roughly doubled over the past five years, to $1.4 trillion. Once limited to the middle market, direct lending played a role in many of 2022’s largest leveraged buyouts, reportedly financing some or all of the debt in six of the ten largest announced LBOs of the year.

Direct lenders are by no means immune to the effects of the markets, and the pace of their commitments slowed significantly in the second half of the year. But we expect their ascent to continue over the coming years, as top players raise larger funds and become more capable of writing commitments as large as those provided by traditional money-center banks, and as large family offices and pension funds continue to get into the act. Banks themselves seem to agree, with major players like JPMorgan and Goldman Sachs expanding their own “direct lending” offerings.

In the near term, it will be interesting to see how direct lenders act and react if the real economy softens. For instance, will direct lenders step into a void and finance CCC-rated companies that CLOs, stuck with concentration limits, cannot? And when distressed borrowers seek consents from direct lenders for amendments to their debt documents in challenging circumstances, will direct lenders play hardball (à la sponsors), or take a more constructive approach (à la traditional banks)? In the longer term, we will watch to see whether the currently myriad direct lending players shake out into a less numerous group of much larger players, and how the competitive dynamics among direct lenders impact both terms and practices.

Lightning Round: Other Developments to Monitor

Each year sees the emergence of new developments in the financing markets, and 2022 was no exception. Below are several we are keeping our eyes on as we head into the new year:

Advantage to Investment Grade Issuers? While debt markets slowed across the board in 2022, investment grade borrowers enjoyed considerably more favorable conditions than leveraged borrowers in terms of both economics and credit availability. It will be interesting to see whether investment grade strategic would-be-buyers – particularly those that are willing (and able) to add balance sheet cash to the mix – will fare better vis-à-vis sponsors in competitive acquisition processes in the current rate environment than they have over the last decade.

Buybacks to the future. A substantial amount of corporate debt is currently trading at steep discounts, and not just hung bridge loans. Many issuers with financial wherewithal have begun to explore repurchasing this debt at prevailing (below-par) market prices, a trend last seen en masse (with respect to bond debt) in the wake of the 2008 financial crisis. But unlike loans originated prior to 2008, many modern bank loans (in addition to bonds) include technology that permits the issuer to repurchase such debt; borrowers with cash on hand and debt trading at a discount should read those provisions carefully and consult their advisors (including their tax advisors) so they can stand ready to pull the trigger if the math works.
Underwater convertibles. Many companies – particularly in the technology sector – issued convertible notes with low coupons and short-dated maturities in 2020 and 2021 to increase cash-on-hand in the wake of the Covid-19 pandemic (or simply to obtain cheap money). As equity values have plummeted and credit markets have flagged, many of these convertible notes are now deeply out of the money, and trading at considerable discounts. An open question for the coming years is whether and how these convertibles will be refinanced: if they are refinanced with new convertibles, such instruments will be highly dilutive to then-existing equity holders; if they are refinanced with regular-way debt, the company’s interest burden may become untenable.
A new threshold for “sacred rights”? In the U.S. market, amendments to the most “sacred” terms of debt documents (such as principal amount, interest rate, and maturity date) typically require the unanimous consent of all affected lenders. In last year’s memo, we suggested it was time to look to the U.K. practice of replacing this requirement for unanimous consent with high supermajority consent thresholds for “sacred rights” amendments. This year, we saw such technology trickle into the U.S. debt markets. We welcome this development and believe greater adoption would benefit both borrowers and lenders by facilitating consensual workouts and amendments and averting “holdout” problems.
Time to kill the ECF sweep? Leveraged loans in the U.S. typically require the borrower to apply some portion of its “excess cash flow” to prepay the loan (commonly called an “ECF sweep”). We think it’s time for the bell to toll on this provision. In good times, mandatory pay-downs are barely desirable for lenders (few lenders want their capital to dribble back, only to have to find ways to redeploy it). And when a borrower faces challenges and such a prepay might be valued, the modern ECF sweep provision, with a pages-long suite of deducts and exceptions, rarely results in a calculation requiring the borrower to repay any debt at all. As a result, in many deals, the ECF sweep amounts to many heavily negotiated pages of little practical substance. We think market participants should consider saving a tree and chopping the ECF sweep out from the U.S. credit markets.

We enter 2023 facing known challenges and considerable uncertainty in the financing markets; but no matter what the new year brings, borrowers who remain informed, flexible, and creative will be well-positioned to make sound financing decisions.

Joshua A. Feltman

John R. Sobolewski

Neil M. Snyder

Gregory E. Pessin

Emily D. Johnson

Sumita Ahuja

Michael S. Benn

Benjamin S. Arfa J

oel M. Simwinga