The relationship starts to change

How times change. Only last November Gazprom signed one of the biggest syndicated loans ever for an emerging-markets borrower. Russia’s gas company obtained $3 billion on respectable terms ­ paying 175 basis points over Libor for an eight-year maturity. And the deal was oversubscribed: 39 banks signed up for amounts ranging from $242 million apiece for arrangers Crédit Lyonnais and Dresdner Bank Luxembourg, to $5 million each for ABN Amro and Mediocredito Lombardo.

Now no banker would take a Russian loan within a mile of a bank credit committee. But borrowers in less-troubled markets are also finding that the appetite for lending has diminished over the past couple of months. The syndicated loans market is still open for a variety of lenders. Deals are being done. But the market is suddenly shifting gear. Prices are rising, tenors are shortening and terms are tightening for many types of borrower.

Instead of banks queuing up to lend money, there is now a big backlog of deals. “With the exit of Japanese banks, 20% of liquidity had already been removed from the market,” says Don McCree, managing director for global syndicated finance at Chase. “And now global market uncertainty has added to the liquidity drain. At the same time you are seeing massive demand because most of the other markets, such as the high-yield bond markets, are largely closed.” The result, since August, has been sharp price increases in the US, a virtual shutdown for emerging-market borrowers and patchy transaction flow in Europe.

Bankers are nervous that the capacity for funding will fall further, making it impossible to do deals at all. But most talk confidently of the flow of business picking up in 1999. And many find it hard to conceal their satisfaction that the balance of power has shifted from borrowers to lenders. “The days of borrowers beating up the banks are over,” says the head of syndicated loans at a major bank. “The boot is on the other foot now.”

There is no more visible demonstration of the changing balance of power than pricing. The hottest topic among syndicate heads is a change in the wording of loan documentation. Traditionally, the arranger of a syndicated loan gives the borrower a commitment to underwrite the deal at a certain price and structure and for a certain maturity. Now several banks are asking borrowers to sign up for transactions at provisional prices. The arranger can invoke what is usually called a market-flex clause to increase the price if it discovers the market does not have the appetite for the deal.

This approach has spread remarkably quickly. David Morley, banking partner at law firm Allen & Overy, recalls: “We sent a note to many leading banks two to three weeks ago, suggesting the kind of flexible language they might want to use in loan documentation in this new market environment. At first, many said the market wouldn’t stand for it, then over the last couple of weeks we have been inundated with enquiries.”

US banks are the most enthusiastic proponents of market flex. Atiq Ur Rehman, managing director for global loans structuring at Citibank, believes that this stipulation is becoming a global standard. “In emerging markets particularly it is essential,” he says. “All the new deals coming to the market now use full market flex.”

Bankers at Chase, which has been using clauses invoking market flex for over a year, express surprise that it has become such a burning issue. McCree says Chase uses market flex in most of the underwritten deals it does. And he believes borrowers understand the need for it. “We haven’t had a negative response from our clients about this,” he says. “And the proof of the pudding is in the eating: we are getting plenty of repeat business from happy clients. This is not something we are trying to impose on the market, we just feel this is the right way for us to be doing business.” Some European banks also see the spread of market flex as positive. Warburg Dillon Read, for example, expects to use it in most of its financings.

Tim Ritchie, global head of syndication at Barclays Capital, believes in selectively introducing market flex in the current market environment and says that it plays to his bank’s strengths. “It means that it’s even more crucial than ever for borrowers to choose a leading arranger with proven deal distribution and execution skills, to ensure liquidity is being efficiently tapped so the best deal is achieved.” Most other European banks are far more wary. “I think there is some merit in the practice,” says Tony Rhodes, global head of loan syndication at HSBC. “In project or acquisition finance, for example, there may be a long gap between the underwriting agreement and the launch of the deal. In those circumstances it makes sense. But we believe that in most cases an underwriting commitment should mean just that.”

Richard Munn, head of Deutsche Bank’s London loan-syndication team, takes a similar view. “Deutsche Bank is not using market flex for a deal that is launched straight after signing,” he says. “We take the view that we are being paid to underwrite.”

Many borrowers are also uneasy about market flex. “That sort of clause is not an appealing thought,” says Gerry Petit, treasurer at UK brewer Bass. “We’re not directly affected by current market turmoil because we don’t have an immediate funding need. But I’d hope that if we did need to use the market we wouldn’t have to borrow on those terms.”

It may seem surprising that a change in the way loan documentation is worded has sparked such passion in the gentlemanly world of syndicated lending. But market flex goes to the heart of a wider issue. The financial crisis has added a new dimension to the debate about what sort of market syndicated lending should be and about the nature of the borrower-bank relationship.

For many banks, lending has long been a loss leader: a way to establish a relationship that might result in more profitable ancillary work. The consequent willingness to lend on generous terms has driven prices down. The low was reached in 1996 when many top corporate borrowers were able to secure large amounts at margins of less than 20bp for five-year funds. A bank that committed the BIS minimum of 4% of tier-one capital against such a loan would be making a return on capital of only 5% (assuming it funded itself at Libor) even before taking account of the need to make a return on tier-two capital.

Yet many bankers insist that the low headline margins for many deals do not reflect the full value of the business for lenders. Underwriters, for example, earn fees on top of the basic margin. And many syndicated-loan deals are for credit facilities rather than money (term loans) and these do not attract capital weighting until the actual funds are lent. They also stress that they are using syndicated loan underwriting to secure a flow of profitable business from established clients. “Syndicated lending is not just an asset play,” says Rhodes at HSBC. “It’s about relationships.”

Banks claim that the process of measuring the value of individual clients has become more scientific recently. “It’s a process that has spread from the US banks,” says a European banker. “But the European banks have caught up. I would say that the top 40 or so banks in Europe are making use of models to measure the value of their banking relationships.”

But no model can measure the value of future flows of ancillary business from a borrower and it seems there is no longer enough supplementary business to go around, forcing banks to become more selective. “Borrowers are under mounting pressure to promise future mandates in return for low-yielding commitments,” says Jonathan Macdonald, head of loans syndicate at Warburg Dillon Read. “The result is that borrowers which require a range of financial services are among the few which still have access to cheap bank funding. Those with little business to spread around will be forced to pay up.”

The amount of spin-off work is likely to reduce even more next year. “With the euro there may be less ancillary business,” says Deutsche Bank’s Munn. “There will be less cash-management work, less forex business, less need for hedging. There may be an increase in M&A work but that may go to a narrow range of banks.”

For several of the biggest players, syndicated lending is an activity designed to be profitable in its own right. Many bankers are keen to stress that new practices, such as market flex and ensuring that loans are tradable, are part of the inevitable convergence of bank and bond markets and are not designed to fleece borrowers. “The new environment is about developing consensus, forming a club, book-building,” says Bill Fish, managing director for global loans sales at Citibank. “It’s about quality of execution.”

Some believe that market flex could rob the syndicated-loans market of one of its key attractions to borrowers ­ the fact that prices are known from the point the deal is agreed. But for McCree at Chase, the real appeal of syndicated loans over bonds is their flexibility. “This is the single market where a borrower can raise tailored finance,” he says. Loans can be of any maturity and can be repaid at any time, allowing refinancing when things change for the better.

What’s more, banks are a much less volatile source of funds. “Prices in the loan market are unlikely to go as high as they can in the bond market,” says Rhodes at HSBC. “Some bond prices have gone to 10% over Libor. The most you are likely to see for a senior syndicated loan is 300bp.”Capacity has fallen sharply, however, especially for lower-grade credits. This is not new. Bankers draw parallels with the early 1990s when bank capacity was reduced by recession and by new BIS capital adequacy rules that forced many banks to improve their balance sheets. So far during this downturn banks remain well capitalized, although losses in emerging markets and through exposure to hedge funds may yet change that. But the key similarity between then and now is that liquidity has been dramatically reduced.

Still cheaper in Europe

So far, borrowers have been affected to varying extents across different markets. Pricing has increased sharply for US borrowers. But several creditworthy European corporates have secured loans recently at margins and tenors that appear good by any standards. In September, for example, Dutch retailer Koninklijke Ahold signed a revolving-credit agreement arranged by Chase, ABN Amro and JP Morgan for $1 billion. The borrower paid 10bp over Libor for a seven-year maturity (though the margin increases to 112.5bp after five years). Last month UK insurance group Royal & Sun Alliance obtained a five-year revolving credit facility for £1.6 billion ($2.7 billion) for 22.5bp over Libor in a deal arranged by Chase. In September, BNP, Citibank and Paribas launched a revolving-credit facility for French hypermarket group Carrefour priced at 12.5bp for the Ffr9.5 billion ($1.7 billion) one-year tranche and 22.5bp, stepping up to 25bp after three years, for a Ffr9.5 billion five-year tranche.

There is widespread agreement that prices for European borrowers will rise in the not-too-distant future. “Recently we have seen some rare names come to the market ­ Royal & Sun Alliance for example ­ and a lot of banks haven’t wanted to miss out on those deals,” says McCree at Chase. “Some of the more regular borrowers are sitting out because they already have access to facilities on good terms. It will only be when those borrowers have to return to the market that pricing for European corporates will really be tested. And that process may take a couple of years. In the US you have already seen 50bp to 100bp moves. For now, Europe is lagging behind, but that is just because the market hasn’t been tested in size across the risk spectrum yet.”

Syndicated lending is one of the few sources of financing still available to European and North American borrowers ­ even if the terms are becoming more difficult. For emerging-market borrowers, however, the market is now almost entirely closed.

Emerging-market recovery

Although business volume is expected to remain low over the next couple of years, some bankers are predicting a gradual recovery in emerging-market lending. Nonetheless, there will be fewer borrowers, pricing will be higher and maturities will be much shorter. Some structures and techniques that have been overlooked in the rush to invest in emerging markets are likely to make a comeback.

“Banks are favouring structures which mitigate country risk,” says Macdonald at Warburg Dillon Read. “Structured trade or export deals may be the only financing route open for the foreseeable future.” He gives the example of an emerging-market borrower exporting to a western buyer under a supply contract. Repayment of the facility is linked to payment by the importer on delivery of the commodity by the exporter. The structure allows credit committees to focus on the performance risk of the exporter rather than its actual credit risk.

Rehman at Citibank believes there will be a return to methods used to finance emerging-market borrowers before the emerging-markets boom of recent years. “Borrowers will be looking for support from export credit agencies and multilateral bodies such as the IFC,” he says. “That will involve tighter restrictions such as covenants against leverage. And in project finance, the equity component will increase, reversing the trend of recent years to push equity ratios down.”

Banks’ capacity for emerging-market loans has been badly affected by their bond losses. That creates problems for many borrowers. In Brazil, for example, several billion dollars-worth of bridge financing was extended in July to companies that bought parts of privatized telecommunications operator Telebrás in the expectation that the loans could be refinanced later on better terms. “It seems unlikely that those bridges are going to be taken out,” says a banker closely involved in lending to emerging-markets borrowers. “They will be extended and repriced. But the banks are going to be stuck with them.”

The number of clients in emerging markets that will be able to access the syndicated-loans market will be much reduced, but Rehman at Citibank sees several broad categories of emerging-market borrowers that will be able to return fairly quickly. Referring to stronger issuers in investment-grade emerging-market countries, he says: “First, there will be sovereigns. Most of them will be able to get deals done. Second, there are the top few banks in each country. They can call on their relationships with correspondent banks. Third, there will be the top tier of corporates. In addition, there will be project-finance deals and loans to local operations of multinationals.”

Nonetheless, few bankers expect lucrative business from emerging markets in the near future. By contrast, much attention is focused on the leveraged sector of developed markets.

Bankers claim to be spending much time looking at M&A and LBO deals and insist there are a lot of discussions taking place about takeovers and buy-outs, even though only a few deals have been announced recently. Many forecast that lower share-price multiples will feed through into an increase in the number of mergers and acquisitions being done. “There has been a big increase in the volume of deals associated with acquisitions in the last 12 months,” says Richard Cartledge, deputy managing director at HSBC in London, “and this is likely to continue.”

The LBO market, which has boomed in Europe over the past year as a result of the emergence of an embryonic high-yield bond market, now appears to be stagnating. Indeed, some commentators have written it off for the foreseeable future. But several banks are confident of a resurgence in buy-outs, stating that this area will provide a strong flow of loan deals over the coming year ­ particularly in the absence of a high-yield bond market. “We see leveraged lending as a huge growth area,” says McCree at Chase. “There is a lot of private equity money out there, the bank market is open and you will see mezzanine finance and even high yield start to come back.”

Munn at Deutsche reckons deals will need to be priced more realistically. “Leveraged deals are becoming more conservative in structure to reflect the appetite of the market,” he says. “They will have a smaller amount of bank debt, maybe a bit of mezzanine and more equity.” McCree agrees: “Whereas before you might have seen leveraged acquisition structures consisting of 50% senior debt, 30% high yield and 20% equity. Now, you might get 60% senior debt and 40% equity.”

Many also believe that the quiet process of convergence between loan and bond markets that has been under way for several years will continue ­ provided economic stability can be restored. The syndicated loans market has become increasingly globalized, and investment banks such as Goldman Sachs and Merrill Lynch have made inroads into this traditional preserve of commercial banks. Before the financial crisis, loans were beginning to be traded more actively as banks sought to mark their exposures to market. Non-bank investors, meanwhile, were starting to buy loans as well as bonds and other securities. Rhodes at HSBC believes that this process may be inevitable. “In future banks may no longer be the low-cost providers of funds,” he predicts. “Non-bank investors are not constrained by regulatory capital requirements in the way banks are.”

The joys of lending

However the current state of the markets has halted this ­ for the moment, at least. There is virtually no liquidity in the secondary loans market and many investors are looking to offload portfolios at a fraction of their original price. A quick return to stability may result in a reversal of these trends. But should the slowdown in developed economies such as the US turn into recession, banks will need to rediscover the skills of survival rather than success.

A recession might even highlight the benefits of traditional lending. Banks could rediscover the joys of being a lifeline to struggling companies. They might not be able to boast a great return on equity, but they could revel in the warm and fuzzy feeling generated by the realization that they are the only thing that is keeping large parts of the economy afloat.