Financing growth & acquiring debt
Article Date: Aug 07 2006in partnership with Ernst & Young:
Debt finance is relatively cheap and readily available to fund growth. But a recent surge in debt trading could put your equity at risk from acquisitive hedge funds if you fail to meet the targets and covenants agreed with your bankers.
Who owns your company’s debt? For many entrepreneurs this may be a surprising question. It’s natural to assume that when you agree a debt facility, typically with your high street bank, you will continue to deal with the same lender throughout the life of the loan. You will probably also assume that the bank’s approach and requirements will remain consistent. A decade ago, that would probably have been true; but now it is becoming an increasingly unreliable assumption. And the implications for your business could be significant if not alarming.
The odds have never been higher that during the lifetime of your loan, the ownership of your debt will change hands. The European market for ‘traded corporate debt’ has seen an upsurge over the last decade and demand is still rising. The direction of trading is largely one-way – from the hands of traditional players such as banks and pension funds to institutions such as hedge funds, whose investors are far more aggressive in their pursuit of value than the banks they replace. Frequently their ultimate interest can be ‘loan to own’ – seeking to gain control of a business, using the ownership of debt to force a stressed business to either transact or swap debt for equity.
A decade ago, when the traded debt upsurge started in London and became established in Europe, only debt from larger corporates was normally traded. But as the market has grown, demand has also expanded – fuelled more recently by a high volume of capital thirsty for investment and low interest rates on conventional investment. According to Standard and Poor’s Leverage Commentary, in 2000 hedge funds accounted for just 6.75 per cent of the leverage European Loan Market; they now represent 35 per cent. It’s now not unusual for debt of any middle market company to be traded, and the ‘threshold’ is likely to continue to drop. There is so much liquidity at the moment that most investors of non par debt (i.e. debt traded at below the nominal value) say there is not enough opportunity to meet their needs.
To put this into perspective, debt trading is unlikely to impact on a middle market company which is consistently able to meet or beat its planned targets and doesn’t breach the covenants which will normally form part of its borrowing agreement (to maintain ratios like leverage, net asset value and liquidity).
But should there be a ‘blip’ in the performance of your business or deviation from the initial plans you may find the situation changes quite quickly. The previous regime of visits from the bank’s relationship banker, keen to support your growth with more and more innovative banking products and services, may be replaced by an altogether keener interest, often from a different level of the bank where the debt on the bank’s balance sheet is actually managed.
What you may not see, unless your lending agreement contains a right for you to veto a transferee, is the bank looking to ‘lighten up’ on the debt, either by trading it or by passing on the ‘economic interest’, a process known to bankers as sub-participation.
A bank’s approach to stressed situations is usually supportive and seeks to maintain a good relationship with the corporate whilst protecting value for all the stakeholders. However, it is at this point that who owns your debt can be a very important question. Most banks are likely to consider trading or be approached by a debt trader to sell the debt of a customer that is ‘stressed’ – so that targets are missed or covenants broken. An analyst at Fitch Ratings estimates that hedge funds now own 50-60 per cent of the debt in stressed companies.
