Podcast: COVID-19: Insights Into Key Practice Areas Across the Globe
In this Ropes & Gray podcast, finance partner Leonard Klingbaum leads a discussion on the impact COVID-19 is having on various practice areas across the globe. Leonard is joined by his finance partner Alyson Gal, based in Boston; finance partner Malcolm Hitching, based in Europe; special situations partner Dan Anderson, who heads the practice in Asia; bankruptcy partner Matt Roose, based in New York; private equity partner Jay Freedman, located in San Francisco; and asset management partner Jessica O’Mary, who is a leader of the firm’s credit funds team and based in New York. These global colleagues offer insights on the impact the COVID-19 pandemic is having on (1) event driven and bespoke financing transactions, (2) creditor representations, and (3) private equity and credit fund investments.
Leonard Klingbaum: Hello, and thank you for joining us today on the Ropes & Gray podcast. I'm Leonard Klingbaum, a partner in the New York office in the finance practice group. My practice is focused on event driven financing opportunities, special situations matters, workouts and restructurings. As we all adjust to a changing normal in respect of our and our families’ health and safety, and contend with rapidly changing markets and the related volatility, we wanted to take a few minutes of your time to share some insights into what we are seeing happening in certain of our key practice areas across the globe.
Joining me today are my partners Dan Anderson, who heads our special situations practice in Asia; Malcolm Hitching, who focuses on event driven and bespoke financing transactions in Europe; Alyson Gal, a finance partner based in Boston and whose practice includes distressed and special situations financing matters; Matt Roose, one of my bankruptcy partner’s who focuses on creditor representations; Jay Freedman, a partner in the private equity practice group based in our San Francisco office who represents private equity firms and strategic investors; and Jessica O'Mary, a partner in the asset management group and leader of the firm's credit funds team. I'll turn it over now to Alyson.
Alyson Gal: Thanks, Leonard. And thanks for giving us the chance to comment on what's been going on in the market. It's been quite a hectic time this week for all of us and for all of our clients. One thing that hasn't changed for credit fund lenders, they are still well positioned – they can move quickly, they have flexible capital and they've had to get used to scouring the terrain for attractive opportunities and creating flexible structures. They do look to be compensated for the risks that they take, but they're comfortable assessing those risks, charging for taking them, and they generally do not want to sit on the sidelines. I will say there's definitely – I won't say hesitation, but a fair amount of deliberation going on in terms of credit fund lenders' approaches. People are still very much assessing the duration and magnitude of the current crisis, both in terms of the credit qualities of their borrowers and in terms of their own liquidity sources.
Credit funds with NAV-based leverage facilities have potential tightening of borrowing capacity to think about, in addition to assessing opportunities in front of them. As part of a focus on liquidity, borrowers have been conserving cash, making larger revolver draws and generally showing heightened borrower concern over lender ability to sweep cash. Lenders with control agreements simply have more leverage in these situations. The major factor in terms of whether particular deals are moving forward in the face of the current crisis is how lenders assess a borrower’s vulnerability to this crisis. Some of the deals I have that are on pause are industries such as aerospace part supplies that are vulnerable. Others that are moving forward, at least at this point, are in the health care space, including health care diagnostics where the fundamentals seem to be sound.
We're not seeing borrowers or lenders wanting to go to the brink with one another – lenders are not seeking to invoke MAC clauses as a basis to refuse funding, for example. But borrowers are not particularly thrilled about pushing the issue either, and certain industries are in more acute situations, for sure. One thing to note is that there are important differences in the formulation of MAC clauses and lenders are certainly focusing on those differences. Whether “prospects” are included is one element, but also whether the ability to perform payment obligations under a credit agreement is included in a MAC cause – that can be an easier case to make for a lender than a general business MAC. And so I think borrowers and lenders are paying particular attention to the formulation of MAC clauses, even though, as I said, parties are seeming not to want to be particularly aggressive in the current climate. We certainly anticipate there will be a need for waivers on many, many credits, given likely delays in audit deliveries, declines in revenues and other issues that are being exacerbated by this crisis. And as part of the amendment processes, we can expect to see lenders taking a fresh look at their collateral packages and at their remedy provisions, tighten up those positions in their documentation, wherever possible.
Leonard Klingbaum: Thanks, Alyson. Malcolm, turning to you now.
Malcolm Hitching: Thank you for that. Let me share the view from London with you just briefly. Thus far, lenders generally, and credit fund lenders specifically, appear to be well capitalized and we’re yet to come across meaningful liquidity concerns. We are aware of some funds that have called for more capital, either directly from their LPs or via bridge facilities, but there have been no material concerns so far. On the flip-side, detailed discussions with portfolio companies are of course ongoing and there is particular focus on companies in obviously affected sectors, whether that’s travel, hospitality, retail or similar customer-facing businesses. There is no suggestion of a material adverse change as of yet, but that will no doubt be a focus as things evolve over the next few days and weeks. The immediate focus for most lenders is to try to stabilize credits as far as possible, but once that’s been achieved, there will, I’m sure, be a further focus on the details of existing credit facilities – whether that’s in the context of financial covenants, events of default, which focus on cessation of business, solvency events or otherwise. We are already in discussion with both lenders and borrowers as to a close analysis of EBITDA add backs and other accounting treatments, which might apply to this crisis, so a lot more focus on that will follow, I’m sure. One final point to make – on the flip-side, it is important to note that new deals are still be perceived. One specialty lender has promulgated two new deals this week and we’re also aware of another major transaction that’s gaining traction too. It’s early days, but there are still some signs of life in the market and we will all look forward to pushing those deals forward as best we can. Thank you.
Leonard Klingbaum: Thank you very much, Malcolm. Dan Anderson from Asia.
Daniel Anderson: I think a lot of the points that Alyson and Malcolm made apply equally to Asia. Credit funds are not trying to be overly aggressive in this environment, but they are spending a lot of time trying to access and understand the vulnerability of various borrowers. Many loans in Asia have maintenance covenants, especially loans made by credit funds, and borrowers are likely to face difficulties in meeting EBITDA tests in this challenging business environment. However, it is going to take some time for these breaches to develop. A more immediate issue are potential payment defaults. Amortizing loans are common in the Asian market and credit funds are examining their portfolios for liquidity constrained borrowers that have upcoming amortization payments to get ahead of potential payment defaults. Travel restrictions around the region have made it difficult for borrowers to make adequate progress in their audits, which is likely to result in covenant breaches as delivery timelines in information covenants are not met, and we expect waiver requests to come related to the delays in audits. Generally, even though Asia has been in this coronavirus crisis longer, I don't think we have a head start really in understanding its magnitude as the effects on financial performance and business operations are not yet fully understood.
Leonard Klingbaum: Thanks so much, Dan. It's worth adding that while we are aware of the pent-up supply of capital throughout parts of the world, we continue to be focused on how such capital can be deployed in light of existing debt document limitations. What we are seeing even more so now than before is the need for being able to see and advise clients on the absence of limitations in loan agreements, and not just the limitations written on the pages of a credit agreement, and this is something that Matt Roose will touch upon as well.
Matthew Roose: Thanks, Leonard. The number of industries immediately impacted by COVID-19 and the resulting government response is very broad – it includes any industry or company that primarily relies on consumer spending, including retail, hospitality, leisure, airlines and many more. But the initial impact of declining consumer spending is only the beginning – there will be a follow on effect from the drop in business investment, unemployment and the like. As a result of the economic impact of coronavirus, we're seeing a large uptick in the number of debt reviews we are doing. Clients are primarily focused on, among other things, the following: whether borrowers can draw on their revolvers, or whether an MAE out can be exercised, how borrowers can add or layer debt, upcoming financial covenant issues, EBITDA add backs for non-recurring events, and year-end audit requirements.
In addition to clients looking to protect existing investments, clients are also exploring lending opportunities. Clients are identifying industries or companies that they think will survive an economic downturn and will thrive on the rebound. For these companies, clients are looking for opportunities to provide capital now – the capital will help companies manage the downturn without having to layoff employees or cut business investment. As a result, these companies will be better positioned to take advantage of the rebound. Generally, clients are looking for opportunities towards the top of the capital structure, senior secured debt. Some clients have even floated PIK interest for a few quarters to give to company additional financial flexibility through the downturn. The barrier to entry now seems to be that no one knows where the bottom is or what form government stimulus will take. Clients are continuing to weigh these factors as they explore their opportunities.
Leonard Klingbaum: Thanks so much, Matt. Jay Freedman, turning to you.
Jason Freedman: Given this period of uncertain time, it's not surprising that private equity sponsors are focused on their portfolio. In terms of investments that we're seeing, we're seeing lots of focus on rescue capital or other types of financing into existing portfolio companies with respect to equity cures. In terms of new investments, clearly, things have slowed down. Where there are opportunities, private equity sponsors are looking for direct lender solutions for financing their LBOs. Also of note in this depressed economic environment, are our stocks beginning to look cheap to our clients? In respect of companies needing capital or just value to be found, sponsors are increasingly looking at types and other type of investments into public companies. And finally, when companies are looking cheap, given the depressed stock price, clients are looking at building toehold positions to attempt to take the company private at a later period of time.
Leonard Klingbaum: Thanks very much, Jay. And turning now to Jessica O'Mary.
Jessica O’Mary: Thank you, Leonard. As to the credit fund fundraising market, we are still largely seeing managers and investors pushing forward with closings, and in some cases, trying to accelerate them. But at the same time, we are starting to see some uncertainty and hesitancy with some investors, and it's a little unclear at this point whether that uncertainty is with respect to all of the operational issues we're all dealing with in this changing environment, whether it's going to be a more permanent issue for fundraisers. Managers may want to review their fundraising periods for funds that are nearing the end of their fundraising period so that they're aware and on top of what type of amendments or votes would be needed to extend their fundraising periods. We are also seeing managers updating their disclosures to be more specific on COVID-19 issues. Most are currently focused on their Form ADVs, but we're also seeing this in PPMs in anticipation of upcoming closings. Managers with upcoming closings are also paying particular attention to whether material updates should be made to performance and valuation disclosures before accepting commitments. Managers are also reviewing DDQ responses on COVID and preparing updates to investor inquiries on their continuity business plans and how they are being executed.
In terms of other fund level issues we are seeing, managers are communicating with their audit firms, not only with respect to the transactional deal document issues mentioned earlier, but also because of the timing for any audits for year-end 1231 due to their custody rule requirements under the Advisers Act. On the regulatory front, SEC exams are continuing, although the SEC has moved to conduct exams remotely. We are seeing inquiries from the SEC on COVID-19 preparedness, although it's varied depending on the exam team, from being high-level questions, to being very specific. Finally, as Alyson had mentioned earlier, we are seeing a high volume of draws and revolvers. As a result, at the fund level, we are seeing managers review their portfolios for potential funding needs and assessing the options to facilitate funding under their organizational documents, particularly for their older funds.
Leonard Klingbaum: Thank you so much, Jessica, and to all of my partners who have taken time out of what I'm sure is an extremely busy time to provide some insight into what's happening in your practice areas right now. The global situation, both in terms of health and financial impact, remains very fluid. We will continue to provide market leading advice to our clients and, as partners with them, thought leadership, bringing to bear our global team of seasoned lawyers, several of whom you've heard from today. For more information on the topics that we discussed or other related topics of interest, please visit our website at www.ropesgray.com. And of course, if we can help you navigate any of these topics – please don't hesitate to get in touch. You can also subscribe to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening and stay healthy.