With two weeks leading up to an historic election in the United States, the credit markets continue to move forward at full speed. As we discussed in "Tapping opportunity in the debt markets", the high yield bond market has proven to be a ready source of liquidity in 2020, already topping previous annual issuance records by the end of the third quarter. Buoyed by the equity markets, private debt has also shown surprising resilience and activity remains strong.
Credit markets remain active
The increasing likelihood of a contested election and the threat of a second COVID-19 wave have contributed to heated credit markets in recent weeks. Sponsors and borrowers are securing additional liquidity while interest rates are low, and sponsors are using favorable lending terms to declare dividends, as evidenced by the fact that the month of September recorded the highest volume of dividend recapitalizations since October 2016. As a consequence, credit terms such as dollar caps on free and clear incremental tranches, MFN sunsets and caps on EBITDA carve-outs have become more borrower-friendly. Notwithstanding these borrower-friendly terms, lenders are seeing opportunity in the market. Canadian public pension funds' private debt allocations have increased more than 5% in the first 10 months of 2020, according to Prequin data—the biggest increase in five years.
Whether this level of activity in the market will continue after the election, and how the credit markets will be impacted, remains to be seen. If November 3rd results in another four years of a Republican White House, low corporate tax rates and decreased regulation should help to fuel M&A. Nevertheless, institutional investors such as Goldman Sachs have announced that a Democratic White House would likely result in a stronger economic outlook for the United States. Higher taxes and increased regulation would be offset by proposed government spending and more stable trade relations, which support a strong outlook.
Potential for regulatory changes
It is currently unknown whether a Biden administration would promote specific legislation affecting the lending markets, but the fate of the Leverage Lending Guidance (the Guidance), which dramatically affected the markets when issued in 2013, may well be decided depending on who wins in November.
Under the Obama administration, bank regulators announced new limitations on leveraged lending by regulated banks in an attempt to improve bank underwriting and risk management standards. The Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency issued the Guidance, which, among other things, set leverage limits at six times and required that borrowers demonstrate the ability to repay all senior debt or half of total debt within five to seven years from their free cash flow. Loans with higher leverage levels would be treated as classified loans requiring banks to hold higher levels of capital, and failure to comply would result in fees and censure.
In the handful of years following announcement of the Guidance, banks pulled back on lending to borrowers with higher leverage, opening the door for unregulated and non-bank lenders to fill the gap for higher-levered credits. We saw many of our non-bank investor clients take advantage of this increased opportunity.
However, on October 19, 2017, the Government Accountability Office determined that the Guidance was a "rule", which must be submitted to Congress for review before it becomes enforceable. This ruling effectively invited Congress to invalidate the Guidance and called into question the ability of bank regulators to enforce it against member banks. Under a Trump administration, the Guidance became a dead letter and agencies refrained from enforcing it.
A shift in power in Congress could result in legislative action to shore up enforceability of the Guidance, and a Biden victory would ensure regulatory-friendly appointments to the agencies that enforce them. While this would have the effect of limiting the ability of U.S. banks to participate in loans to higher-levered borrowers, it would ensure that the door remains open for non-bank lenders, specifically Canadian pension and other types of investment funds—a welcome edge in an already crowded field.
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