November 5, 2020 - The LSTA (Virtual) Annual Conference spanned two weeks in late October, and will feature bonus election-related sessions the week of November 9th. Despite the challenges of bringing our usual day-long, 1,200-person conference online in an all-virtual format, this year’s conference was content-rich and addressed timely and must-discuss issues. Below, we recap the critical takeaways (and link to slides and replays!) and foreshadow what is coming next.
The conference began with a look back to historical lessons and will end next week with a look forward to the post-election world. We commenced by chatting with noted historian, author, journalist and commentator Amity Shlaes. Ms. Shlaes, who has written four New York Times best-sellers covering the Roaring 20’s, the New Deal and the Great Society, indicated how government intervention during these three distinct periods in 20th century American history can help chart our course out of the coronavirus pandemic. Ms. Shlaes argued that broad changes in government policy and regulations, intended by its authors to improve society and support prosperity often have the opposite effect: lengthening recessions, limiting options and creating new kinds of poverty. Before embarking on new programs, we should look back and gauge the historic impact of similar nostrums, not because history repeats itself but because it does often rhyme. While Ms. Shlaes looked back, the conference series will end next week, looking forward with two sessions. First, we have a special session dedicated to this year’s nail biter election – featuring noted political analyst Charlie Cook – and the impact it will have on the world. Second, we’ve added a “bonus” Thursday session, which will deconstruct the impact of the election on key loan market issues like Bankruptcy, Risk Retention, Volcker and Leveraged Lending Guidance.
Between the historical and futurist bookends, we dove into the loan market. Contemplating the last 10 months, managers from Invesco, Ares, CIFC and CSAM discussed how loan strategies faced many challenges from the COVID-19 pandemic and the global economic shutdown that was undertaken in response. While 2Q U.S. GDP dropped at an astonishing 31.4% annual rate and risk based assets, including loans, fell more than 13%, markets performed well, finding equilibrium all the way down and back up to the mid-90s. It would appear that asset allocators and institutional investors continue to have confidence in the leveraged loan asset class. Case in points: CLO creation has seen a strong recovery and the primary loan market remains a source of capital for American companies. Meanwhile, direct lending performed much better than pundits predicted as many managers in that growing corner of leveraged finance have met the liquidity and capital needs of their borrowers. While the loan market continues to have its challenges, the asset class remains an important source for spread in a diversified portfolio.
So what happens next for the loan market? Practitioners from Citigroup, Marathon Asset Management, Barclays and Pinebridge believe that a combination of ultra-low interest rates and additional stimulus will lead risk assets higher in the next 6-12 months. While loans are not expected to outperform over that period, investors should expect a coupon driven return despite heightened credit concerns. How? Panelists explained that while the current credit environment is challenging, it should be manageable and should not lead to another prolonged selloff. That said, panelists agreed that default rates will continue to rise sharply into the high-single digits, peaking in the next 12-24 months, as recovery rates trend down into the 50s.
Speaking of defaults, 2020 has seen the odd confluence of rising default rates (and bankruptcies) and increasingly aggressive documentation. Our legal panels deconstructed each trend. The “Bankruptcy Blitz” panel, featuring partners from Sidley Austin, focused on some of the changes to bankruptcy practices resulting from the wave of pandemic-related filings. Major takeaways included (i) it’s getting rough out there; sponsors are engaging in liability management tactics that can profoundly impact recoveries for senior secured creditors; (ii) bankruptcy cases are being filed in jurisdictions, like Houston and Richmond, whose judges are sophisticated and predictable and that offer efficient and transparent technology; (iii) while the market for “DIP” loans is fiercely competitive, some DIP loans can be quite risky because of the effects on cash flow of the pandemic; and (iv) “SPACs” have become new and plentiful sources of capital for companies in Chapter 11.
But even as defaults and bankruptcies climb, the extreme supply/demand imbalance of the loan market has driven the return of aggressive credit agreement terms since August, said a panel of partners from Kirkland & Ellis, Davis Polk, Morgan Lewis and Sidley Austin. Toward the end of 3Q20, the impression of an overall robust loan market has dominated, fueled by a rigorous borrower self-selection process that has seen only certain borrowers accessing the market. Borrowers that have successfully closed deals have generally done so with favorable covenant packages that mirror those available pre-pandemic, including significant flexibility to incur senior leverage, broad EBITDA addbacks, and investment capacity, including capacity of the sort that permits the drop down transactions similar to J. Crew.
While the default and document swings we’ve seen this year are extreme, they also reflect the waxing and waning credit cycle to which we are accustomed. But a massive secular change is looming as well: The End of LIBOR. Experts from J.P. Morgan, Bank of America and KKR discussed the likely timing of cessation (end of 2021), when Hardwired LIBOR Fallbacks will start emerging (now!), when new SOFR loans are likely to emerge (likely second quarter 2021) and what they are doing to get ready (organizing with their customers, revamping loan documentation and systems to handle SOFR, identifying all their LIBOR exposures and determining their LIBOR remediation plans).
The LSTA would like to thank our 2,000 registrants and 20 sponsors for the support that allowed us to host an all-virtual (and all-free!) 2020 Annual Conference.
