LONDON (LPC) - Aggressive documentation on European leveraged loans is highlighting the role of lawyers that work for private equity firms and also represent the banks lending to sponsors’ buyout loans.
Investors and banks are now declining aggressively structured deals and some are questioning private equity firms’ ability to exercise control over deals by selecting and paying for banks’ lawyers.
“As a lawyer you have an ethical duty to act for the best interests of your bank client, but the sponsor is picking up the fee so naturally you don’t want to upset them either,” a banking partner said.
Investors often do not have legal representation, and use services such as Covenant Review and Debt Explained to review deal documents, while private equity firms pay for arranging and participating banks’ lawyers.
Legal fees are likely to remain a contentious issue for the broader market until banks pay for their own representation, a banking partner at a law firm said.
“No one is stopping the banks paying their own fees but they don’t want to hit their profits,” he said.
Hard designations, where private equity firms instruct their banks to use specific law firms, are more common in Europe than New York, where banks sometimes pay their own fees, and are being seen more frequently.
Private equity firms originally designated law firms to ensure that they were working with trusted partners and to avoid multiple legal opinions on the same deal. But the motive may have changed as documentation has grown more aggressive, the second lawyer said.
Potential problems could also arise if private equity firms’ lawyers advise them to use other law firms for the banks, who then feel compelled to return the favour, the second lawyer said.
“You’re almost taking the client out of the equation in that situation,” he said.
Private equity firms often meet objections to documentation by telling banks to pay for their own legal representation or be removed from the deal. Banks’scope to negotiate on documentation via their appointed counsel is now considerably smaller, another lawyer said.
“Now, what seems to happen is that law firms for sponsors serve up the terms and that’s just it,” she said.
Some banks have responded by hiring lawyers with documentation expertise to their syndicate desks for a second opinion to “take the sting out of their general counsel,” the second lawyer said.
Market participants view the growing prominence of sponsor-focused law firms in particular as a significant change, who are often identified as driving the aggressive terms.
“The sponsor-focused law firms can be the bad cop. I know that these firms openly say to a sponsor ‘we couldn’t care less about whether the banks or investors lose money’,” the second lawyer said. “These law firms get paid twice as much, end up getting a load of terms that the sponsor doesn’t need and then say they’ve now got market precedent.”
Sponsors are succeeding in removing lender protections including provisions that give them more flexibility to make add-on acquisitions, the ability to limit cash sweep protections, which repay debt with excess cashflow, and are seeking to limit the use of sale proceeds to repay debt or reinvest.
Moody’s said this week that cash sweep protections are now at their weakest level on record.
One of the most common complaints from leveraged finance bankers and investors is that law firms are applying aggressive documents designed for large, liquid loans to riskier smaller middle market companies.
The £300m term loan B backing Carlyle’s buyout of Accolade Wines,for example, has similar debt incurrence capacity to the largest deals in the market.
Moody’s noted that only 5% of term loan Bs issued in EMEA in 2017 had more than one covenant, and a negligible amount of deals had a full suite of creditor protections.
While some investors are questioning the close relationship between private equity firms, their lawyers and lenders, a large supply-demand imbalance is giving sponsor the upper hand.
A lack of deals is forcing investors to continue to accept the erosion of lending terms in return for yield to avoid sitting on cash.
“In Europe the economic power of the sponsors drives the market more, whereas the US is more precedent-driven,” the first lawyer said.
Having a variety of law firms working on the same transaction can prove very expensive, a third partner said, and the move to one designated firm highlights the growing commoditisation of the private equity business model. It is also a function of competition among law firms in a hot market, a leveraged finance head said.
“Like the bank market, the law firms are also slightly cartelised. If you’re a new entrant, you’ve got to compete hard. In the last two to three years, maybe one or two firms have made a very strong push,” the leveraged finance head said.
The European leveraged loan market has also moved in line with the larger US market in terms of deal structures and documentation, as the institutional buyside has developed following the financial crisis, and these changes are also reflected in the legal market.
“Fundamentally the European legal market has shifted since the crisis to the US firms, which are more entrepreneurial and deal-driven. They’re businesses, not clergy, and maybe the market just hasn’t adjusted to that yet. The terms are very different now but the client service is also astronomically better,” the leveraged finance head said.