May 4, 2016
The changing regulatory landscape in the wake of the global financial crisis has resulted in a number of practical and legal challenges, particularly for those actively lending in the global markets – whether they are banks, financial institutions, funds or alternative capital providers.
One of the most prominent banking reforms implemented to date is the EU Bank Recovery and Resolution Directive (the "BRRD"). The BRRD seeks to establish a common framework for failing financial institutions, notably providing regulators with bail-in powers to write down and/or convert into equity certain liabilities of a failing financial institution. The BRRD requires that an "EEA financial institution" includes the contractual recognition of a bail-in clause within almost all documents to which it is a party and which are governed by the law of a non-EEA country under which the financial institution incurs, or could incur, a potential liability. The contractual recognition is designed so that the other parties to the agreement acknowledge that an EU resolution authority action may impair the financial institution’s liabilities under the relevant contract. In the lending market, these liabilities extend to commitments to lend, indemnification and other such obligations. Whereas those who invested in or were reliant on banks could until now take comfort from the belief that most banks would ultimately be supported by relevant governments, the reality of the European bail-in regime has created uncertainty amongst bank investors that they may be subject to bail-in and consequently suffer loss, thus demonstrating the increasing liquidity pressures faced by banks.
To date, much of the focus and media coverage in this area has centered on banks and the effect of regulatory intervention on their ability and/or willingness to lend. Every cloud has a silver lining, however, and the changing regulatory framework and its impact on banks is having beneficial consequences for other market participants, including direct lending funds and alternative capital providers. The BRRD does not apply to the vast majority of direct lending funds or alternative capital providers and, therefore, they fall outside the scope of the new regulatory framework and are not subject to the bail-in regime. Indeed, whilst there has been some discussion of an EU regulatory regime for direct lending, the early-stage proposals are intended to facilitate rather than limit such funding. Nor do higher capital and tougher liquidity requirements for banks generally apply to direct lending funds. To the extent that this increased regulation, together with the enforcement of US leveraged lending guidelines means that banks are no longer as active in the mainstream European syndicated loan markets, the opportunity for growth in market share by direct lending funds has increased.
We have seen these players become increasingly active since the financial crisis, and several of the major funds in the market have already raised, or are in the process of raising, larger direct lending funds capable of offering a wide variety of alternative capital solutions with big ticket sizes. In addition, in part because of concerns regarding regulatory enforcement, banks are showing a diminishing appetite for what are perceived to be higher risk credits, whether for sector, leverage or other reasons. By contrast, direct lending funds offer more flexibility in this area and have become a viable (albeit slightly more expensive) option for corporates and sponsors, sitting alongside other non-traditional sources of lending. Whereas direct lending funds may once have been seen as relatively small players in the mid-market, of late, there has been an increasing acceptance of their presence and, as their ability to underwrite substantially larger amounts of debt has increased, so they have become significant investors across the credit spectrum and across a range of mid to high cap transactions. In this respect, the European market is beginning to mirror the US market, where alternative capital providers and direct lending funds play a major role, and direct lending has now become a viable option for many credits. As the role of direct lending funds continues to develop, capital structures will also develop to reflect the increased flexibility that direct lenders provide, and in this regard, we expect to see a continued resurgence of second lien and PIK debt, together with more creative ways in which to inject equity into structures.
The new world of regulatory intervention, illustrated by the BRRD, is heralded by many as a reminder of the delicate balance that must be sought between the independence of financial institutions and the involvement by regulators and the state. However, it is equally a reminder that there remain a number of participants in the lending market who can benefit from the consequences of these regulatory changes and the impact on the bank market, and that there is significant scope for these players to become more prominent in the coming months and for more creative structures to develop as a result.
 EU Bank Recovery and Resolution Directive (2014/59).
 Bail-in is automatically recognised in contracts governed by the laws of an EEA country.
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