Traditionally, a lender seeking to remove all or part of the credit risk on a particular loan from its balance sheet — or to otherwise share the risk inherent in advancing money to a borrower — would look to do so in the physical secondary loan market, by either selling the loan or granting a sub-participation. Should the lender sell the loan outright via an assignment or, more commonly, a novation, usually using a novation mechanic contained in the syndicated loan agreement, it will make a clean transfer of the loan (or that part of the loan being sold) and all risks and rights in the loan (including voting rights) will pass to the buyer.
However, outright sales may only be permitted to certain types of lender, may require consent, can give rise to withholding tax issues for borrowers (or lenders if the gross-up does not apply) and the identity of the buyer will be revealed to the borrower (which neither the buyer nor the seller may want).
Alternatively, where the lender wants to maintain its relationship with the borrower, or the incoming party does not wish to reveal its identity to the borrower, the lender may grant either a funded or an unfunded sub-participation in a loan. An important consideration for a bank seeking to reduce its credit exposure to a company or on a specific loan will be to satisfy the relevant regulatory capital requirements. This is easily achieved on a loan sale and is likely to be achieved on a funded participation where all or part of the original loan is matched with secondary funding structured to behave like the original loan. Since an unfunded participation works much like a guarantee — with money only being paid to the lender upon a default by the borrower — there is a second risk of a default (that of the participant) that also impacts upon recognition for these purposes.
Correspondingly, the participant in a funded participation takes on a double credit risk, on both the original borrower and also the lender that has granted the participation. For these reasons, whether a participation is funded or unfunded, these arrangements are really most suited to banks and highly-rated entities. It is worth observing that the participant is unlikely to enjoy voting rights on the loan or influence key decisions unless the participation (funded or not) is of 100% of the lender’s participation in the original loan.
Another method used by banks to reduce exposure to a borrower involves credit default swaps (CDS). The CDS market is highly developed and liquid in respect of single-name, investment-grade corporate and sovereign entities (the reference entity) in respect of unsecured debt (either bonds or loans). A single-name CDS is an agreement that one party (the protection buyer) will make a fixed periodic payment to the other (the protection seller) in return for a payment from the protection seller upon the occurrence of certain events, such as a default on a debt instrument (a credit event), calculated in accordance with a prescribed formula intended to make the protection buyer whole as regards debt of the reference entity at the time the credit event is declared. Alternatively (and more usually), the protection seller may deliver an agreed quantity of debt of the reference entity in return for the payment of, typically, the par value of that debt. As a result, the protection buyer is able to transfer the risk of a default occurring on debt of the reference entity in exchange for the payment of the premium to the protection seller.
Like loan transfer and participations, a CDS is generally recognised for regulatory capital purposes as transferring credit risk if certain conditions are met. Among other requirements, the CDS must include failure to pay, bankruptcy and restructuring as credit events — although, in the absence of restructuring, the CDS may nonetheless be recognised as mitigating credit risk at a reduced value.
The extension of CDS to syndicated secured loans is one which has been advocated for some time and has been around for a while in the
However, whereas a single-name CDS is based on unsecured credit risk of what is often an investment-grade reference entity, LCDS is very much focused on a specific underlying obligation of a particular priority and is priced on the basis of the secured credit risk. In addition, LCDS addresses certain issues of particular importance in the context of loans, such as refinancing.
While the single-name CDS is a highly tradable product, the development of LCDS has been influenced by the conflicting need to create a product that is both an effective hedging tool for risk mitigation and is sufficiently tradable to ultimately create a liquid market. While in the US — where International Swaps and Derivatives Association documentation has been available for some time — the LCDS more closely resembles a single-name CDS (a result of an LCDS market driven by trading institutions, such as hedge funds, rather than lenders), the European LCDS finds a third way which embraces both these objectives.
One of the principal issues is whether the instrument should allow for the termination of the LCDS upon the pre-payment of the referenced leveraged loan. From the perspective of a person who is purely trading in credit spread, probably not. Yet for specific hedging and synthetic investment in a specific loan, termination on pre-payment is perhaps exactly what the parties want. Unlike the US forms, the European LCDS forms therefore allow for the parties to elect that, upon pre-payment of the reference loan, the LCDS terminates — although if no election is made, the default position is that the LCDS attempts to roll into a substitute reference loan or loans of the same priority secured over substantially similar assets. In addition to this divergence of approach from the
A major advantage of LCDS over loan participations is the much larger pool of potential counterparties (synthetic investors/divestors). Whereas there may be legal, regulatory and practical restrictions on the types of entity which can take a physical position on a loan, no such limitations exist in the synthetic world. In addition, whereas participations in loans assume ownership of rights by the grantor and also introduce unsecured credit risk from one party to the other, with LCDS there are no such issues, enabling hedge funds, other institutional investors and collateralised loan obligation (CLO) managers to participate as possible synthetic investors and divestors, whether or not either party has an interest in the underlying loan itself.
Like a risk participation and a single-name CDS, an LCDS is generally an unfunded product, with the protection seller only settling the transaction on the occurrence of a credit event (and in this respect resembles an unfunded participation) — although there is no particular reason why a funded transaction could not be entered into if the parties wanted to. A more sophisticated approach is for the parties to post collateral to each other to cover the mark-to-market on the LCDS i.e. the inherent potential value (or potential loss) to the parties on the LCDS, at the time taking into account default probabilities.
There are features of LCDS that prospective participants ought to be aware of. Most syndicated loan facilities now permit a lender to disclose information relating to the borrower and the loan to any party with (or who potentially has) an economic interest in the loan — which is usually wide enough to include LCDS counterparties. However, if neither party to an LCDS holds a physical position in the underlying loan, then since information relating to the loan will not necessarily be publicly available, it will not always be possible to know, for example, whether a credit event has occurred. This lack of information and transparency is more the case with European than
LCDS does represent a genuine alternative to traditional methods of transferring or mitigating credit risk, or simply just trading, in the growing leverage loan market. It opens the door to a new asset class to investors who have not previously been directly involved in the loan market and offers a flexibility and type of credit protection that ought to be attractive to both investors and lenders seeking to transfer risk.
Guy Usher and Edward Miller are partners at Field Fisher Waterhouse.
