The cost of protection

Uncertainty surrounding the UK Government's second banking bailout was cleared up following the release of a term sheet in late February. The scheme is designed to boost confidence in the sector by guaranteeing certain assets held by participating banks, with the Government promising payments covering 90% of the asset value once a pre-specified initial loss has been taken by the institution.

Behaviour analysis

Though theoretically simple and effective, it is important to consider how the scheme is likely to affect the behaviour of banks vis-a-vis private equity. Significantly, although protected creditors should now be able to confidently attribute a value to the assets on their balance sheets, this hypothetical amount could still be considered less attractive than cash value.

This could potentially derail attempts to restructure portfolio company debt, as payments are only forthcoming following the occurrence of a "trigger event" - namely a default or an event that effectively constitutes a default (such as bankruptcy). The implication is that these creditors will be less motivated to reach a quick resolution and realisation of a distressed debt; and may prefer to allow a default to occur rather than negotiate a traditional consensual standstill agreement.

Beyond the issue of private equity firms trying to preserve value in their investments, this could have a detrimental effect on the survival prospects of the target company. "Businesses suffer if they cannot get quick measures in place in the event of a covenant breach or looming default; when the market gets wind of potential problems it can be commercially damaging," explains Corinna Mitchell of law firm Dechert.

Reduced options

Furthermore, there are several restrictions to what can be done with assets that are subject to the scheme.

1. They are not allowed to be transferred away from the participants, which could have knock-on effects in the distressed debt market. Indeed, with two of the largest leveraged finance lenders across Europe in recent years - Royal Bank of Scotland and the new Lloyds Banking Group - already signed up to the scheme, the volume of trading on the secondary market could see a sharp decline.

This will concern those investors (and LPs) that have joined the rush into distressed debt in the last year, not least because there may be a reverse of the steep downward trajectory in pricing.

2. Participating institutions are restricted from gaining direct or indirect control of any business related to a covered asset. This means that certain debt-for-equity swaps are off the cards if they would result in the creditors gaining a controlling interest in the company in question. Though this is not all that common, in Mitchell's words it does result in the "menu options of some restructurings being reduced."

3. Finally, once debt has become subject to the scheme, any subsequent refinancing can only be completed with HM Treasury approval. This will increase the complexity of future restructurings and is likely to lead to the sorts of issues seen with Icelandic banks, with decision-making becoming a much more time-consuming process.

Upping the ante

This last point may actually deter banks from eagerly allowing companies to default in order to gain protection under the scheme, as they will likely wish to avoid too much Government involvement in their dealings. It is also worth noting that participation in the scheme does come with terms, such as a cap on remuneration of employees, which may also cause institutions to avoid utilising the scheme where possible.

But despite these drawbacks, participating creditors are likely to have a changed approach and will no longer easily fold on terms in favour of a quick cash solution. Pressure will therefore be on private equity firms to make sure that any offer to a lender is better than that available simply by allowing a default to occur. "Though banks must attempt to mitigate losses, natural forces will tend towards a new mindset. Creditors involved in the scheme will have a different agenda now and there will need to be a substantial commercial incentive for them to act," Mitchells concludes.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• Regulation
• UK / Ireland