Direct lending in Spain: insights and promising trends

June 2020 | SPOTLIGHT | BANKING & FINANCE

Financier Worldwide Magazine

June 2020 Issue

Bank lending remains the most popular source of financing for Spanish companies. However, the number of direct lending deals led by private debt funds has substantially increased over the past few years. This has been fuelled by greater regulation for credit entities, a lack of leveraged credit to middle-market companies and a rise in investor demand for higher-yielding debt products.

Overview: concept and market players

Broadly speaking, direct lending is an asset-class source of corporate financing whereby a private debt fund (as lender), acting through its manager, provides a loan to a sponsored (private equity-backed) or non-sponsored borrower without the use of an intermediary. Private debt funds raise capital from a wide array of professional or institutional investors with an appetite for attractive risk-adjusted returns derived from robust long-term projects, acquisition finance, real estate development, reinvestments or restructurings. Borrowers, in turn, often seek to receive private debt funding through levered non-recourse project finance structures, which in many cases involve the setting-up of special purpose vehicles (SPV). Their shareholders may be private equity firms or corporate investors, operating either locally or internationally.

Regulatory framework: advantages and drawbacks

Lending in Spain is not reserved for credit institutions. Non-bank financial intermediaries may carry out lending activities without requiring authorisation or registration in Spain. Non-Spanish lenders can thus operate on a cross-border basis or through a permanent establishment or subsidiary. In this context, direct lending funds, despite their significant size (comparable in many cases to that of some banks) do not qualify as credit entities and therefore are not subject to prudential supervision by the Bank of Spain or the European Central Bank (ECB). Thus, rules on solvency – and related capital and own funds requirements – liquidity, supervision, restructuring and resolution of financial institutions are not applicable to direct lending funds.

Falling outside of the regulatory scope of bank supervisors does not mean, however, that direct lending funds are completely unregulated entities. They remain subject to the securities and asset management regulation in their respective jurisdictions of incorporation, and the marketing or offering of interests in a direct lending fund totally or partially addressed to Spanish investors may also be overseen by the Spanish National Securities Market Commission. Likewise, even if subjects merely engaging in the lending business do not require a licence, their lending activity must comply with certain regulations on the prevention of money laundering and terrorism financing, the protection of consumers and the prevention of usury, which focus on the type of activity rendered (lending), rather than the type of entity rendering it.

Finally, private debt funds can generally take security over any assets of the borrowing group on the same terms as a bank lender. However, some types of security (or security-related benefits) are reserved to credit entities or a restricted group of financial institutions, such as: (i) the contractual netting and financial collateral arrangements regime provided for under Directive 2002/47/EC; (ii) floating mortgages, which may secure an indefinite number of liabilities up to a maximum amount; and (iii) certain tax benefits in relation to stamp duty levied on subrogations in mortgage loans.

Financing structures: corollary of private debt strategies

Some of the financing structures typically used by private debt funds, in descending order of seniority, are listed below.

Senior first lien loans. Senior loans benefit from a first-priority perfected lien against the borrower’s assets. The structure and terms of these loans are very similar to those offered by regulated banks (i.e., lower yields and lower loan-to-value (LTV) ratios). One particularity, however, is that direct lenders generally seek to set tighter controls over the borrower’s (or the borrower group’s) ongoing cash flow, in the form of negative covenants in the facility documentation that place a stronger emphasis on distributions, such as dividends and refunds or repayments of shareholder loans.

Unitranche loans. This is a structure used by direct lending funds that combines senior and junior secured credit positions into one facility. The facility bears a blended interest rate that reflects the underlying mix of senior and junior lien risks and is uniformly secured with a first lien on the borrower’s assets. The split of the unitranche facility into senior lien debt (‘first-out’ debt) and junior lien debt (‘last-out’ debt) is instead separately agreed among the lenders as an allocation of risks and a payments waterfall under an agreement among lenders. Unitranche facilities are generally fully drawn at closing and repaid as a single payment upon maturity (bullet) or also through balloon payments and make-whole fees are often agreed for any voluntary prepayment. Borrowers in need of highly leveraged financing may find unitranche facilities an attractive alternative to traditional first lien senior loans (limited by stricter LTV requirements that often result in lower facility commitments). In contrast with first lien senior loans, debt service coverage ratios and other ratios related to the business cash flow in unitranche loans are often more borrower-friendly as they include less restrictive permitted-payment provisions.

Mezzanine. This form of financing falls between senior financing and equity and is often unsecured. It carries higher yields, but its repayment is subordinated to that of senior debt. In turn, it ranks above equity in the event of liquidation, distributions or restructuring of the borrower. Mezzanine facilities are characterised by long-term maturities with a single bullet payment. Voluntary prepayment is generally subject to higher make-whole fees than senior loans.

Hybrid structures. Some private debt funds are even open to acquiring a minority stake in the borrower’s share capital simultaneously to providing debt financing, in order to have partial access to the borrower shareholders’ potential upside in the form of dividends. This might result in less predictable, but potentially higher, yields for the fund and its investors. Direct lending in Spain sometimes also takes the form of participating loans, which bear an interest that is indexed to the borrower’s business performance and are treated as the borrower’s net equity for some corporate law purposes.

Some characteristics of direct lending

Given the distinctive features of direct lending funds, it is not unusual to find some dedicated contractual provisions in the facility documents or particularities that affect the deal negotiation process. Below are some examples.

Purpose of the financing. A significant part of the funding provided by direct lenders is intended to finance event-driven strategies, such as real estate projects, acquisitions or restructurings (also in distressed markets). It is nonetheless true that funds are gradually becoming keener to finance a borrower’s working capital needs.

Swiftness in the financing assessment process. The risk management assessment process carried out by direct lenders is generally fast and allows a final decision on the approval or rejection of complex and sophisticated deals to be made quickly. For instance, direct lending is particularly relevant in event-driven financing in relation to which time is of the essence, such as competitive acquisition processes.

Term and repayment. Because private debt funds are not as corseted as credit institutions in the process of maturity or liquidity transformation, they are more willing to lock up capital and seek strong long-term returns in line with their investors’ enhanced yield expectations. Perhaps for this reason, bullet repayments (as opposed to amortising loans) are a distinctive feature of direct lending in Spain.

Interest. In direct lending deals, interest rates paid by borrowers are commonly higher than those negotiated in bank lending given that the business strategy of private debt funds towards their investors is to provide an appealing source of returns on a risk-adjusted basis through illiquid and less volatile investments.

Financial covenants and other obligations. Direct lenders seek to control capital structures with maintenance financial covenants (in the form of financial ratios) tailored to the cash flows from the project or transaction to which the financing is applied. Although covenant-lite structures are popular in the US and UK markets, they have yet to gain traction in the Spanish market. In an attempt to secure direct access to cash flows, direct lending facility documentation often contains reinforced financial reporting obligations, make-whole provisions, restrictions on prepayments, ongoing cash sweep and minimum liquidity provisions and, in the case of capital-intensive businesses, maximum capital expenditure covenants.

Security package. Because private debt funds are not subject to the solvency, accounting and capital regulations affecting financial institutions, they are more likely to focus only on taking security over the key assets of the project, undertaking or investment that receives financing, as a form of downside protection. Market practice in Spain for leveraged loans remains, however, that lenders almost invariably receive a full-fledged security package (e.g., pledges over shares, bank accounts, receivables, key operational agreements and insurance agreements, as well as mortgages over property and, in some cases, machinery or intellectual property (IP) rights).

Bank accounts. As non-credit entities, private debt funds cannot open bank accounts for customers for the purposes of making loans available to them. The utilisation of a facility and payments to be made by the borrower thereafter (e.g., interest or principal payments) thus often require the involvement of a third-party partner account. The facility documentation or the utilisation request form often specify the terms on which the funds will be made available to the borrower and the payment mechanics to ensure timely utilisation, such as the delivery of cheques or the disbursement of the loan directly to a third-party payee’s account.

Direct lending in Spain after Brexit

Some foreign direct lending funds operating in Spain have traditionally followed the standard form templates published by the Loan Market Association (LMA), which by default are subject to English law and to the courts of England and Wales. However, submission to the exclusive jurisdiction of the English courts, as well as the recognition and enforceability of their judgments in Spain, face uncertainty in the aftermath of Brexit. Unless measures are adopted to address the issue prior to 31 December 2020, Regulation (EU) No 1215/2012 on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters and the Hague Convention of 30 June 2015 on Choice of Court Agreements will cease to apply in the UK.

A number of alternatives have been suggested to bridge the gap between pre- and post-Brexit scenarios, such as the UK’s accession to the 2005 Hague Convention, to the Lugano Convention of 21 December 2007 on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters, or to the Hague Convention of 2 July 2019 on the Recognition and Enforcement of Foreign Judgments in Civil or Commercial Matters (which is not yet in force). None of these initiatives, however, appear to have crystallised as of the date of writing this article.

In parallel, other private lending funds typically choose Spanish law as the governing law of the facility documentation and submit any disputes to the Spanish courts, a trend which is becoming more popular even among non-Spanish funds – perhaps, partially in response to the uncertainties brought about by Brexit. One of the benefits of such an election is that under Spanish law an authorised transfer by the lender of its rights and obligations under a loan to a third party – known as ‘novation’ under English law, as opposed to an ‘assignment’, which simply involves the transfer of rights, but not obligations, under an agreement – does not, per se, entail the cancellation of the underlying security interests or jeopardise the validity and enforceability of such security interests in the event of the insolvency of the borrower. The choice of Spanish law and courts for the facility documents may therefore strengthen the synergies with the security package – which, when perfected over the borrower’s assets located in Spain, will almost invariably be governed by Spanish law – and contribute to its smooth enforcement by the lender.

These synergies also become apparent if the borrower undergoes a debt restructuring process in Spain. While English law governed schemes of arrangement have been used occasionally during the last decade to restructure the debt of Spanish borrowers, Spanish pre-insolvency debt restructuring mechanisms are fully consolidated tools that have been widely used in most large debt restructuring processes that have taken place in Spain in the last five years. These may turn out to be more effective, especially if the (Spanish) borrower’s creditors are atomised, in which case, the Spanish homologación judicial mechanism may be used to ask a Spanish court to impose a cram-down over the dissent of certain classes of creditors.

Conclusion

On balance, direct lending seems to be gaining momentum in the Spanish market as a flexible alternative to bank lending. Private debt funds are capable of meeting the increasing financing demands of certain borrowers and activity segments with limited access to traditional sources of financing, in exchange for generally higher yields, tight controls on borrowers’ cash flows and some characteristic provisions in the contractual documentation, which is swiftly negotiated and tailored to the borrower’s financial and commercial needs. It remains to be seen, however, how direct lenders will react to upcoming events such as the end of the Brexit transition period and whether this will have an impact on the content of the financing agreements entered into with Spanish borrowers.

As a final reflection, following the COVID-19 outbreak in Spain and the ensuing economic impact, a significant number of direct lenders have acted swiftly and are proactively offering working capital solutions to help with stretched liquidity in the short and medium term. Fully cognisant that time is currently of the essence for many Spanish borrowers, private debt funds are designing standard form template facilities with more flexible security packages to streamline the subscription process. Similar to the financial crisis of the late 2000s and early 2010s, direct lenders are now presented with a major opportunity to access new customers and fill gaps in the market. Perhaps the only difference with that earlier period is that many direct lenders are no longer newcomers to the Spanish market and their existing credit portfolio may now also feel the effects of a deteriorating economy.

Eloi Colldeforns is a senior associate and Josep Moreno is an associate at Uría Menéndez. Mr Colldeforns can be contacted on +34 934 165 131 or by email: eloi.colldeforns@uria.com. Mr Moreno can be contacted on +34 934 165 615 or by email: josep.moreno@uria.com.

Eloi Colldeforns and Josep Moreno

Uría Menéndez