Banking and Finance in Germany: an Introduction

After a very promising start to the year – with the effects of the COVID-19 pandemic petering out, a strong pipeline of sales processes and prospective IPOs – the start of the war in Ukraine brought the markets to a sudden halt. Within weeks the equity markets were shut, IPOs were postponed or aborted, and debt issuances became more difficult and expensive. Just a few months later, Germany is heading towards a recession, with a high inflation of more than 9% and rising interest rates.

In all this turmoil, it is difficult to pinpoint the overarching trends, but here are some important themes from the past months.

LIBOR Phase Out

In light of the discontinuation of most LIBOR settings from 1 January 2022 and the impending discontinuation of the remaining settings, LIBOR (historically one of the main interest rate benchmarks for US dollars and other currencies) had to be replaced by new, risk-free rates. Whilst this was comparatively simple in new transactions, amending legacy documentation was often a laborious exercise. The sample documentation developed by the Loan Market Association was quickly accepted by the market, making amendments less contentious but still technically demanding.

The so-called credit adjustment spread (CAS) became the focal point of discussion between the parties on both sides. The CAS was historically fixed in March 2021 based on a five-year historical median calculation to reflect the difference resulting from the term credit risk premium built into the LIBOR rates but not built into the new alternative/risk-free rates. But even where borrowers accepted the continuing application of the CAS, lenders increasingly insisted on a margin top-up for US dollar and other foreign currency drawings, reflecting the significant increase in funding costs, at least for bank lenders.

Environmental, Social and Governance

ESG continues to be a mega-trend for all forms of lending, with the majority of new financings in the corporate and leveraged lending markets featuring an ESG component. Where it is not possible to agree on a detailed and definitive ESG concept in the new loan agreement (eg, in acquisition finance where the new facilities are negotiated without full access to the target business or where the borrower is still in the process of developing finance-compatible ESG-policies), the parties often agree that an ESG concept shall be developed, agreed and added to the loan agreement within a certain period after closing ("rendezvous clause").

One bank in the lender group frequently acts as ESG co-ordinator and in such capacity provides guidance on ESG criteria and helps to implement the consent and amendment process. In most transactions, tailor-made key performance indicators (KPIs) were favoured over an external ESG/sustainability rating, but lenders are typically open to both. The ESG margin ratchet can be very moderate (eg, plus/minus 2.5 basis points in corporate loans), but even where there is hardly any pricing incentive, ESG provisions are highly valued by the parties and will soon become indispensable.

Run on Refinancings

In light of the rising interest rates, many borrowers (corporate and leveraged alike) scrambled to refinance early and lock in favourable financing terms. While the public debt capital market became very difficult early in the year for cross-over and sub-investment grade credits, bank lending and the Schuldschein market remained open, albeit on much less attractive terms. The leveraged finance market saw a dearth of attractive target companies and, given the macro-economic risk factors, the focus shifted to tech-heavy and asset-light businesses, ideally with no Ukraine/Russia exposure and no reliance on discretionary consumer spending.

The Re-emergence of Hedging in Finance Documents

In the financing transactions that made it over the finish line, one particular point was in the spotlight again after a long time: interest rate hedging. With the negative reference rates in past years, and the comforting belief that any rise in interest rates would be smooth and protracted rather than sudden, hedging was mainly left to the borrowers and their commercial prudence. In many deals, there was no mandatory hedging requirement or the mandatory hedging was deferred until such time when the reference rate (eg, EURIBOR) would exceed a certain level.

In the new environment, lenders are keenly focused on the borrower's interest rate protection and demand a minimum interest rate hedging fairly soon after closing, with demands for coverage as high as 75% of the nominal loan amount and a minimum duration of the hedges. Most borrowers were not concerned by these demands, as they intended to enter into interest rate hedges anyway, but lenders met with resistance where attempts were made to prescribe the type of hedging instrument, the hedge counterparties and further details of the hedge.

Mandatory hedging provisions are expected to be a common feature in leverage and cross-over loans, but it is unlikely that lenders will micro-manage the borrower's hedging strategy with detailed hedging provisions.

Annualised Recurring Revenue Covenants

Financings for businesses in high growth sectors, particularly for "software as a service" and similar business models, saw a trend towards a new financial covenant model: annualised recurring revenue (ARR) covenants. Typically offered by debt funds rather than bank lenders, this type of financing can be very attractive for borrowers in a venture capital-like stage of their development, where their business is either not yet generating positive EBIDTA ("pre-EBITDA") or the EBITDA is insufficient to support a conventional leveraged-based (ie, multiple of consolidated EBITDA) financing.

In an ARR financing, the debt quantum is measured against annualised recurring revenue. Recurring revenue is typically generated from long-running service or similar contracts, with subscription fees or other recurring pre-agreed customer payments. The ARR covenant is typically a net leverage covenant – ie, the ratio of the net debt of the borrower group to its ARR must not exceed a certain level.

To enhance lender protection, this is often combined with a minimum liquidity covenant to ensure that lenders can react where the ARR still holds up while the business is running out of cash. This covenant converts into a traditional net debt to EBITDA-leverage model at a certain point in time, often expressed to be the earlier of a borrower election and an agreed date.

During the growth phase and the application of the ARR covenant, the finance documentation often contains additional features designed to protect the cash position of the group, such as generous PIK toggle options, but, more generally, the loan agreements take the form of a conventional unitranche documentation. This trend in leveraged lending is a relatively recent development and it will be interesting to follow its further evolution.

New Deal Activity and Outlook

General deal activity has been subdued so far in 2022 and, considering the macro-economic circumstances, the outlook is bleak. Larger financings that rely on syndication to institutional investors (such as Term Loan B-financings and high-yield bonds) are likely to remain very difficult but mid-cap financings will also become more challenging and expensive.

Lenders are expected to apply additional scrutiny when analysing business models and credit stories. Will this bring an end to sponsor-friendly "loose" documentation terms? This is unlikely to be the case. It is likely that the parties will focus their attention on numbers and financial covenant protection rather than general documentary terms. But the coming months will definitely not be a time in which sponsors would be well advised to push the finance documentation to new limits.

In corporate lending, the new pricing reality has already sunk in, and many borrowers are expected to seek to refinance/extend their financing facilities as soon as possible, given the uncertainties that lie ahead. If the market should change again towards a lower pricing, existing financings can always be adjusted by way of a repricing, but the same cannot be said for new financings or extensions: if conditions deteriorate, businesses may struggle to secure new or extended financing. The coming months will show if borrowers choose to be proactive or observant.

It is likely that many businesses will be hit by exploding energy costs this winter, and this and other effects of the current economic and political environment will almost certainly result in a number of restructuring situations. The government is readying itself to intervene with subsidies and legislative changes to prevent businesses from prematurely sliding into insolvency – eg, by temporarily shortening the forward-looking period for the determination if a company is overindebted. During the COVID-19 crisis, many businesses proved to be remarkably resilient and gained experience in deploying countermeasures. It can therefore be hoped that a wave of insolvencies will be avoided and that debt markets will recover soon.