Legal market overview in United States
The US corporate bond market shrunk in 2018 with debt value dropping by approximately 19%. Although a notable contraction, it comes on the back of six consecutive years of increased corporate debt issuances culminating in 2017 - a year that saw borrowers rush to take advantage of cheap debt to refinance and lock-in deals before the heralded rise in interest rates.
High-yield bond volumes absorbed a larger part of the plunge in debt volumes, while the investment grade market recorded a significantly smaller 12% drop. During 2018, the value of corporate high-yield bond issuance plummeted by 40% year-on-year to $168bn; this represented the lowest total high-yield issuance value since 2009. A bumpy year finished on an ominous note, with no US high-yield bonds offered between November 30 and January 10; the dry December marked the first month since November 2008 that no junk bonds were issued.
Sentiment appears to have shifted going into 2019. Following a 6.7% plunge in oil prices on Christmas Eve, crude soared above $50 a barrel leading to rallies in the junk bond market – the energy industry represents around 15% of the US high-yield market. This recovery saw a return on high-yield bonds of 2.6% during the first week of 2019, which marks the best start to a year since 2009, according to UBS. Midstream energy company Targa Resources was the issuer to end the record 40-day drought with a $1.5bn offering, which had been upsized from $750m due to strong investor demand.
Among the hot areas for debt offerings, financial services was by far the best performing sector and accounted for well over a third of deal activity - the next most active sector was healthcare at 10% of deal activity, and energy came in third at 9%. CVS Health Corp undoubtedly provided the mandate of the year on the debt side; its $40bn notes offering represented the third-largest corporate bond sale on record. Another deal to note was Comcast’s twelve-tranche public offering of $27bn in new debt financing to fund its acquisition of Sky — that deal marked the fourth-largest bond sale in history.
Going forward, rising interest rates and market volatility are expected to create another jittery year for the junk market, with recent swings exacerbating investor fears of end-of-cycle behavior.
In the US equity market, 2018 was a year of two very different halves. A strong start to the year marked the eighth year in a row that the S&P 500 rose in the first six months, with the Russell Micro Index (small cap and micro-cap stocks) and Nasdaq 100 (the largest non-financial companies) posting double-digit gains of 10.2% and 10.1% respectively.
A bumpy end to the second quarter saw the previously robust technology sector falling from a 7% gain during May, to a negative performance during June. The market then went through a period of dramatic volatility, with sudden downswings immediately followed by confident upsurges. This theme was even evident during the more robust first quarter: on 25 days during the first three months of the year stocks climbed or fell by 1% or more. To put it in even more stark terms, the Dow has swung 1000 points in a single trading session only eight times, and five of those swings occurred in 2018. The most extreme example came at the end of 2018, when the Dow and S&P 500 dropped more than 2.5% on Christmas Eve as interest rate concerns, a government shutdown and a potential China-US trade war all weighed heavily on investors. Two days later, on December 26, a post-Christmas rally saw the Dow close more than 1000 points higher — its biggest points gain in history.
Eventually, after a turbulent December, US stocks posted their worst annual performance for a decade. Only for the tone to change again at the beginning of 2019 as increasing optimism surrounding US and China trade talks saw stocks recover.
Although the end of the year was blighted by spooked investors and stalled equity offerings — exacerbated by the government shutdown and the accompanying impact on the SEC — several headline issuances did take place. Interestingly, IPOs (arguably the bellwether for the capital markets) actually performed well year-on-year: equity IPO value increased by around 3.7%, while deal count was also slightly up. The most important float of the year was undoubtedly Spotify Technology, which eschewed a traditional IPO in favor of a groundbreaking direct listing that valued the company at $26.5bn. The three hottest sectors for equity offerings by deal value were financial services (25%), healthcare (21%) and technology (16%).
Global equity capital markets volumes were down as well in 2018, falling from $781bn to $688bn; however, it was a solid year for IPOs. The value of global IPOs increased by just under 5% to hit $208bn, although deal count was down slightly. On the debt side, global debt capital markets activity recorded an 8% slide compared to 2017.
As a general theme, stock markets finished down across the US, Europe and Asia, with the FTSE All-World index (an index that tracks over 3,100 companies in 47 countries) showing a 12% decline – this is against a 25% gain in 2017.
That said, although 2018 was a challenging year for mature markets, it was slightly more promising for some emerging markets. Latin America was among the market stars, with the region as a whole posting an 8.2% climb and Brazil’s Bovespa increasing by 15%. Rising oil prices also lifted the Middle East, with Qatar, UAE, Saudi Arabia all posting gains. Other strong performers included Russia and Israel.
CLOs were the big story in the securitization space this year. In early 2018, the Court of Appeals for the DC Circuit ruled that Dodd-Frank does not authorize federal agencies to subject CLO managers who acquire collateral for deals on the open market to risk retention regulation. This only applies to open-market CLO managers, however; it does not apply to middle-market CLOs. The court’s ruling in this case was expected to boost new issuances, and it certainly has; or at the very least it has been correlated with new issuances. Following several years of heavy refinancing/reset work, new issues reached record levels in 2018. That said, some firms are still concerned with European risk retention rules in the future, but the most pressing issue for CLOs are the germinal Japanese risk retention rules. Japanese investors are among the most active (if not the most active) investors in US CLOs, and Japan is looking to introduce risk retention rules that could undo some of the legal victories won by managers in the US. These proposed regulations are in the very early stages however, and it is not yet clear what adjustments will need to be made.
There were also some points of note in the derivatives space, and equity margin lending in particular. The collapse of Steinhoff International in December 2017 resulted in bank loses of more than $1bn tied up in equity derivatives. After that particular debacle, Bank of America and HSBC both noted sharp rises in quarterly loan impairment (a 40% spike in the case of HSBC). Equity margin lending has remained a relatively active area, though one would expect some of the large investment banks taking more consideration of possible default scenarios, especially given some of the very recent global market uncertainty. Bank of America, Nomura and Citigroup, in particular, have stated that they will be re-assessing the scale of their margin lending in the future.
Despite the intention of some banks to bolster their internal risk analyses as a matter of best practice, federal regulation mandating more stringent risk management - both internal and external - has come under scrutiny. Against the backdrop of almost a decade of tightening regulatory controls aimed at the country’s financial services industry, the Trump administration’s relatively light regulatory touch has come as a welcome relief to banks seeking to make more profitable returns. Indeed, according to a recent study, issuance of financial regulations has dropped to a 40-year low, a strong indicator that the Trump administration is fulfilling its deregulation agenda. While not quite as overarching as the originally proposed Financial Choice Act, the so called ‘Crapo Bill’ (named after Republican congressman Mike Crapo, who proposed the legislation), which was signed into law in May 2018, has diluted some of the most stringent regulations imposed by Dodd-Frank. Most significantly, by raising the threshold (from $50bn to $250bn in total assets) for which banks are considered significantly important financial institutions (SIFIs); the bill has reduced the number of banks that are automatically subject to Dodd-Frank’s enhanced supervisory regime. Under the new legislation, banks with assets of less than $100bn would be freed of current oversight requirements, and those between $100bn and $250bn would no longer be bound by tougher rules after 18 months, although the Federal Reserve can, utilizing its own discretion, determine periodic stress tests and other tailored oversight measures. While the bill received the bipartisan support necessary to pass through Congress, it has received a significant level of criticism from prominent Democratic politicians, including Nancy Pelosi, Elizabeth Warren and Maxine Waters, who have argued that the weakening of regulations could potentially lead to a repeat of the financial crisis of 2008. The legislation has primarily impacted the community and regional banking space, with money center banks still largely unaffected by the regulatory rollback. As a caveat to that, however, there is considerable policy activity and discussion regarding a potential rewrite of the controversial Volcker Rule, which prohibits banks engaging in proprietary trading. Following the Democratic Party’s successes at the midterm elections, however, there is expected to be (at least until 2020) a significant pushback against Republican-led deregulation. Moreover, with the GOP still holding a majority in the Senate, market commentators expect an impasse on legislative change in the financial sector.
Fluctuations in the debt and equity markets in addition to regulatory and geopolitical uncertainty brought two years of unimpeded growth to a halt in the final quarter of 2018 as rates rose and covenants tightened. For most firms ranked in the commercial lending tables, whether the focus be on borrowers or lenders or both, the brief hiccup proved a salutary reminder of the importance of diversification. Debt capital markets and acquisition finance work might have taken a breather as the markets corrected, but other areas picked up the slack, such as refinancing and restructuring. The energy crisis has somewhat abated, however oil and gas restructurings continue to provide significant work, particularly for firms with a solid footprint in Texas. The ‘Amazon effect’ continues to plague retail, the Chapter 11 filings of Sears and Toys ‘R’ Us being the most prominent cases producing significant work in the market. Cross-border work, notably in Latin America, is keeping many firms busy. Outside of Venezuela, the landmark case in this area being the bankruptcy of Brazilian telecoms giant Oi. A trend towards out-of-court prepackaging is paradoxically running parallel to an increase in litigation in the sector, with inter-creditor disputes becoming more frequent. The major matter going forward is sure to be around the possible bankruptcy filing of Pacific Gas & Electric, with the company potentially liable for billions in damages caused by the California wildfires.
The market for Chapter 9 filings, however, continues to be slow, driven as it is by economic cycles. The landmark case is still Puerto Rico, the largest municipal bankruptcy in US history, which dominates the market and generates the majority of work in the sector. In a more recent development, inter-creditor disputes are rising. In terms of the big picture, structural deficits at the municipal level have not gone away, meaning the prospects of increased distress have been temporary allayed but remain tied to the next economic downturn.
Finally, the importance of private credit funds and alternative lenders in the current economic landscape is becoming increasingly evident. Since private credit funds do not syndicate their loans, the short-term whims of the market have less of an impact on the investments they are willing to make, and as many funds have started pooling their resources through joint ventures, these investments are growing. Almost all of the lender-side law firms listed in the table recognize the importance of this side of the market and are increasingly filling their ranks with specialized private fund lawyers. As most of the credit funds were born in the private equity sector, traditional sponsor-side firms are also following their clients over to the lender side of the negotiating table.