LOS ANGELES — The use of direct lending continues to increase among municipal issuers in California, not just to restructure existing transactions, but increasingly for new money borrowing, according to industry experts.
"What I'm seeing is that issuers are looking to direct placements and direct lending for new money issuances and new financing structures," said Rudy Salo, a partner at Nixon Peabody LLP. "I'm seeing more and more movement away from just using direct placements as a replacement for refundings, and I think there's going to be a lot more new money issuances in the direct lending world."
Salo, who said a significant part of his practice is direct lending, discussed the increasing trend with other speakers during a panel at The Bond Buyer's recent California Public Finance Conference here.
The market for direct lending has been growing since 2009, when bank credit enhancements, such as letters of credit, became more expensive for municipal issuers. This was due in part to bank downgrades following the financial downturn, and an expectation that future regulation, such as Basel III, would increase costs for banks. As a result, banks could still provide LOCs, but charged more.
As LOCs that backed variable-rate debt started to expire, issuers began looking to direct lending as an alternative. Since then, much of the municipal direct lending market has consisted of refunding money.
From banks' perspectives, direct lending has been a way to get away from contingent liabilities and the expected increase in capital requirements, according to Readie Callahan, vice president of public finance capital strategies at Wells Fargo.
"At first, direct purchases were really a variable rate alternative, but since that time, they've really become more of a robust product," Callahan said during the panel. "We do anything from floating rate to fixed rate and anything in between."
Direct lending is a broad term that can encompass a number of financing types, including bank loans, direct purchases, private placements, and even revolving credit facilities.
Public finance attorneys at Nixon Peabody have been working on an alternative to direct placements that is similar to a revolving credit agreement.
Salo said they recently closed a transaction where a very large issuer was considering a commercial paper program, but after discussions with banks, they came up with an alternative.
Rather than having a CP program where the issuer would have to put together an offering memorandum, secure ratings, and hire dealers, the issuer entered into a revolving credit agreement and could borrow and re-borrow up to $200 million from banks over a three-year term.
"We're seeing a lot more of these come to market," Salo said. "There are some banks that don't want to own securities and, for many reasons, want to structure these as pure loans, and this product is something that's come about from that."
For issuers, direct lending offers certain advantages over borrowing in the public market, including fewer requirements, such as to prepare an official statement or obtain ratings, fewer upfront costs, including no underwriter's takedown and lower legal fees, and greater flexibility, in general.
"Greater flexibility can also translate into more of a custom-tailored credit agreement with specific types of covenants that are particular to that financing," said Diana Chuang, another panelist, who is a shareholder in the public finance department at Richards Watson & Gershon.
The bank can adjust the terms and structure of each transaction to fit the needs of each individual issuer.
In addition, the issuer does not have to do a roadshow or make investor presentations, so these transactions are able to be completed a lot faster than is possible in the public market.
For example, Callahan pointed to a recent deal where an issuer was ready to offer a refunding at the beginning of the summer, but when interest rates started to climb, it could no longer meet its savings targets.
When rates became more favorable in September, Callahan said the issuer was able to do a direct placement and quickly price the deal within a day's notice.
"In the capital markets, you may have disclosure that's stale, and you still need to market the transaction," Callahan said. "But we were able to price and close well within the time that would normally be needed for a traditional fixed rate bond."
Direct lending has also been an attractive alternative to floating rate notes lately, according to Callahan. Issuers that have found FRN deals difficult to price — whether it's due to the large size of a deal or an increase in spreads — have been able to instead take out direct placements at lower costs.
To be sure, direct lending also comes with its disadvantages. Banks can impose stricter requirements and tougher covenants, including tender rights or consent requirements. The most commonly referenced downside, however, is the lack of transparency.
Currently, there are no disclosure requirements for direct lending transactions, although there have been efforts to encourage issuers to voluntarily disclose such information.
In May this year, a municipal bond market task force, which included the National Federation of Municipal Analysts and National Association of Bond Lawyers, issued a paper urging issuers to consider disclosing the information. The paper discusses how, when, and what information to disclose.
Chuang said one of the issues with disclosure, or lack thereof, is the question of how direct lending will impact the issuer and the bondholders.
"The argument along those lines is that when bonds are issued, there are public documents, there's disclosure filed, and everyone is aware of the bonds that are out there," she said. "But if you get a private bank financing, who's going to know about that? Is that increasing risk for existing bondholders without that kind of transparency?"
In terms of increasing risks, she said existing bond documents already include certain tests that have to be met before additional indebtedness can be issued, regardless of whether it's bonds or bank debt.
But the question of transparency is left open, since there is no legal or contractual obligation to disclose the transaction, and the responsibility falls upon the issuer to voluntarily provide such information.
Callahan said that at Wells Fargo, they encourage issuers that take out bank loans to post the documents to EMMA for transparency purposes. However, whether that happens will depend on the policies of issuers and banks.
Since there are no disclosure requirements for direct lending, the exact amount of how much the market has grown over the last five years is unclear.
Callahan said Wells Fargo currently has around $20 billion in direct placed assets on its balance sheet, and that's just one firm.
Past estimates have put the amount ranging from $10 billion in 2009 to up to $40 billion in 2011. However, none of the panelists could give a more accurate or recent estimate.