IFR 02.29.2020

10 International Financing Review February 29 2020

Top news

ESG reframes weak covenants

as governance issue

„ People & Markets ESG strengthens investors’ argument for tighter covenants

BY TESSA WALSH

Leading global asset manager

Federated Hermes is looking at

an old problem through a new

ESG lens and is calling for weak

covenants embedded in private

equity buyout debt to be

REDElNEDûASûAûGOVERNANCEûISSUE

Deteriorating covenants have

been the scourge of

institutional investors in recent

years and are now as weak as

they have ever been, as

AGGRESSIVEûLAWûlRMSûPAIDûFORûBYû

PRIVATEûEQUITYûlRMSûSTRIPPEDû

investor protection from deals

to compete for business.

A push to reframe the thorny

problem as a “G” problem in the

ESG spectrum could be a less

contentious way of discussing

covenants with sponsors, and

coincides with other initiatives

by trade associations, including

the European Leveraged Finance

Association.

“Of all the issues in leveraged

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DIFlCULTvûSAIDû-ITCHû2EZNICKû

head of research and sustainable

lXEDûINCOMEûATû&EDERATEDû

Hermes. “Covenant design and

construction is a measure of

how the shareholders balance

THEûINTERESTSûOFûALLûlNANCIALû

stakeholders. That’s why it’s a

governance issue.”

#ASHûRICHûPRIVATEûEQUITYûlRMSû

have been slow to the

sustainability party, but are

facing increased pressure on ESG

from their own end-investors and

lXED

INCOMEûINVESTORSûAFTERû

nearly a decade of excess demand

in a bull market has allowed

them to play hardball with

investors chasing yield.

The push to reframe weak

covenants as an ESG issue could

prove to be an effective lever to

bring private equity to the table,

as investors continue to push for

ESG disclosure and sponsors

start to adopt their own

corporate social responsibility

programmes.

“Whilst covenants are, a priori, a

governance issue, the momentum

in ESG is an opportunity to

reinvigorate the case for covenants

that are amenable to the whole

market,” Reznick said.

Federated Hermes is a leading

ESG investor with US$5756bn of

assets under management

following the combination of US

investment manager Federated

Investors and Hermes

Investment Management in

February.

Hermes has a more than 10-

year track record in ESG

investing and was seen as a

world leader in the space by

Federated Investors, which is

currently integrating Hermes

ESG factors into its products.

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53ûOFlCE

SHARINGûSTART

UPû

Deal-contingent options:

risky business gets riskier

„ People & Markets Banks slug it out to provide cross-border hedges

BY CHRISTOPHER WHITTALL

When Montagu Private Equity

agreed to buy part of US medical

lRMû24)û3URGICALûINû*ANUARYûTHEû

European investor wanted a way

to avoid losing out if the euro

fell materially against the US

dollar before the US$490m deal

closed.

Notable hurdles remained to

the acquisition getting over the

line, including a shareholder

vote and sign-off by the US

government. But that did not

STOPûBANKSûCOMPETINGûlERCELYûTOû

provide a risky type of derivative

contract that would let Montagu

hedge its currency exposure

cheaply.

Such deals have become

commonplace as the market

for so-called deal-contingent

options has roughly doubled

in size over the past few

years, according to industry

experts.

.OWûINTENSIlEDûCOMPETITIONû

to provide these hedges against

the backdrop of historically low

currency volatility is raising

questions over the rigour of

banks’ underwriting processes –

and whether some could be

opening themselves up to

meaningful trading losses down

the road.

“There are valid questions to

be asked over whether

underwriting standards are

slipping. Accidents will happen

at some point. It’s been

going remarkably well for a

sustained period, and that’s

unlikely to last,” said Jeroen

Rombouts, co-head of corporate

derivatives in EMEA at Goldman

Sachs.

Deal-contingent derivatives

trace their origins to private-

equity deals in the mid-2000s.

For clients, they look like the

perfect hedge: a derivatives

contract that protects against

adverse currency moves in the

months between when a cross-

border acquisition is announced

and when it closes. The best bit:

if the deal fails, you can walk

away without paying for the

derivative.

For the banks that provide

them, though, they are fraught

with risks. If a deal falls through,

THEYûCOULDûlNDûTHEMSELVESûONû

the hook for sizeable losses if

currency markets have moved

against them.

Most banks that have long

been prominent in this space

have seen deals fail over the

years, including Citigroup,

Credit Suisse, Deutsche Bank

and Goldman Sachs, according

to sources familiar with the

matter. No major blow-ups

have come to light so far,

though some believe it may

only be a matter of time given

the number of new entrants to

the market.

“It’s a risky product for the

banks. We’ve seen a number of

public deals go wrong. It’s not a

pile them high and sell them

cheap kind of business,” said

Tim Owens, EMEA head of

structuring at Nomura.

Note: By value including net debt of target

Source: Refinitiv

0

200

400

600

800

1,

1,

1,

1,

Announced cross-border M&A Withdrawn cross-border M&A

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

US$bn

GLOBAL CROSS-BORDER M&A - ANNOUNCEMENTS AND FAILURES

4 IFR Top news 2322 .p 4 - 14 .indd 10 28 / 02 / 2020 19 : 41 : 47