Aggressive US cov-lite terms revealed

Author: Danielle Myles | Published: 14 Jun 2011
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Borrowers are getting more flexibility in US cov-lite deals than before the crisis. But changing market sentiment is dictating availability from week to week, with some US counsel seeing maintenance covenants creep back this month.

Up to 25% of 2011’s leveraged loans have been cov-lite (according to Standard & Poor’s), which now means no maintenance covenant in term loans but a leverage ratio in the revolver.

The revolver market is thinner than the term loan market, so borrowers have had to accept a financial covenant here, according to Davis Polk & Wardwell partner Joseph Hadley.

But term loan lenders have fought over the past months to include a cross default combined with a 45-day standstill provision, so they can benefit from the leverage ratio. "This has been a hot topic for negotiation in the US," said White & Case partner Eric Leicht.

But a cross acceleration provision has now become the norm in cov-lite deals, said Hadley.

One of the biggest differences between pre and post-crisis deals is the revolver’s leverage ratio being a springing covenant that takes effect only if the facility has been drawn in the preceding quarter.

By managing their cashflows, including through equity cures injected before the quarter’s end, borrowers can avoid having the covenant tested at all. Some more aggressive sponsor term sheets go further and ask for the covenant to be tested only if the revolver is outstanding at the quarter end.

"This basically means that the borrower could have revolving loans outstanding 361 days during the year but never have to comply with a financial maintenance covenant," explained Michael Goldman, practice lead of Cravath Swaine & Moore’s banking practice. Goldman, who acts for lenders, said he has not had to agree to this.

Another change to pre-crisis covenants is the leverage ratio applying to pari passu debt as well as junior and unsecured debt. Starting in 2010, for the first time borrowers are not being required to deleverage and instead are being allowed to incur debt that ranks equal to the banks’ collateral positions.

"This is one of the big structural changes from pre-crisis, and could adversely affect lender recoveries in a default," said Goldman.

Two features from 2006/2007 that have returned are net senior secured leverage ratios and aggressive definitions of Ebitda.

Cash holdings are carved out of the debt figure used in a net leverage ratio, making it easier for the sponsor to comply. It appeared in other loans in the previous cycle, but generally not in cov-lite deals. It adds a new level of cash management and covenant flexibility for cov-lite borrowers, said Sullivan & Cromwell partner Hydee Feldstein.

Ebitda is moving towards bond-like definitions, particularly in financial sponsor-backed deals, meaning lenders have potentially less protection than they thought. Borrowers are being permitted to inflate their Ebitda figure by adding back expenses deemed nonrecurring or unusual.

A fickle market

While the past months have proven that cov-lite has survived the financial crisis, this month some US counsel have seen leverage ratios and even interest coverage tests slip back into deals that were expected to be structured as cov-lite.

"Certainly this past week, lenders were pushing back on covenant lite in some deals and seeking to put one if not two financial covenants back into the term loans," Hadley told IFLR last week.

It’s too early to say whether this is a shift or just a glitch in the market. Most banking lawyers think cov-lite "has legs" and will become more prevalent. This contrasts to Europe, where news of the first cov-lite deal since the crisis last week was met with surprise by the market

There are, however, other signs that the market could turn. JCrew’s $1.2 billion cov-lite loan in March, for example, features a margin of Libor plus 325 basis points when its senior secured leverage ratio drops to 3.25.

Some say margins and leverage converging can be the first signs of a bubble. "To me, that’s a sign that the market is getting a little overheated," said one partner.

It seems likely, however, that last week’s developments suggest that in the US the structure has become a function of supply and demand.

"As a question of institutional acceptance, cov-ite loans are back. As a question of investor appetite, it depends on overall market conditions," James Florack, a partner with Davis Polk.

A key condition over the past months has been pricing. Lawyers hear from bankers that the pricing differential between cov-lite and traditional loans is tightening. "I think the pricing premium for cov-lite has been shrinking – but it’s a fickle market," said Goldman.

Lawyers do agree that cov-lite has returned faster than expected. In 2008, people predicted it wouldn’t be back for a long time, but over the past four months there has been an abrupt switch to acceptance of cov-lite terms.

"It seems as though the cycle has shortened up," said Feldstein.