Loans without financial maintenance covenants, known as cov-lite, continue growing in popularity in Europe, fuelled by investor appetite for returns. This is pushing them towards riskier speculative-grade loans in their droves and allowing borrowers to dictate the terms almost entirely.
In the first quarter of 2017, 67% of all term loan B (TLB) leveraged finance deals were cov-lite, up from 48% in the same period in 2016 and 27% the year before, according to Moody’s. Richard Etheridge, associate managing director at Moody’s said the competition between TLB leveraged deals and high yield (HY) bonds has enabled the convergence in terms, as they now attract the same investors. “The credit funds that invest in leveraged loans are generally used to cov-lite from their experience investing in HY,” he explained.
This erosion of investor protection will be standard throughout 2017, though smaller, less popular transactions generally considered to be more volatile and less liquid – in sectors like retail, for example – will be among the few still featuring financial maintenance covenants going forward, added Etheridge.
But according to Clifford Chance partner Charles Cochrane, even deals containing financial covenants are now often set with more generous headroom than in the past – and often do not require improving performance over time.
This is echoed by Moody’s. It finds that the proportion of transactions with under 30% headroom at the time of closing fell from 42% between 2013 and 2014 to 30% in 2015-17, shifting fairly significantly in the borrower’s favour.
Yields in the leveraged debt space are also falling, according to Linklaters partner Adam Freeman. “If you know there’s a huge demand for your paper and you can put forward aggressive terms that the market will accept, why wouldn’t you, for the flexibility?” he said.
KEY TAKEAWAYS
Loans without financial maintenance covenants, known as cov-lite, continue to grow in popularity in Europe – 67% of all TLB deals were cov-lite in Q1 of this year;
The product’s convergence with high yield has allowed for the relaxation of terms as they now attract the same investor base;
Covenants are now for the most part only appearing on more volatile, smaller deals that are considered less liquid;
Default rates are historically low by definition though there have been a few warning signs;
Those in the market feel the trend will continue for as long as economic conditions stay broadly the same;
Even high yield bond issuer Abengoa’s high profile restructuring did little to subdue demand.
High yield in disguise
While some believe that covenants are essential for creditors to keep tabs on the companies they invest in, others argue that such covenants were invented at a time when it was almost entirely banks, with substantially different risk profiles and requirements, buying the debt. The increased presence of funds has in a way outgrown the need for such terms, so it goes.
A covenant breach may lead to a distressed company addressing its balance sheet earlier, with a subsequent quicker recovery than a cov-lite deal with no triggers, said Etheridge.
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"If you know there's a huge demand for your paper and you can put forward aggressive terms that the market will accept, why wouldn't you?" |
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But that might not always be the best thing for the company. This came up during the financial crisis, when virtually every company was impacted in some way by external macroeconomic factors. It meant in many cases, covenants were breached and restructurings happened early on.
“Sponsors will tell you that was unfair in many instances,” said Freeman. “A lot of the businesses that were restructured immediately post-Lehman weren’t flawed and just needed time, and it meant the sponsors lost control prematurely.”
Leveraged loans are not just competing with and mimicking HY in terms of covenants. According to Cochrane, they are increasingly incorporating more flexible terms across the board.
“The big advantage of HY was always the cov-lite nature, but if you add that to loans then the loan product becomes very attractive,” he said.
Warning signs
Speculative grade loan default rates are historically low, at around two percent.
Moody’s does not track cov-lite default rates in Europe, though it notes that recovery rates on defaulted cov-lite loans in the US are gradually getting worse.
None of the cov-lite deals tracked by S&P have defaulted. But according to its analysts, the majority of defaults occur three to four years after origination, and European issuance has risen significantly since 2014 – so they can’t be ruled out altogether.
That’s partly down to cov-lite deals only being available to high quality credits. Plus the very nature of them makes defaults less likely, as the borrower would have to run out of cash altogether.
According to the Moody’s research, defaults are for the most part limited to distressed exchanges such as debt buybacks or restructurings, so covenants haven’t been as relevant in that context anyway.
When Spanish energy firm Abengoa tabled plans for a financial restructuring at the end of 2015, many speculated that the cov-litd party would be coming to an end. But while HY issuance has fallen, the loans numbers speaks for themselves.
Freeman thinks it will take more than one or two high profile defaults to change the way things are.
“The only thing I really think would have an impact would be some sort of macro crisis that led to a huge number of defaults,” he said.
See also
Leveraged debt fights back
No respite for buyside on HY terms
US cov-lites creep into European mid-market