Bankers take a back seat

When Apax Partners and Cinven teamed up to acquire Belgian yellow pages group VNU World Directories for €2.1 billion ($2.8 billion) in September 2004, strong confidence was expressed in the firm's prospects. In a statement at the time, Cinven partner Brian Linden said: “World Directories has been a highly sought-after asset. It is a very attractive international business with a strong reputation.”

Not everyone shared this bullish sentiment. The response of a leading London-based daily was fairly typical when it concluded that the deal's debt multiple of 7.5 times earnings was “staggering”. Such cynicism appears unmerited in retrospect. Two and a half years on, in March 2007, the backers of VNU were still confident: so much so, in fact, that a consortium of lenders to the business led by JP Morgan agreed to provide a refinancing package incorporating “covenant-lite” loans. The package was yet to be syndicated at press time.

The significance of “covenant-lite” is essentially that it allows greater leeway to pursue a portfolio company's business plan free of interference from the company's lenders. In Europe, loans in support of buyout deals have typically included maintenance covenants [also referred to as financial covenants] designed to provide bankers with a significant degree of security over the asset they are lending to. These covenants require the borrower to report to the lender on a periodic basis (normally monthly, quarterly and annually) in order to provide comfort that certain pre-specified indications of financial health are being achieved. Covenants such as these, says Richard Ginsburg, a banking and finance partner in the London office of law firm Weil, Gotshal & Manges, act as an “early warning system” of potential problems at a borrowing company.

In a covenant-lite scenario, maintenance covenants are replaced by incurrence-based covenants. The latter dictate that indications of financial health need only be evidenced when a specific event occurs: such as, for example, the borrower making an acquisition and/or seeking to incur additional debt. Such covenants are familiar to investors in the high yield market, where bondholders don't tend to have – and, more to the point, wouldn't normally expect – a close relationship with the borrower. But their transplantation to LBO financings appears seminal in terms of lessening the accountability a private equity-backed company has to its debt providers.

“If trigger events never happen, then it is difficult for the borrower to be in breach [of incurrence-based covenants],” points out Ginsburg. “It's easier on the company. Its financial performance might deteriorate, but unless the borrower fails to make interest or principal payments it will be more difficult for the lender to call a default on its facilities.”

MORE FLEXIBILITY
Given that such a default is normally the point at which a lender would be able to haul a borrower to the negotiating table and perhaps implement remedial action, it is clear that a covenant-lite agreement gives a company far more flexibility to run its own financial affairs without interference. Says Ginsburg: “Unless there is a payment default, the borrower may be in a position to undertake its own restructuring plans and on its own timeline, without the pressure of having to involve and consider the wishes of the lenders during the process.”

This effectively changes the status of the lender from backseat driver to mere passenger and requires increasingly active portfolio management by the private equity sponsor. “With the possibility of covenant-lite loans allowing a degree of underperformance that may have led to a financial restructuring in the past, it is important that private equity owners take the action they need to in order to enable businesses to survive – as the banks may not be able to force it,” comments Dean Merritt, a partner at restructuring advisory specialist Kroll Talbot Hughes in London.

He adds: “The success or otherwise of the concept of covenant-lite loans will depend in part on how active private equity firms are in terms of portfolio management, as reduced lender control will demand a degree of self-policing.”

At this point it seems pertinent to ask why banks would be prepared to agree to looser covenants in credit agreements in the first place. In fact, there has been some resistance. Legal sources say that one argument sometimes heard from Europe's bankers and their advisers is that looser covenants mean a greater risk that the deal will struggle in syndication. This is only partly to do with the erosion of influence that such covenants imply – also of significance, they say, is that the documentation will be viewed with suspicion by a European buy-side largely unfamiliar with it.

But to such arguments, there is a compelling response. Says one legal adviser to European buyouts: “We do come across bankers who argue that the syndication risk is greater with deals including covenant-lite loans – but our response to that is to hand over credit agreements from prior deals that have been structured the same way and been 200 percent oversubscribed.”

There is, after all, a growing archive of such agreements to refer to. In Europe, while VNU appears to have been the most publicised covenant-lite deal to date, it was not the first: a covenant-lite senior revolving credit facility was used, for example, as part of the €1.3 billion refinancing of Grohe, the German bathroom fittings firm owned by TPG and CSFB Private Equity, in February this year. Following VNU, it emerged that the £1.35 billion (€1.9 billion; $2.5 billion) buyout of Trader Media, the UK publisher, would also feature covenant-lite facilities. As with VNU, Trader featured Apax as equity sponsor and JP Morgan as lead debt arranger. Reports have also surfaced that KKR is lining up covenant-lite facilities in support of its £10 billion offer for health retailer Alliance Boots.

GP POWER
Such deals in some ways simply reflect the power that GPs have in the current climate – one might as easily refer, for example, to the way in which they are able to extract favourable terms and conditions from limited partners when raising new funds. Says Andrew Barker, an acquisition finance specialist at international law firm Jones Day in London: “Covenant-lite is really an evolution rather than a revolution. Private equity firms have had very favourable conditions over the last few years and have pushed hard to weaken the restrictions in the loan documentation. Covenant-lite, to an extent, follows naturally from already established provisions like equity cures and covenant mulligans, which give sponsors scope to breach covenants a certain number of times before banks can call a default.”

In the US, meanwhile, covenantlite deals saw a surge in popularity last year. According to figures from law firm Debevoise, only $2.4 billion worth of covenant-lite facilities were seen in the US in 2005, compared with $22.6 billion in 2006 and $29.5 billion in the first quarter of this year. This is not to say that structures tailored to a high yield investor base are a new thing in the States. “Syndicated loans with high yield style covenants were first seen in the late 1990s and were a popular trend until around 1998, when they disappeared with the arrival of a more restrictive credit environment,” says David Brittenham, chair of Debevoise's leveraged finance group in New York.

By looking at the US you get a big clue as to why covenant-lite loans are gaining such traction: most of the investor base there is of the high yield variety that is used to, and comfortable with, incurrence-based covenants. Organisations that have been exposed to such deals in the US are currently providing much of the liquidity for the covenant-lite deals being seen in Europe. Ginsburg says: “I would expect that there will certainly be resistance from some investors, but there will also be others ready to get involved, especially investors who have been active in the US market and have seen covenant-lite for some time.”

In Europe, institutional investors such as CDOs and hedge funds are a smaller element of the investor base than in the US, but growing fast – reflected in the fact that financing structures are increasingly being tailored more to their requirements and less to those of the banks.

For the time being, it appears that candidates for covenant-lite treatment in Europe are being selected very carefully, with the key issue being a high degree of trust in both the company and its sponsors. Observers say both VNU and Trader Media have demonstrated stable cash flows; both firms are backed by equity sponsors and banks that the market is broadly comfortable with. The need for this degree of comfort partly reflects the fact that, in Europe, covenant-lite is still at the toe-dipping stage. That said, even in the US, such facilities “are not universal”, says Brittenham. “It's all about the right deal, sponsorship and a good story. If you don't have those characteristics, it won't happen.”

COMPARISON OF COVENANT-LITE WITH TRADITIONAL EUROPEAN FACILITIES