Forget covenant-lite: The devil is in the document’s details

Steven Miller and Jessica Reiss of Fitch Solutions examine the subtle changes to credit agreements that could pose a danger when today’s deals are affected by the next downturn

The rise of covenant-lite structures – which eliminate the quarterly financial tests that were once a sacrosanct feature of loan agreements – has become shorthand for eroding lender protection.

In recent years, the trend has become undeniable across the $1.2 trillion leveraged loan market. Covenant-lite loans now comprise 80 percent of the Credit Suisse Leveraged Loan Index, which tracks broadly syndicated leveraged loans to speculative grade issuers. That is up from 16 percent a decade ago. A decade before that, the index held no covenant-lite loans. Today, 81 percent of new-issue loans were covenant-lite over the first five months of 2019, according to LevFin Insights.

However, the covenant-lite shift is not the end of the story. As traditional maintenance financial tests for leveraged loans gave way to bond-like incurrence tests, a gateway opened to more subtle, but in many ways more profound, changes to credit documents that cut against lender protections.

As we face one of the longest economic recoveries in US history, the time is ripe to consider the implications of such a sea change. Without it, lenders and investors will be glossing over one of the most significant new factors to affect recoveries since the last downturn.

Documentation deterioration

Although covenant-lite has become industry shorthand, four specific documentation features have emerged that are emblematic of a bigger shift:

  • Incremental loan tranches Most leveraged loans today allow the borrower to add new loans equal to up to 50-100 percent of its pro forma closing EBITDA without the lender’s consent and without meeting any financial tests. This is a sharp departure from loans of the past and allows a borrower to, for example, increase the par amount of a first-priority loan claim against the collateral pool by typically 20-25 percent.
  • Asset sales sweep step downs In the not-too-distant past, when leveraged loan borrowers sold assets, they were invariably required to reinvest the proceeds or use them to pay down loans. That has started to change at the margin. In the year to April, Covenant Review data show that roughly one-third of syndicated leveraged loans allowed the borrowers to use asset sale proceeds for other purpos­es provided they had met certain financial tests.
  • Loose EBITDA adjustment definitions Many of the provisions of a loan agreement are tethered to the borrower’s EBITDA. Most loans today allow borrowers to incorporate certain assumptions to adjust them higher – say, for corporate actions not yet completed – thus providing additional flexibility to issue debt or pay dividends.
  • Transfer baskets Loan agreements are riddled with ways for borrowers to transfer assets to units, typically known as unrestricted subsidiaries, that sit outside the lender group and that are therefore beyond the reach of collateral liens. The most notable example of how these provisions can be used to reduce lender value is J Crew. The storied but struggling apparel marketer used a loophole in its document to transfer ownership of its brand name – a valuable piece of intellectual property – to an unrestricted subsidiary. Although the particular loophole in question is rare, showing up in just 11 percent of 2019 new issue loans, many credit agreements in today’s market allow for substantial investments in unrestricted subsidiaries, irrespective of whether they contain that loophole.

Naturally, covenants, like loan coupons, are subject to market dynamics. When supply outpaces demand, lenders see tighter covenant terms and higher coupons. And the reverse is true when demand outpaces supply. In this way, the loan market is no different today than any other capital market.

With the bull market roaring, loans have trended towards looser covenants, even in the short term. In the year to May, Covenant Review’s documentation score averaged 3.45 on a scale of 1 (strongest covenant protection) to 5 (weakest). This is roughly even with 2018’s reading but less protective than 2017’s average of 3.22.

A new dawn or clouds ahead?

It wasn’t always this way. At the dawn of the leveraged buyout era in the mid-1980s, commercial banks were the main source of leveraged loan financing. These loans, therefore, had many of the documentation protections banks require, and these pro              tections were more or less impervious to market conditions. After all, the proverbial banker is someone who hands his client an umbrella when the skies are bright and asks for it back when storm clouds appear.

“We know from the last downturn that where risk lurks, regulators may follow”

Over the past 25 years, structured fi­nance vehicles and asset managers have slowly but steadily edged out the banks when it comes to pro­viding leveraged loans for anything other than relatively small working-capital lines. In the decade since the last financial crisis, regulation has exacerbated this trend as banks have curbed their risky lending activity, thereby creating a bigger opening for alternative capital. Banks, by and large, are now in the moving business — arranging and syndicating leveraged loans to non-bank players for a fee — rather than in the storage business of holding these loans to term. One result is that leveraged loan covenant terms for large, syndicated loans have drifted in a bond-like direction.

Loss adjustment required

With fewer covenant protections, most market players expect credit losses to be above-trend when default rates spike during the next recession. Of course, that assumes all else is equal, which it never is. The depth of the next recession, how hard it hits sectors that are over-represented in the loan index, and the response of the US Federal Reserve in providing liquidity are among myriad factors, known and unknown, that will profoundly influence the severity of credit losses on defaulted loans.

We know from the last downturn that where risk lurks, regulators may follow. This makes the impact all the more important in determining the future of lending, both for traditional banks and their alternatives, and especially if the political winds change.

Undoubtedly when the next downturn emerges, the devil and the angels will be in the details. For lenders, credit documents are the places to look. More protective documentation terms will help lenders prevent collateral value from leaking, meaning lower credit losses in a bankruptcy. By contrast, documents with Swiss cheese-like provisions that allow borrowers to shift assets outside the collateral pool and use asset sale proceeds to take dividends, may make credit losses in a bankruptcy much more severe.

Steven Miller is head of leveraged finance intelligence at Fitch Solutions and Jessica Reiss is head of loan covenant research at the company’s Covenant Review service