Cov-lite and Cov-loose every time

As ratings agency Standard & Poor’s criticises covenant loose loans for being covenant-lite by the backdoor, a senior banker tells Toby Lewis cov-lite loans will become extinct.

The ratings agency Standard & Poor’s has recently stepped up discussions of covenant-lite loans. It claims unlike the cov-lite structures relatively rare in Europe, very similar covenant loose loans are far more prevalent, corresponding to 20-30 deals of the 188 signed last half. According to S&P this is troubling because the robustness of loans has taken on greater importance in determining post-default recovery prospects for loans bought by collateralised loan obligation funds.
Covenant lite loans only have incurrence tests, used to examine the operating performance of borrowers relative to a predetermined “trigger” level, after the borrower has taken a certain action such as debt issuance, dividends, share repurchases, merger, acquisition, or divestiture.

In the absence of one of these actions the company’s operating performance does not trigger a default.

Due to problems in the credit markets borrowers are likely to reject incurrence-only deals, according to a senior leveraged finance banker at a large American bank today.

Borrowers instead prefer maintenance tests for their loans because this gives them more control. These tests involve regular reviews of operating performance and are not triggered by a borrower action, providing lenders with more control over their investment.

Paul Watters, a director at S&P’s European leverage finance team, warns covenant loose deals, even though they have maintenance clauses written into the contracts, only provide lenders notional powers. S&P is researching this issue further and it has begun consultation with the industry this week about its definition of cov-lite loans.   

Yet a partner at a European buyout firm argues the loans are often appropriate in certain deals. Kohlberg Kravis Roberts, for instance, is selling £9 billion of covenant loose loans for its acquisition of pharmacist Alliance Boots. But demand for the KKR deal is apparently high because other than the controversial structuring of the loan agreement it is a defensive acquisition.

Discussing the deal in the abstract, the partner points to the company’s 80 percent turnover coming from the health sector as demonstrating it is a business that is counter cyclical. “Nobody is going to stop popping pills any time soon. It’s a credit no-brainer”.  Investors on this deal are going to see debt being paid down pretty rapidly, so they are happy to take on the favourable terms even with little to no maintenance clause.

“There is little difference between cov-lite and cov-loose but on the right deal the structure is appropriate,” he said. The controversial agreements provide more flexibility to the buyout firm and thereby allow them to be more efficient on the deals, he says.

The ability for buyout firms to avoid pressure from activist investors is an added advantage of such loan agreements. Although the partner warns “cov-lite deals are less obvious targets from predatory hedge funds, but innovation always outpaces financial structuring.”

Watters says such advantages do not convince him. “Why is getting rid of these clauses such a big issue for buyout firms?”  Cov-lite fails to provide lenders with a relative pricing dynamic and so investors have no guarantee of liquidity. The covenants have been driven by a strong supply of investors trying to get into the market and borrowers have taken advantage of this. S&P would prefer the lending market to be priced more in terms of risk than responding to the vagaries of supply and demand, although Watters adds “some may say that sounds rather self-serving”.

Yet with worries about the sub-prime mortgage sector in the US encouraging a sell off of all forms of high risk debt last week, the appetite for such loans amongst investors has diminished. Watters says the changes of the last three weeks in the debt markets were a very welcome repricing of risk in the marketplace. “Clearly there are some deals which have been underwritten in Europe that has been underwritten at the wrong level and some investors will lose out accordingly.”

The partner admits the credit crunch will make it harder for even the best names to do high multiple deals in the future as they won’t be able to get the leverage available.  Yet he thinks any buyout firm which is able to get a covenant-lite loan will take it. “The loans are good for companies if not for banks and whenever cov lite is possible the borrower will take it,” he adds. Sadly for more aggressive GPs this may not be for very long if the debt markets continue to decline.