In a cov-lite world, investors should prepare for a correction: report

Using the 30-day post-default debt price as a proxy for an eventual recovery, data imply that covenant-lite loans produce smaller recoveries than covenanted debt.

Even as the economy keeps humming along, limited partners should start preparing for a downturn, at a new report from JPMorgan Asset Management has cautioned.

Investors should look to diversify their private credit allocation beyond direct lending and consider special situations strategies, according to the document, authored by Leander Christofides and Brad Demong, co-chief investment officers of the special situations group.

“At the same time, the seeds of a traditional distressed market are being sown, with over $4 trillion of growth in global credit markets since the last cycle, a loosening of lending standards and an expansion of covenant-lite lending,” the paper read.

The 30-day post-default prices, which Fitch used for a proxy for eventual recoveries, for covenanted debt stood at 83 cents on the dollar, while that figure was 65 cents on the dollar for covenant-lite loans.

Notably though, that figure for covenant-lite deals is affected by the energy and retail sectors which, due to the unique capital structure, often have covenant-lite term loans, the debt measured in the post-default prices.

Energy and retail businesses often used asset-based or reserve-based loans, which contain the financial maintenance covenants rather than the term loan containing those provisions. With those sectors unaccounted for in the Fitch data, covenant-lite 30-day post-default prices would be around 79 cents on the dollar.

“The market seems to be implying that defaults are later on in cov-lite deals and potentially with lower recoveries, though it is still a little too soon to tell,” said Eric Rosenthal, a senior director of leveraged finance at Fitch Ratings. “The 2017 cov-lite recovery sample involved an overwhelming majority of issues (87 percent) originated before 2015.”

In 2017, the default amount on institutional covenant-lite leveraged loans was $18.6 billion, up from $8.3 billion in 2016; for covenanted debt, those figures stood at $7.4 billion in 2017 and $9.1 billion in 2016.

The jump in covenant-lite loan defaults can partially be attributed to the 45 percent jump in covenant-lite loans from 2016 to 2017, Rosenthal explained.

“It is easier for the covenanted default rate to jump up because it is a smaller universe,” Rosenthal said. “Covenanted defaults will be a little higher [this year] because of iHeartCommunications,” he added, noting the San Antonio-based distressed media company’s likely default on $6.3 billion of debt with traditional covenants.

However, a low overall default rate environment – 2.4 percent in 2017 and projected to reach 2.5 percent this year – has presented fewer distressed opportunities than such investors would like.

Energy and retail have been two of the bright spots in that regard; the two sectors together produced 51 percent of the defaults in 2017. For 2018, those two industries as well as broadcasting and media are expected to produce 70 percent of the anticipated defaults, with broadcasting and media making up the largest portion thanks to iHeartCommunications’ likely default.

The JPMorgan report notes that special situations extends beyond distressed investing. It splits special situation into two sub-divisions: distressed credit and stressed or event-driven debt, both targeting 15-20 percent returns. Having an investment vehicle that has a flexible investment mandate, allowing both sub-strategies, will allow it to adjust to economic cycle.

Ivan Zinn, founder and managing partner at Atalaya Capital Management, told Private Debt Investor early last year that the “special situations” moniker allows his firm significantly greater flexibility than labelling a vehicle as a “distressed” fund. This is especially the case during market cycle years when the majority of private debt deals are not distressed.

The Fitch report also broke down default rates on deals with and without a private equity sponsor. The non-sponsor default rate stood at 3.3 percent in 2017, lower than the 1.9 percent sponsored default rate.

The wider latitude in financial covenants, or lack thereof, in credit agreements with private equity firms often accounts for the lower default rate in sponsored deals, Rosenthal said.

Editor’s note: The article has been updated to reflect nuances in the interpretation of 30-day post-default price data, showing that differences in pricing are not necessarily due to the presence of covenants.