Even though covid-19 is the proximate cause of the dire straits many companies and lenders now face, the seeds of this distress were planted over the past few years.
Lenders incentivised to deploy and grow assets quickly, investors eager for yield, and corporate borrowers seizing the easy credit decade to lever up and pay large dividends collectively set the stage for defaults, liquidity crises, mass unemployment and likely principal losses, given the record amount of borrower-friendly loans since the great financial crisis.
The following trends merit specific attention:
Covenant-lite Before the global financial crisis, almost all loans contained covenants (limits on borrowers that protect lenders and their capital). Today, most levered loans lack true covenants.
Coupon-lite Until covid-19, lenders kept getting paid less and less. Loans spreads have been on a steady decline over the past 10 years. Per a 2019 Kansas City Fed study, spreads pre-covid neared 20-year lows.
Collateral-lite Assets that lenders view as collateral may disappear. Sponsors pre-covid were often able to move assets into unrestricted subsidiaries away from lenders, as happened in the cases of Caesars, J. Crew, PetSmart and Nieman Marcus.
EBITDA-lite Add in major puffing of EBITDA, and the leverage of borrowers is a lot higher than claimed – and the loans are therefore a lot riskier (especially now, given covid-19’s immense economic impact). This is due to EBITDA addbacks that are common in the sponsored and broadly syndicated markets. Such addbacks boosted EBITDA as borrowers and lenders agreed to give credit to future events or proposed cost savings that might – or might not – occur. Given covid, the chances of those events occurring has dropped, likely significantly.
Info-lite Rather than giving lenders reports quarterly, sponsors and large borrowers have often been able to limit their obligations to providing reports merely every 120 days.
Access-lite Sponsors took further advantage of the pre-covid excesses to eliminate the right of lenders to speak with management. Imagine if you loan money, the quarterly numbers are concerning, and you have questions for management. Previously, you had a contractual right to speak with management at least quarterly; but, post-GFC, in some loans, you no longer have a contractual right to speak with management ever. Imagine that now, with covid tearing the world apart.
Recovery-lite Cov-lite loans historically have much lower recovery rates. Cov-lite loans are far more prevalent than was the case before the GFC, borrowers are more highly levered, and lenders are more exposed through less collateral, slower information, and little access to management. As such, the prospect for strong recoveries seems dim, particularly given the additional impact of covid-19.
Who bears the downside? Unfortunately, it is the pre-covid lenders and their investors who, in a low if not negative interest rate environment, were desperate for yield and acted without due regard for the long term. Note that share prices in business development companies have dropped by around 40 percent – and by even more for some of the more suspect managers.
Now that the next recession is likely to have arrived, we fear that the default rate and the recovery rate for all these lite loans will be even worse than in past cycles. This will cause more pain, not only for lenders and their investors, but also potentially for the workers at these borrowers who may be at greater risk of losing their jobs when these riskier borrowers start failing to pay their debts. Indeed, only weeks into the covid crisis, nearly 10 million people in the US have already filed for unemployed.
The bill for the market excesses of the past decade is now due. And while the headlines may blame covid-19, the root cause is as much the over-levered, poorly structured (e.g., cov-lite) borrower-friendly loans that dominated for many years previously.
Those who showed discipline and focused on covenants and low leverage will now hopefully be well positioned to take advantage of the significant opportunities in 2020 and 2021.
Gregory Racz is president and co-founder of New York-based fund manager MGG Investment Group