Covenant-lite loans, which were originally designed for the large-cap leveraged finance market, are becoming a more common feature in the mid-market. Concerns have been raised that the new phenomenon could lead to the mispricing of risk.
Looser covenants in general have come about as a result of an increasingly borrower-friendly environment. Vast amounts of capital and lacklustre deal flow have led to intense competition between private equity sponsors, and even more so between lenders. This is particularly acute in the mid-market where the growing high yield market, the influx of alternative lenders and the return of banks to lending have created an increasingly crowded environment.
Heightened competition between lenders and debt products was the most profound change in the European debt markets during 2014, according to a recent survey by law firm DLA Piper of more than 300 debt practitioners. Eighty-four percent of respondents believe competition between lenders increased, it found in its European Acquisition Finance Debt Report for 2015. And 81 percent of respondents, including debt providers, advisors, sponsors and corporates, believe competition between debt products was more pronounced.
Panellists at the launch of the report in February agreed that the sheer breadth and depth of debt on the supply side is set to continue, sparking concerns that mispricing may enter the mid-market as a result of lender protections eroding, particularly in light of the illiquid nature of the market.
James Ranger, co-head of acquisition finance mid-markets team at Lloyds Bank, questioned whether some fund managers were getting paid enough for the risk: “We are concerned that some credit funds are prepared to sacrifice covenants for yield in the mid-market. These loans are largely illiquid and there is limited opportunity to trade out if performance deteriorates. We are not convinced that risk is being properly priced and, in some situations, lenders are driving towards a future car crash.”
Accusations are regularly flung back and forth between banks and debt funds with each accusing the other of driving down pricing and loosening terms.
LOOSER AND LIGHTER
In 2014, 16 percent of first-lien loans in Europe were cov-lite, according to a report from White & Case, Debtwire Analytics and Xtract Research. That may not sound like a high percentage but the year before there were none. The trend is for a US-style market, where nearly half of first-lien loans were cov-lite in 2014, a 50 percent increase from 2013.
Without covenants, lenders lose the ability to step-in at the early signs of struggling performance. The thesis supporting cov-lite loans, whereby all four maintenance covenants – leverage, cash flow cover, interest cover and maximum capex – are removed, is that for large loans there is a liquid market where lenders can trade out of a position if the business gets into difficulty, albeit potentially at a discount. However, trading out in the smaller mid-market is much more difficult.
Cov-lite loans are not typically being offered to businesses with EBITDA below the €50 million because of the low level of available cash flow. However, Ranger tells PDI that for some businesses cov-lite loans are available “at a price”, well within that informal benchmark – at around €10 million EBITDA. In addition, cov-loose loans are also appearing, all the way through the size-range, he said. Cov-loose is a broad term though, he added, ranging from loans granted with wider headroom on covenants to loans where only a leverage covenant has been left in place.
Lender protections have been eroding in this way over the past 12 months, Faisal Ramzan, partner at law firm Proskauer, tells PDI: “The covenant packages offered in the European mid-market are becoming increasing aligned to the US style “covenant loose” agreements. It is now not uncommon to see loans with just a leverage covenant or a leverage and cashflow covenant.”
Another erosion of lender protections is in equity cure provisions, Ramzan continues. “Pre-financial crisis, borrowers were enjoying favourable equity cure rights, however in the years following, when capital was not easily accessible, lenders mostly managed to eradicate the concept altogether,” he says.
However, over the past two to three years, equity cure rights have made their way back into documents, and the terms of those equity cures have really loosened.
Within the last 12 months the maximum number of cures has crept up from three to four or even five, says Ramzan. Previously, the sponsor’s equity injection was used to directly pay down debt.
“The boundaries of the pre-2008 equity cure have been pushed even further during this time, demonstrated by borrowers who are now sometimes permitted to hold the injected cash on balance sheet (and cure a breech by adding this cash to EBITDA), whereas previously any cash injected pursuant to a cure had to be used to pay down debt,” he adds.
Headrooms between performance base case scenarios and where financial covenant rates are set have also widened, in some cases as high as 40 percent, Ramzan says. There has to be a real deterioration in the performance of the business before covenants as they stand today are breached, he explains.
NEW BREED OF DEBT
Understandably, there are concerns about credit quality deteriorating throughout the market. Industry sources agree, covenant-lite in the mid-market is not a great trend.
“It’s dangerous in the mid-markets. In managing mid-market companies one of the reasons you need covenants is to effectively have an ability to intervene early when there are challenges inside the company and if you have covenant-lite there is no ability to intervene,” Symon Drake-Brockman, managing partner at Pemberton, tells PDI. However, he thinks that the trend is relatively UK-centric at present, where there is more competition. The challenge is that there are a number of funds struggling to get capital deployed. Hence, the onus will be on debt funds to remain disciplined, he says.
With the problems that led to the credit crunch still fresh in practitioners’ minds however, industry sources opine that this has hopefully led to relatively better underwriting standards. One source tells PDI that LPs will likely start to pay more attention, and look to private debt funds for consistent underwriting standards. But with a lot of LPs still just getting to grips with the debt market and its particular risks, investor discrimination will take some time to trickle down into the market.
Lenders must take responsibility for their own credit discipline, which looks like it will only get more difficult in the year ahead.