The talk last year was of the growth of lenient covenants that were proving the borrowing strength of private equity houses. Now, the talk is of no covenants. The move from scepticism regarding leniency to the spectre of no covenants at all has been relatively swift. Where do we go from here?
This practice of using “covenant-light” structures has, of course, come over from the US (see Financial Markets p15) where it emerged last year. Europe has seen little use of it yet. It has featured in only a couple of deals, namely the €1.2bn
But now it looks likely to be used in the financing of
Informed commentary on the topic seems to agree that large, well established mid-market companies would be best suited for covenant-light, not massive corporates such as Alliance Boots.
However, in defence of the structure, some bankers argue that what they are in fact using are “incurrence covenants” as opposed to “maintenance covenants” and that these covenants have been used in the high-yield bond market for some time and do in fact have a number of safeguards that do not leave the bank entirely exposed.
These safeguards include clauses that stipulate a certain return to investors through dividends, a certain amount spent on investment and, most importantly, that leverage ratios do not exceed certain multiples.
They also argue that the deals done so far have very low leverage ratios – World Directories was 5.5x – therefore the spectre of default in fact remains relatively low, and also that these companies are generally strong businesses with strong track records and if they were to get into a restructuring situation it would normally be to do with the outside environment rather than fundamental problems with the business. The senior lenders are, therefore, likely to get their money back anyway.
All this might sound all right in theory but the reality is that “incurrence covenants” have been in use in the high-yield bond market for a reason – because it is high-yield and therefore more risky.
Also, if one of these companies does get into trouble, by the time the banks find out it will be very far down the road and probably in very serious trouble, so the likelihood of getting money back would probably be very slim.
Last and most importantly – they might be doing these types of deals on relatively low leveraged stable businesses – for now – but how long will that last? Until World Directories goes through another refinancing and suddenly it is leveraged at 11.5x?