Loans Return To Covenant-Heavy Mode

Icarus, the mythological Greek hero, fashioned a pair of wings from bird feathers and beeswax. He flew too high, the beeswax melted, the apparatus came apart, and Icarus fell to his death.

These days the heroes of the leveraged finance markets are feeling that falling sensation. Risk premiums are rising and leveraged finance transactions are streaking earthward. Covenant-lite transactions—deals with covenant packages structured without maintenance financial covenants and with permissive, “bond-like” negative covenants, as well as payment-in-kind toggle features—have come down hard.

The leveraged finance troubles began in the mortgage and collateralized debt obligation (CDO) markets when the weak credit quality of subprime mortgages became apparent in an environment of rising interest rates and a weakening housing market. The strain created in the mortgage markets constrained liquidity in the debt markets generally. Leveraged finance—previously soaring high, with climbing leverage, less restricted covenant packages, and non-cash pay features—lost altitude.

By the beginning of July, the financing of Kohlberg Kravis Roberts & Co.’s $45 billion acquisition of TXU Corp. encountered turbulence. By mid-July, Standard & Poor’s Leveraged Commentary & Data indicated that a key measure of liquidity for the largest and most liquid issuances had fallen more than 100 basis points, reflecting the pressure on leveraged finance pricing. Other deals, including the $29 billion acquisition of First Data Corp., were flapping madly to stay aloft. The response of syndication desks has been invoke market flex terms in their loan agreements to require higher interest rates and better terms; otherwise, they won’t be able to sell the paper to hedge funds and other institutional investors without taking a big haircut. By the end of July, sponsors were agreeing to buy significant pieces of second-lien debt to finance their own sponsored acquisitions. The New York Times business section recently led with the headline “Bam! Easy Credit Evaporates and So Does Buyout Frenzy.”

Negative Covenants

Covenant-lite transactions appeared briefly in the late 1990s, then faded with the Asian financial crisis and the credit crunch that followed. Then, as now, covenant lite was essentially a bank loan product containing less stringent covenants than traditional bank loan products. In particular, covenant-lite facilities typically have no maintenance financial covenants, and have negative covenants that are liberal and open-ended if incurrence tests are met.

Negative covenants are common to bonds, particularly high-yield bonds. Because bonds have a longer term of seven to 10 years, are difficult to amend, and are expensive to refinance (if not subject to a no-call prohibition altogether), more flexibility is a logical and well understood feature of the product. A flexible covenant package is essential for a bond if it is to accommodate a changing business over a longer term.

Traditional bank covenants, on the other hand, include maintenance financial covenants. Maintenance financial covenants are tested periodically over the term of the loan. Common examples are leverage ratios (debt to EBITDA) and interest coverage ratios (EBITDA to interest expense). If financial performance deteriorates, an event of default may be triggered even without any affirmative action by the issuer of the debt.

The negative covenants in a traditional bank covenant package prohibit the incurrence of debt, the incurrence of liens, sales of assets, the making of restricted payments and investments, and affiliate transactions. These prohibitions are subject to listed exceptions. But regardless of financial performance, traditional bank covenants do not typically permit transactions that are not included in the listed exceptions. To incur indebtedness or make restricted payments not contemplated by the covenant package, a consent or amendment is needed, even if financial performance is strong.

Traditional bank covenants provide that the occurrence of a change of control is an event of default. In a bond transaction, however, a change of control typically triggers an offer to the noteholders to repurchase their bonds at 101 percent of the outstanding principal amount thereof, plus accrued interest.

In a covenant-lite transaction, the bond-style provisions converge with a bank credit agreement. Instead of maintenance financial covenants, a covenant-lite transaction will contain incurrence financial covenants. As long as the issuer of the debt takes no affirmative action that violates the credit agreement, poor financial performance—short of payment default on the debt—will not trigger a default.

The negative covenants in a covenant-lite transaction contain prohibitions on the incurrence of debt and the making of restricted payments and investments. These limitations, however, typically do not apply to any transaction where an incurrence-based financial test can be met on a pro forma basis.

Rather than a prohibition on asset sales, subject to exceptions, a covenant-lite transaction can have an asset sale offer provision pursuant to which the issuer offers to repay the loans with the proceeds of asset sales above a certain dollar amount. The repayment requirement is subject to exceptions for reinvestment of the proceeds. Usually the asset sale must be for cash up to a percentage—usually 75 percent. This limitation can be diluted by including specified non-cash consideration—such as a short-term seller note—in the cash portion of the consideration. Likewise, in place of a change of control event of default, a covenant-lite transaction may have a change of control offer provision.

Impact On Lender

The effect of a covenant lite package from the perspective of the holder of the debt is that there is less control over the migration of value away from the debtor and an inability to move to a work-out when financial performance is poor. This is true for so long as debt service can be maintained, because poor financial performance by itself does not trigger an event of default. As a result, covenant-lite packages, generally speaking, involve greater risk of value loss. For lender protection, somewhat more reliance is placed on equity and management self-interest and competence, and somewhat less is placed on covenant protections.

Many of the recent covenant-lite transactions have been structured with first and second-lien tranches. The second-lien product has been a growing part of the market in recent years, and has been favored by the leverage finance debt purchasers, because it has been perceived as offering better risk-reward dynamics than other junior products. Having an interest in the collateral is intended to place the second-lien participants ahead of unsecured creditors who, being unsecured, do not have an interest in collateral.

Second-lien transaction structures typically have been documented as mirror agreements of the first-lien documents. A first and second-lien covenant-lite transaction structure typically would have a second-lien tranche with still looser covenant protections. The risk created by a liberal covenant package falls primarily on the second-lien lenders, because the entire second-lien tranche usually is rendered unsecured before the loss of value affects recoveries of the first-lien tranche.

The current flat-spin trajectory of the debt markets is a function of purchasers wanting a greater premium for the risk, especially for a vulnerable covenant structure—or not wanting the paper at all. This instability has been exacerbated by the combination of the covenant-lite structure, particularly in the second-lien tranches, with payment-in-kind toggle features. These features allow the issuer of the debt to elect to pay all or a specified portion of the interest by the delivery of additional identical debt obligations. The payment-in-kind toggle feature allows more leverage, because debt service can be capitalized and deferred.

The payment-in-kind toggle feature affects the incurrence tests in some covenant-lite transactions. As lenders measure the non-cash interest expense and non-cash leverage in the incurrence test which permits the incurrence of additional debt, in certain recent covenant -lite transactions, the incurrence financial tests have migrated away from familiar tests such as a fixed charge coverage ratio of two to one. Some transactions have employed leverage tests above five to one or even above seven to one as the incurrence financial covenant. These are high multiples, and it is not hard to understand how the glue holding together covenant-lite market could lose its adhesive qualities.

The rapid descent of the covenant-lite issuances of the leveraged finance markets is about pushing boundaries, not unlike the story of Icarus. The markets pushed for the limits of liquidity provided by the funds that buy leveraged finance debt. The story of July 2007 is that the markets found those limits.

Interestingly, it is not the failure of a covenant-lite covenant package to protect a particular lender group against a loss of value that has triggered the crisis. Rather the larger economic forces affecting liquidity in the market place, in a cascade of failures, have reunited the covenant-lite product with the pull of gravity.

At least for now. While it is hard not to acknowledge the incremental risks a covenant-lite package presents to the various lender tranches, covenant-lite also reflects a continuing long-term and positive trend towards the convergence of the bond markets and bank markets. As a result, the fluff of feathers hurtling to earth likely signals a temporary— though possibly protracted—retreat of the covenant-lite product. Icarus, on the other hand, never flew again.

J. Eric Wise is a partner in the Banking & Finance Practice at Kramer Levin Naftalis & Frankel LLP where he focuses on leveraged finance transactions and distressed and special situations lending. He can be reached at ewise@kramerlevin.com.