- Investors insatiable for floating rate debt
- SunGard Availability tests the limits
- Pricing and leverage multiples are the key
The new deals, dubbed ”covenant-lite 2.0” by investors, allow companies to pile on more debt, encouraged by investors’ seemingly insatiable demand for floating-rate loans, sister service Thomson Reuters Loan Pricing Corp reported. Covenant-lite lending has already attracted the attention of regulators, who are concerned about overheating in the wider U.S. credit market.
A record $238 billion of U.S. covenant-lite loans were issued in 2013 and around $68 billion of covenant-lite loans have been issued so far this year, according to Thomson Reuters data. Covenant-lite loans have also spread to Europe, which saw its first ”pure” euro-denominated covenant-lite loan for French animal feed maker Ceva Sante in late March.
Conventional covenant-lite loans have no maintenance covenants. The new covenant-lite 2.0 deals allow companies to increase the size of restricted payments baskets and to issue extra debt at whatever rates borrowers choose. These changes are being seen increasingly frequently but are not popular with all investors, many of whom are becoming worried about recovery prospects in the event of a default.
“Some of the tricky print in covenant-lite 2.0 is bothering us much more than 1.0 because it can change loan to value (ratios) and lead to lower recovery in the event of default,” said Scott Page, director of floating rate loans at Eaton Vance.
Companies are mounting the size of restricted payments baskets, which usually limit the amount of debt that companies can use to pay dividends or other shareholder payouts, or are tweaking them so that they can be bypassed altogether if firms hit certain leverage ratios. Several recent M&A deals have had large synergy adjustments that have raised eyebrows from investors.
The size of incremental facilities, a feature of pre-crisis loans which allows companies to add debt in the future up to a specified amount, is also growing. The incremental basket on the new $1.275 billion credit from SunGard Data Systems spinoff SunGard Availability Services was cut to $200 million from $400 million during syndication (with no change to limits on the ratio debt), and the restricted payment basket was chopped to $35 million from $75 million to provide more protection to lenders. Both companies are backed by a group of private equity sponsors, including Silver Lake, Bain Capital, The Blackstone Group, Goldman Sachs Capital Partners, Kohlberg Kravis Roberts & Co LP, Providence Equity Partners and TPG Capital.
Other concessions include removing Most Favored Nation (MFN) status for lenders, which prevents companies from issuing new debt with higher interest without compensating existing lenders. Investors are spending more time studying credit agreements as a result and are pushing back on deals including a $2.35 billion loan backing talent agency William Morris Endeavor Entertainment’s acquisition of IMG, another deal involving Silver Lake, due to aggressive add-backs and integration risk.
“A significant number of managers will tell you they’re spending more time in the credit documents and being very selective. But just because you might see terms weakening, it doesn’t mean there aren’t good companies to lend money to,” said Jonathan DeSimone, a managing director at Sankaty Advisors, the credit arm of Bain Capital.
More aggressive covenant lite loans are appearing as leverage ratios are rising and the use of subordinated junior debt instruments is growing, all of which point to red-hot market conditions reminiscent of the peak of the market in 2007. Leverage ratios have been climbing in the last couple of years and are now slightly higher than 2007 for most rating levels, according to a December report from Moody’s Investors Service.
The use of second-lien loans, which have a second claim over assets in the event of a default and are structurally subordinated to first-lien loans, is also rising. January and February saw $7.4 billion of second-lien loans issued, compared to about $4.5 billion in the same period last year, Thomson Reuters data shows.
Looser lending standards could bring bigger losses to investors in the next default cycle. While the effects may not be immediate now, they could become more apparent in a worsening economy or when the Federal Reserve’s liquidity spigot is turned off.
The speculative-grade default rate of 1.95 percent on a trailing 12-month basis in February, is the lowest level since December 2011, according to a March report from Standard & Poor’s. Borrowers have however pushed out maturities on speculative-grade debt and 71 percent of the debt is not due until 2017-2018, according to a February report from Moody’s.
The market will also be able to find market-clearing pricing to mitigate the risk of any loan.
“Pricing and leverage multiples are the key determinants, and then the other provisions—whether you have a financial covenant or how many, where the cushions are set, uncapped restricted payments baskets based on a test, or uncapped debt incurrence based on a test—those are derivative of where the leverage between the issue and the lenders is on those first two points,” a lawyer representing corporate lenders said.
Natalie Wright is a senior correspondent for Thomson Reuters LPC.