Tuesday 29 May 2012

Credit - The return of Cov-Lite loans and all that jazz...

Definition of Credit Market insanity:

"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."
"The Distressed Hedge Fund Panel participants lamented the return of some of the worst practices such as HoldCo PIK dividend recaps and the triumphant return of cov-lite deals so shortly after many had believed the credit markets had learned from its past excesses."

As a reminder from our 2011 conversation, we referred to what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, said in her article - Corporate Subprime - The default crisis that never happened:
"When most of us think about the credit bubble that burst in 2008, we think about the lax terms of mortgage loans. But many corporations, particularly those that were bought out by private equity firms, also got debt on lax terms. This debt was known as "covenant-lite," because the normal terms of corporate credit—such as a requirement that a company, say, maintain a certain level of profits—were waived by deal-hungry lenders.
After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their "no documentation" loans to home buyers. Cov-lite loans plunged in price. At his retirement dinner in May 2007, Anthony Bolton, Fidelity's investment guru, said, "Covenant-lite borrowing … will come back at some stage to haunt the banks." Indeed, Goldman Sachs and other big firms took massive losses when they sold or marked down the price of the bonds they were stuck holding. One person involved in negotiating these deals says his banking clients swore, "Never again."
But less than three years later, cov-lite loans are back. "With a vengeance," my friend David Pesikoff, a Texas-based hedge-fund manager, assures me. Has the world of finance gone insane? Not necessarily. The return of cov-lite loans makes a certain sense in the current financial environment. But I find myself wondering what that says about the current financial environment."

Old habits die hard:
"Cov-lite loans were used to finance some of the biggest, best-known deals of the era, like KKR's buyout of Alliance Boots and Thomas H. Lee and Bain Capital's buyout of Clear Channel. According to the credit rating agency Standard and Poor's, $32 billion in cov-lite loans were issued between 1997 and 2006."

According to Nicole Bullock from Financial Times on the 10th of May in her article - Cov-lite loans make post-crisis comeback:
"In April, companies obtained $7.6bn of cov-lite loans, equivalent to more than 40 per cent of so-called institutional loans extended to companies in the US, according to S and P Capital IQ LCD, a research group. That is the highest monthly proportion since May 2007.
Cov-lite loans extend credit to low-rated corporate borrowers, but strip out some of the traditional protection for lenders. That protection is financial covenants that trigger a default if a borrower’s financial health declines while it is still making agreed interest payments.
When the global financial crisis hit, it was feared cov-lite loans would lead to huge losses for investors. Those losses, though, have yet to materialise, opening the door to a revival of such deals during bouts of market strength."

"Unintended consequences" of low rates environment have led to a flurry of issuance of Cov-lite loans again in the market.

Standard and Poors indicated in a LCD Daily Wrap-up from the 27th of April, such a resurgence of these bad financing habits coming back to play:
"Ineos’ new covenant-lite financing was in focus on the 27th of April after allocating late in the morning. The $2 billion, six-year term loan (L+525, 1.25% LIBOR floor) was pegged at 100.25/100.625, which is off the session’s highs but well above issuance at 98.5 and either side of par on the break. The $375 million, three-year tranche (L+425, 1.25% floor) that was targeted to older-vintage CLOs was also trading at a healthy premium to 99 issuance, rising to 100.25/101 by afternoon."

also on the 27th from the same LCD Daily:
"Schrader cov-lite loans allocate, break atop OIDs
Accounts today received allocations of the first- and second-lienfinancing backing Madison Dearborn’s acquisition of Schrader International. The $235 million, six-year first-lien term loan freed to trade at 98.5/99.5, from issuance at 98, sources said. It cleared the market at L+500, with a 1.25% LIBOR floor, and is covered by a 101, one-year soft call premium. At 98 issuance, the loan yields roughly 6.84% to maturity, which narrows to 6.62% at the midpoint of the bid/ask on the break.
The $100 million, seven-year second-lien term loan broke into a 98.75/99.75 market, from issuance at 97.5, sources added. The second-lien is priced at L+925, with a 1.25% floor; it carries 103, 102, 101 call premiums in years 1-3, respectively. It yields about 11.5% to maturity, or 11.09% at the midpoint of the bid/ask."
As reported, Barclays, Goldman Sachs, and Citi yesterday sweetened pricing on the deal as they stripped maintenance covenants from the term loans. The first-lien term loan launched to market with leverage and interest-coverage tests, while the second-lien originally included a leverage test.
Original price talk, meanwhile, was L+450-475, with a 1.25% floor and a 98.5 offer price on the fi rst-lien, and L+850-900, with a 1.25% LIBOR floor and a 98 offer price on the second-lien.
In addition to dropping covenants, the excess-cash-flow-sweep thresholds were been revised; the sweep starts at 50%, falling to 25% at 3.5x and to 0% when leverage is less than 3x. Previously, the respective step-downs occurred at 3.75x and 3x, sources said."

Corporate loans typically include provisions, or what we call covenants. They can trigger a "default" if finances deteriorate, even if the borrower is still paying interest. This forces the company to negotiate with the bank lenders, often allowing them to force a restructuring. Covenants also act as early warning system when the credit metrics of company start to deteriorate.

According to Moody's, as reported by Patricia Kuo and Katrina Nicholas in Bloomberg today - Europe Leveraged Loan Defaults May Rise to 25%, Moody’s Say:
"At least 25 percent of unrated European leveraged buyout companies with debt due by 2015 may default as the economy worsens and private-equity owners refuse to inject capital, according to Moody’s Investors Service.
An analysis of European LBO companies found that 254 had a combined 133 billion euros ($167 billion) of debt due by the end of 2015, with more than half owed by 36 borrowers, Moody’s said in a report.
“The 2014-2015 refinancing risk remains large and worrisome given our expectations of protracted macroeconomic weakness combined with the weak average credit quality of this universe,” analysts led by London-based Chetan Modi wrote in the report. “We do not expect that private equity sponsors will inject further capital into their own distressed companies
primarily to assist their lenders.”

From the same article:
"Some 125 billion euros of syndicated corporate loans are maturing before the end of 2013 in countries on Europe’s periphery, according to data compiled by Bloomberg. Companies in Asia outside of Japan have more than $110 billion of U.S. dollar-denominated loans maturing in the same period, the data show.
A similar risk of leveraged loan defaults doesn’t exist in Asia, according to Neil McDonald (Hong Kong-based head of law firm Hogan Lovells International LLP’s business restructuring and insolvency practice in Asia), who has advised commercial banks on their debt obligations to Dubai World and bondholders of Sino-Forest Corp. and China Forestry Holdings Co."

Standard and Poor's Leveraged Loan Index Description (Market Value Index Level) - source Bloomberg:

The Europe leverage loan price picture - source Bloomberg:

Looking at the above graph, we do think investors happened to  have been very lucky, once. Indeed, as any statistician would tell you, it was a good outcome for a bad risk. It doesn't mean a good outcome is going to happen again...

"You can't bank on the outcome."
Daniel Berrigan

Stay tuned!

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