Over the last 18 months, we’ve often written about how it’s beginning to feel a lot like 2007. There is indeed no lack of familiar signposts: the prolonged fundraising boom resulting in funds of a size we’ve never seen before; the EBITDA multiples paid for businesses creeping up and up to a level bordering on alarming; the ensuing increase in the amount of leverage being ploughed into businesses.
But there’s an added element this time around, something which the private equity industry didn’t see even in those heady pre-crisis days. Back in 2007, only 29 percent of institutional debt issued in the US was ‘covenant-lite’ – devoid of all maintenance covenants. In Europe, the figure was just 7 percent, according to data from LCD, part of S&P Global Market Intelligence.
This has rocketed to 75 percent of newly issued institutional debt in the US last year, and 60 percent in Europe. To look at it another way, in January 2006, just 0.95 percent of outstanding leveraged loans in the US were cov-lite. In July, that number was 72.71 percent.
In a note accompanying the research, LCD says that “while the popularity of cov-lite loans has prompted worries in some corners of the market, historically, these deals have not defaulted any more frequently than loans with traditional covenants”.
“Then again, as naysayers are fond of pointing out, they’ve never comprised this much of the market before, so they will be under scrutiny once the current credit cycle turns.”
While the cat’s away
Covenants act as warning signals alerting lenders that all may not be going entirely to plan in a business they are backing. Clearing banks have traditionally insisted on the inclusion of four mainstream covenants – typically tests relating to cashflow, leverage, liquidity and net worth – to indicate the health of the borrower.
Maintenance covenants require the borrower to meet these tests on a regular basis. Incurrence covenants are only tested when an event occurs, such as taking on more debt.
Debt funds started from a similar position five years ago to clearing banks, Bill Troup, managing director in the debt advisory team at London-based mid-market M&A firm Livingstone Partners told sister title Private Debt Investor in July. But they’ve been loosening their covenant requirements ever since.
In 2015, 60 percent of unitranche providers in Europe included the full set of four maintenance covenants, while the remaining 40 percent were either ‘loose’ – including only a leverage maintenance covenant – or ‘lite’, according to data from Fitch. However, Fitch figures for 2016 show a reversal, with less than 20 percent including a full set of protections for lenders and more than 80 percent either loose or lite.
Even in transactions with a leverage covenant, EBITDA ‘add-backs’ – adjusting EBITDA upwards by, for example, including the anticipated cost savings and synergies from an add-on acquisition – can mean leverage is higher than it looks. For example, if a company has $30 million in EBITDA and this is adjusted up to $50 million, which is then levered 5x for a total amount of debt of $250 million, the ‘real’ debt to EBITDA ratio could actually be more than 8x.
The reason why cov-lite is attractive to private equity firms acquiring companies is clear: it offers much more flexibility. The firms can pursue expansion plans, add-on acquisitions, new product roll-outs and the like without lenders looking over their shoulders. For the private equity house, cov-lite loans are no more risky than those with a full set of covenants.
“Notwithstanding the flexibility that a PE-backed business may have in its financial covenants, a prudent PE house will be monitoring the financial performance of its business closely as part of good internal financial management and will therefore be able to anticipate any future crunch points well in advance and deal with them appropriately,” Julie Romer, a partner at DLA Piper focused on leveraged finance and corporate lending, says.
However, Randy Schwimmer, senior managing director, head of origination and capital markets at credit asset management firm Churchill Asset Management, makes the case that, if a business starts to go downhill, it’s best for the private equity house to bring the lender in on the discussion at an early stage.
Rather than a punitive measure, covenants are intended to act as “guard rails that provide impetus for all parties to sit around the table and review financial performance”, Schwimmer writes in The Case for Covenants, a special report published in May.
“The sponsor and borrower can then outline what steps they will take to remedy the situation. That in turn allows lenders to provide thoughtful, constructive solutions, including more time and capital.”
In a cov-lite situation, the lenders are forced to take a back seat, Schwimmer tells PEI.
“This mimics bond documents in which borrowers are not held to a financial maintenance test; incurrence covenants only limit additional debt. Otherwise deteriorating operating performance won’t trigger a technical default,” he says, adding that a missed interest payment may be the first opportunity lenders have to compel the borrower to the negotiating table.
“By then the options for lenders have greatly narrowed.”
Adding fuel to the fire
Although cov-lite debt packages do not result in direct additional risk for the private equity sponsor, an extremely borrower-friendly market is pouring accelerant on the mountain of dry powder available for private equity, driving prices higher.
Romer says for the past 12 months or so, a common message from her clients is that the assets being brought to market are not of a consistently good quality, which means “when a good asset does come to market, the process becomes intensively competitive”.
“You will have multiple PE houses chasing the asset, often alongside trade buyers, and each potential PE buyer will be speaking to multiple lenders. It is those prime deals where we’ve seen the debt terms really pushed in the borrower’s favour.”
“Over the past several years, headline market leverage – as measured by debt to cashflow – has risen,” Schwimmer adds. “Covenant packages have become looser with terms increasingly favourable to issuers. These combine to create the sense that overall risk in leveraged lending has grown.”
The lenders, Schwimmer writes in the report, “have no one to blame but themselves”.
“That’s why credit managers are praying for a correction: ‘market conditions’ are an easier excuse to structuring sanity than simply saying no – particularly since a big enough market crack ensures competitors won’t gain the upper hand.”
However, even that may not be enough unless it is of sufficient size; a ‘mini-correction’ came in August 2015 when worries about China and commodity risk caused a steep stock market downdraft. That swung the lending market from being issuer-friendly to investor-friendly.
“But by the spring of 2016 momentum had shifted back, and competitive pressures compelled lenders to resume offering increasingly aggressive terms.”
A rise in interest rates would have more of a long-term impact. However, as Schwimmer points out, LIBOR peaked at around 5.5 percent in 2007; today it’s only at 1.3 percent.
“We’ve got a long way to go before we’re at pre-crisis interest rate levels.”