The erosion of junior debt, looser covenants and less reliable cashflow projections are combining, in the view of some market sources, to produce an unholy brew of toxic ingredients confronting the leveraged loan market.
Research unveiled this week by Cambridge Associates revealed that, since the end of the credit crunch, far less junior debt is being included in deals – largely as a result of it being usurped by the unitranche product, which is often seen as a more user-friendly option by borrowers.
The significance of this is that junior debt helps to cushion senior debt holders from losses in the event of a default. The less junior debt, the quicker senior debt will start absorbing losses. Cambridge estimates that, as a consequence, recovery rates on defaults on leveraged loans may decrease from an average of 60-80 percent to between 46-70 percent.
This is against a background of various pressures which could make defaults more likely. One is the tendency for deal agreements to incorporate questionable assumptions of future cashflow – perhaps based around anticipated synergies, new contracts or revenue generation from initiatives not yet launched. These might uncharitably be described as “pie in the sky” assumptions.
The trend towards covenant-lite structures has been well documented, but certain provisions that have crept under the radar could be more damaging than those which have received more publicity. Cambridge highlights, as an example, agreements which allow the borrower to remove assets from a lender’s collateral pool to generate more liquidity – leaving the lender with less collateral in the event of a default.
Some market sources accuse lenders of having sleepwalked into the current situation. There was no “sea change” event as such, but incremental steps have created arguably the most borrower-friendly environment in the leveraged loan market in recent memory. And that is why legal advisers are now urging lenders to wake up and smell the coffee.
What we hear is that lenders are being urged to find any route possible to renegotiate the documentation. Technical breaches by borrowers – such as late delivery of documents, tardy reporting and questionable capex items – are being used to hold borrowers’ feet to the fire. Lenders are being told to focus on these breaches with alacrity and aggressiveness to try and claw back some of the creditor rights they have too readily tossed away.
Of the imbalance of power, one source told us: “These types of situations tend to find their own solutions, and the shortcomings can be addressed in unconventional ways.” Lenders may be gradually acknowledging this. Whether they can at least partially repair the damage will be intriguing to observe.
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