Both senior and junior debt issued in the last year could pose substantial risk to investors, according to a study on recovery ratings by Standard and Poor’s.
Credit ratings measure the risk of a company defaulting whereas recovery ratings, the object of the study, measure how likely an investor is to be paid by a specific debt instrument after difficulties in the underlying investment. They are relatively new instruments, introduced by S&P just three years ago.
The S&P report, entitled “European Recovery Ratings Show Not All Debt Is Created Equal”, revealed 62 percent of rated second lien and mezzanine debt fell within S&P’s lowest recovery rating category of 6. Yet the remaining tranches of second lien and mezzanine were rated in S&P’s recovery categories of 2, 3 and 4, indicating relatively high recovery prospects.
The recovery prospects for senior debt also varied substantially. 40 percent had recovery ratings in the highest band of 1+ and 1 and 22 percent was rated 2, indicating good recovery prospects, But 20 percent of the debt was rated 3, 13 percent 4, and 3 percent at 5 or 6. The report said the reasons for the discrepancy was that some senior debt had much weaker security packages and capital structures, with higher priority obligations or lower cushions of equity or junior debt.
Marc Lewis, from Standard and Poor’s, said: “Just because debt is senior-secured, it doesn’t mean recovery prospects are equal. There are some types of businesses where you can end up recovering very little due to the underlying debt structure.”
In the last year, lenders have accepted less control on terms and conditions and allowed sponsors to borrow at higher multiples. This has had an effect on the ability of investors to recover debt upon default.
“New structures like PIK toggles and cov-lite have had an impact on recovery expectations because if lenders are not able to reengage with the company before it defaults, more value has been destroyed,” Lewis said.
Recovery prospects for cov-lite loans tend to be 10 percent lower, according to another recent S&P study.