S&P warns cov-loose may lead to backdoor cov-lite

As the sub-prime debt crisis spreads from the US to Europe, the ratings agency Standard & Poor’s believes covenant-loose contracts, with notional maintenance tests written into contracts, may be covenant-lite “in spirit if not the letter”.

Ratings agency Standard & Poor’s is examining covenant loose loans as a way buyout firms convince debt investors to accept covenant-lite by the backdoor.

Only four pan-European leveraged buyout deals in the last half have been covenant lite but far more have been covenant loose deals.

Paul Watters, a director in S&P’s European leveraged finance team, said: “We would like to define the difference between covenant loose and covenant lite, because from our perspective many deals with notional maintenance tests are cov-lite in spirit if not the letter.”

Watters said around 20-30 deals from the 188 signed would fall under that definition. There have also been 14 cross-border deals in Europe involving US companies.

Watters said because of the maturity of the US debt markets, which operate more like public markets, generally there was more scope for such loan packages on that side of the Atlantic. However, the European debt market was more like a private market largely controlled by the large banks and so does not favour such unprotected loan or cov-lite packages.

Watters said: “We will track performance and we will be interested to see how recovery prospects are affected by these deals (cov-lite and cov-loose) and our analysis will need to be carried out over the years.”  S&P yesterday invited industry participants to help refine its definition of cov-lite loans.

“Buyout firms justify cov-lite packages because they worry about aggressive investors like hedge funds using the influence they have to wield undue influence in a difficult situation such as a default.”   Yet it is a very controlling type of behaviour on the part of the big buyout firm unproven by the behaviour of most lenders who are generally very supportive during restructurings, he added. 

Separately Anshu Jain, head of Deutsche Bank’s investment bank, also warned in an interview with UK newspaper Financial Times that there is rising danger of so-called “event-risk” not only in the sub-prime markets but in leveraged finance generally given increasing leverage ratios.