Over the last 18 months, leverage has been creeping up to 2007 levels, but this time around there’s an added element, 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 this year, that number was 72.71 percent.
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.
The attractiveness of cov-lite loans for private equity buyers 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. A prudent GP will be closely monitoring the financial performance of its businesses, covenants or not.
However, Randy Schwimmer, senior managing director, head of origination and capital markets at credit asset management firm Churchill Asset Management, makes the case in his research paper The Case for Covenants 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.
“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.
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 and higher.
Now lenders are so far down this path, it’s difficult to retract; they are “praying for a correction” that will allow them to tighten up on terms, Schwimmer writes in the special report. However, unless the correction is of sufficient size, it won’t have a long-term impact on lending terms.
A rise in interest rates would have more of a long-lasting impact. However, as Schwimmer points out, LIBOR peaked at around 5.5 percent in 2007; in September it was at 1.3 percent.