The Greek crisis and U.S. debt ceiling spectacle have precipitated a long-predicted pause in the two-year-old non-investment-grade-debt bull market.
The prognosticators of market doom will always be right, eventually, and can be counted on to smugly proclaim along the lines of "I knew the market had peaked when ..." A number of these folks are flogging covenant-lite loans, which omit certain lender-protective provisions, as the canary-in-the-coal-mine high-water mark of an overheated leveraged finance market. While high-yield booms of yesteryear have given the naysayers legitimate targets to shoot at (pay-in-kind toggle notes, holding company dividend deals, skinny equity checks, to name a few), with covenant-lite loans, they're barking too loudly and up the wrong tree.
A lot is in the name "covenant-lite." Anything with "lite" affixed to it as a suffix is immediately suspect. Wimpy. Flaccid. A Woody Allen loan as compared to a George Clooney loan. With the name has come a false conventional wisdom. Google "covenant-lite" and the first result, from Investopedia, proclaims a covenant-lite loan to be: "A type of loan whereby financing is given with limited restrictions on the debt-service capabilities of the borrower. The issuance of covenant lite loans means that debt is being issued, both personally and commercially, to borrowers with less restrictions on collateral, payment terms and level of income."
I will resist commenting on the barely literate prose inflicted on us with this attempt at a definition and simply point out that it is a flatly wrong description of a covenant-lite loan, but nonetheless consistent with the general misunderstanding of the product. In truth, a covenant-lite loan is basically the same loan as any other syndicated loan except you don't get a "maintenance covenant" -- a requirement that the borrower not exceed an agreed upon ratio of debt to cash flow -- that would only be breached if the borrower's cash flow turns out to be generally at least 30% less than projected. While maybe not a loan of George Clooney sturdiness, certainly of Hugh Grant fortitude, no?
Contributing to the misinformation have been some silly statements made by otherwise serious journalists of the business press. One reporter wrote, "After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their 'no documentation' loans to home buyers." Really? Mind telling us which banks expressed that particular regret? Another article warned that covenant-lite loans may be a "disastrous idea," as they give borrowers flexibility in tough economic times.
Putting the histrionics aside, the right question for an investor to ask is how much will you pay me to give up the protection offered by a maintenance covenant. If the borrower misses its numbers by a lot after the loan is made, the resulting maintenance covenant breach would permit the lender to reprice the loan (with fees or a higher interest rate) to compensate the lender for the deteriorated credit quality.
A covenant-lite lender agrees to give up this repricing right for a higher interest rate up front, betting that the excess interest paid all along will more than compensate it for the right to reprice if (and only if) the loan goes bad later on. It's essentially a form of default insurance made available to borrowers.
In a June report, Moody's Investors Service analyzed 104 cov-lite borrowers. They compared the 15 cov-lite loans that defaulted to a broader set of 186 loans that defaulted from 2008 to 2011. As we all know, this period provided about as vigorous a stress test for leveraged credits as we ever hope to see again, and covenant-lite loans did better than their counterparts with financial covenants.
The data reveal that holders of covenant-lite loans realized an 89.6% recovery rate as compared to 81.5% for the broader group. In addition, covenant-lite borrowers defaulted at a lower rate (7.87%) than similarly situated borrowers, generally (10.4%). Covenant-lite turned out to be the safer bet.
Even in this cooler market, recent experience demonstrates that lenders continue to make the covenant-lite bet for sensibly structured deals with solid credit characteristics (Capsugel
Belgium BVBA and Academy Ltd. are good examples). I'll make my own prediction: Covenant-lite loans are here to stay, in cool as well as hot markets. n
Richard Farley is a partner in the leveraged finance group of Paul Hastings LLP in the New York office.