Cov-lite has gone pretty well so far
The coronavirus pandemic has subjected the European leveraged loan market, where cov-lite documents reign supreme, to a brutal test. The first results are positive.
For some type of catastrophic financial merchant, leveraged loans complying with covenants are a looming disaster. Consider the following from Frank Partnoy, professor of law at the Berkeley School of Law at the University of California:
“We already know that a significant majority of loans in CLOs have weak covenants that offer investors only minimal legal protection; in industry jargon, they are “cov lite”. Holders of leveraged loans will therefore have the chance to get pennies on the dollar if companies default – nothing close to the 70 cents that were the norm in the past. “
Rating agencies and many investors agree that recoveries may well be lower this time around, with cov-lite perhaps part of the problem.
The data will likely never be conclusive, because unlike an ordinary credit cycle, restructuring or insolvencies related to Covid-19 will likely affect businesses that have seen their revenues evaporate overnight, rather than businesses that have been caught. with a little too much debt at a time when interest costs are rising. .
This could well mean that lenders of once-healthy businesses only get back a few pennies, but it’s hard to see how taking the keys to an empty mall or restaurant chain closed earlier would have helped.
For businesses that have experienced Covid-related difficulties, the combination of a cov-lite term loan and revolving credit facility with sustaining clauses has worked more or less as advertised.
When the pandemic first struck, companies with strained finances (or a cautious approach to cash flow) tapped into their revolving credit facilities, maximizing their own cash balances before the scariest part of the deal. first blocking phase.
This activated the restrictive covenants in the guns, which required companies to maintain a certain debt to Ebitda ratio. For some companies, there was no “spring”, just a hard lever cap still present in the gun.
With a sharp drop in EBITDA expected, stressed companies seemed poised to exceed these ratios at the next test point, so they quickly reached out to their gun lenders (usually a small group of commercial banks) and started trading.
These negotiations went overwhelmingly in the same direction: a waiver of the maintenance clauses for the next test dates in exchange for a combination of dividend restrictions, modification fees and “minimum liquidity” or “balance of” tests. minimum cash flow ”. Cineworld, and several UK advertising companies are among the many companies that have adopted this approach.
The banks knew that companies could not meet the leverage test, but wanted reassurance that a company could pay off its short-term obligations and not send money to shareholders.
Institutional lenders holding “B” term loans had no say in the matter because their instruments did not include any maintenance clause. They weren’t in the room, or even on the Zoom call.
As a thought-provoking experience, how would this process have been different if institutional lenders had been able to force companies to meet maintenance commitments?
First, all the waiver processes would have been longer and more difficult. It is more difficult to combine 40 institutional lenders than to combine four banks, especially when negotiations are underway between 100 different companies at a time.
Creditors’ committees would have become cumbersome and impossible to manage; opinions would have varied on the details, and lawyers and restructuring advisers, already hard at work since March, would have had even less bandwidth.
Since creditworthiness and collection are a function of trust, a waiver and change process that lasts four months is much worse than one that lasts four weeks – and many companies could have run into a technical default on their own. the date of their June covenant test.
Second, there would be some holdouts. Some lenders may have refused to waive or charged exorbitant fees to do so. Healthy but strained companies may have been pushed adrift by a few determined hedge funds to the likely detriment of the rest of the lender group.
The aim of cov-lite is not exclusively to make the life of private equity sponsors easier, it is the reflection that a term loan ‘B’ is now an institutional product held mainly by funds, as close as possible to ‘a bond but in a private loan -shaped envelope.
Sometimes Covenant fans recognize the above issues, but appreciate Maintenance Covenants as a way to get to the negotiating table quickly in the context of a potential restructuring. It is certainly true that bank lenders (the only ones with covenants) had the first chance to negotiate with troubled companies.
But a quick glance at how restructurings work in real life reveals that companies are working hard to bring their institutional lenders to the table as soon as possible. Identifying and contacting creditors is one of the first tasks of a restructuring advisor.
The reason is obvious: there is a first-mover advantage in restructuring. If the business can get a good proportion of senior lenders to support a reasonable debt reduction proposal, it has the best chance of pushing through its preferred plan. Hiding from lenders with a restructuring underway is a recipe for creditors to combine against shareholders and for equity to lose the keys.
Covenant-lite is sometimes used as a lazy synonym to capture all the documentary degradation that has occurred in high yield bonds and leveraged loans over the past few years, but we can make a clear and bright distinction.
The absence of maintenance covenants in institutional loans is enough to make them cov-lite.
But a cov-lite loan borrower may also have bond and loan documents that allow for fantastic Ebitda additions incorporating huge imaginary future synergies, as well as gigantic dividend capacity, subtle legal trick, of numerous seed opportunities and flexibility to eliminate the security of ‘secured creditors.
This could be a real problem as the second wave of Covid hits and another round of restructuring awaits – but it’s not the same as cov-lite.