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Covenant-Lite, Convergence and Consequences: Observations on Leveraged Loans and High-Yield Bonds
As the pain, and arguably memories, of the financial crisis recede, there have been rapid and substantial advances in the volume of high-yield bond and leveraged loan issuances in the United States. In 2012, about $346 billion of high-yield bonds and about $465 billion of leveraged loans were issued. This year’s activity could top that. As of May 30, 2013, about $160 billion of high-yield bonds (compared to $138 billion as of May 30, 2012) and about $304 billion of leveraged loans (compared to $182 billion as of May 30, 2012) were issued.  While some might call these figures eye-popping, it is eye-opening that in 2012 about $87 billion of “covenant-lite” loans were issued and as of May 30, 2013 about $131 billion of covenant-lite loans were issued.
These figures reveal that:
- covenant-lite loans represented a whopping 43% of all leveraged loan issuances in the United States as of May 30, 2013; and
- the total amount of covenant-lite loans issued in the first five months of 2013 exceeded the total amount of covenant-lite loans issued in ALL of 2012 by about $44 billion.
The rise in the issuance of high-yield bonds and leveraged loans has been accompanied by falling yields. For example, yields for BB-rated unsecured high-yield bonds and leveraged term loans fell from 3.89% and 5.55%, respectively, at the end of December 2012 to 3.30% and 4.52%, respectively, as of May 30, 2013. Similarly, yields for B-rated unsecured high-yield bonds and leveraged term loans fell from 6.08% and 8.12%, respectively, at the end of December 2012 to 5.04% and 6.77%, respectively, as of May 30, 2013.
The foregoing numbers speak volumes about the ability of borrowers (and, in many cases, the clout of their sponsors) with less-than-stellar credit to borrow galactic amounts of leveraged debt at increasingly down-to-earth rates. It is fascinating that these dynamics have been at play against the backdrop of an explosion in the issuance of covenant-lite loans, the advent of “high-yield lite” bonds and a growing convergence in covenant terms that is causing the historically more stringent provisions of term B loans to mirror the relatively lenient features of their close cousins, high-yield bonds. Most commentators in the leveraged finance area agree (and we do too) that in the prevailing (some might say, “parched”) low interest rate environment, investors’ thirst for the relatively higher yield offered by high-yield bonds and leveraged loans is the main factor driving an apparent willingness to accept weaker covenant protections.
Interestingly, there is no universally accepted definition of what constitutes a “covenant-lite” loan. Typically, covenant-lite loans exhibit the following features:
- Absence of Maintenance Covenants: In this case, one or more (or all) maintenance covenants are eliminated in the covenant-lite loan (or are included only in the revolving credit facility or for the benefit of the revolving lenders only) and replaced with bond-style incurrence covenants. For example, Facebook, Inc. closed on a $1.5 billion dollar covenant-lite loan with arrangers, J.P. Morgan, Merrill Lynch, and Morgan Stanley, which contained no financial maintenance covenants.
- Maintenance covenants require the borrower to maintain compliance with certain key financial ratios such as Debt/EBITDA or EBITDA/Interest Expense that are typically measured on a monthly or quarterly basis. The failure by the Borrower to comply with the applicable maintenance covenant on its measurement date constitutes an event of default under the terms of the loan agreement. The occurrence of an event of default enables the lenders, if they so choose, to accelerate the entire amount of the debt outstanding under the loan agreement. A prudent borrower that apprehends that it will not be able to comply with its financial maintenance covenants, and is otherwise unable to head off an impending event of default through an equity cure (see below), is well advised to approach its lenders in advance of the measurement date to obtain a waiver or amendment of the loan terms in order to preempt the occurrence of an event of default. While the impending failure to comply with a financial maintenance covenant is not always a harbinger of financial doom for the borrower, given that it may be brought on by an isolated “bad quarter,” seasonality or unexpected one-time events, it does effectively raise a red flag before the real trouble arrives. This works as a highly desirable “early warning system” for the lenders and forces the borrower to sit down with its lenders to “work things out” before the borrower gets into even more trouble with an event of default on its hands. This is especially important for senior lenders who want the ability to be at the table exclusively with the borrower before holders of any subordinated debt and trade creditors have enforceable claims. This gives the senior lenders the opportunity to maximize their loan recovery at the time when the value of the borrower might be quickly dissipating.
- In contrast, incurrence-based covenants that are routinely part of high-yield bond terms do not require any maintenance of financial ratios or metrics that are measured on specific dates. The upshot is that slipping financial performance and metrics alone, even if severe, will not result in a violation of an incurrence-based covenant. Instead, incurrence covenants are tested only when the borrower desires to take some action such as incurring additional debt, paying dividends or making an unscheduled repayment of subordinated debt. This puts the borrower in the driver’s seat and allows it to navigate its business and actions in a manner that is least likely to breach its covenants.
- Springing Maintenance Covenants: In some covenant-lite loan transactions, the financial maintenance covenants apply only to the revolving credit facility or are for the benefit of the revolving lenders only and are “springing” in nature. In these cases, the maintenance covenants apply only at times when the revolver is drawn upon or the outstanding borrowings under the revolver exceed certain predetermined thresholds. In these cases, a borrower may be able to avoid a violation of the maintenance covenant if before the measurement date it repays all outstanding debt under the revolver or reduces outstanding debt under the revolver below the springing threshold amount.
- Performance Cushions: In this flavor of covenant-lite, instead of eliminating the maintenance covenants outright, significant cushions are included in the required financial metrics that may permit a deviation of up to 50% from the borrower’s business projections compared to traditional cushions of 15% to 20%. This effectively prevents the occurrence of an event of default even if the borrower’s business and financial performance materially veer off its projected business model. Another method that is sometimes employed is to permit generous add-backs in the calculation of financial metrics such as add-backs for cost savings that are anticipated to be achieved from a restructuring.
- Equity Cures: This feature permits a borrower’s sponsor or shareholders to contribute additional equity to the borrower thereby increasing its EBITDA and consequently preventing a failure to comply with a maintenance covenant that, for example, requires a certain ratio of debt to EBITDA to be maintained. This once sparingly used tactic has become more prevalent in recent times.
In addition to classic covenant-lite features described above, many covenant-lite loans also permit the borrower to take the following actions in a manner that is relatively more permissive compared to traditional bank loans:
- Additional Debt Incurrence: Instead of imposing a fixed dollar cap on the amount of other debt that a borrower can incur, a borrower is permitted to incur unlimited debt if it is able to comply with maximum leverage ratio or a minimum interest coverage ratio at the time of such incurrence. Some deals also permit the borrower to secure such additional debt (thereby diluting the security of the initial lenders), if it is able to comply with a maximum leverage ratio.
- Making Acquisitions: Instead of limiting acquisitions to a fixed amount, per acquisition, annually or over the life of the deal, many covenant-lite loans permit unlimited acquisitions as long as the borrower is able to demonstrate that after giving pro forma effect to the contemplated acquisition it would be in compliance with a specified financial maintenance covenant or some other specified financial ratio.
- Repay Subordinated Debt: Many covenant-lite loans allow borrowers to repay subordinated, unsecured or second-lien debt subject to compliance with a specified incurrence test.
High-Yield Lite Bonds
The relatively more permissive world of high-yield bonds has not been immune to the “lite” winds sweeping the leveraged finance markets. In February 2013, Moody’s Investors Service announced that covenant quality on North American high-yield bonds declined to its lowest-ever level in January 2013, mostly due to a spike in issuance of high-yield-lite bonds. Moody’s announcement further stated: “High-yield lite covenant packages, which lack a restricted payments and/or a debt-incurrence covenant, accounted for 34.6% of issuance in January , compared with 3.2% in December . Continuing a recent trend to convert to high-yield lite from full high-yield covenant packages, Netflix, Lear and Crown Americas all issued bonds with high-yield lite packages [in early 2013].”
The willingness of investors to live without once indispensable covenants such as a restricted payments covenant or a debt-incurrence covenant is one of the most telling signs yet of their willingness to accept significantly weaker covenant protection in the debt terms of borrowers with a strong credit profile rather put their money into bonds issued by borrowers with weak credit profiles that offer more robust covenant protections.
The convergence of the investor base and covenant terms between term B loans and high-yield bonds has accelerated significantly over the past couple of years. In addition to the classic covenant-lite features described above, the provisions of term loans, particularly covenant-lite loans, are increasingly mirroring the more permissive and relatively lenient features of high-yield bonds.
The traditional model of a borrower seeking leveraged loan credit from its main “relationship bank” or a small group of relationship banks that know the borrower and its business intimately has given way to the widespread “syndication” of leveraged loans. Now it is the norm that corporate borrowers seek to raise debt financing in the tens and hundreds of millions of dollars at one time. It is the beyond the ability and/or the risk appetite of single or small group of banks to lend to one borrower loans in such huge amounts. This has led to the practice of syndicating the leveraged loan issuance where one or two banks act as the primary arrangers of the loans and who then sell portions of the loan to other banks and institutional investors such as insurance companies, hedge funds, mutual funds and certain special-purpose securitization vehicles. A robust secondary market has developed in which leveraged loans are bought and sold in huge amounts and the development of this market has been significantly aided by the provision of standardized ratings of leveraged loans by the rating agencies and the efforts of the Loan Syndications and Trading Association (LSTA) to establish and promote standardized transactions and practices. This has provided an efficient mechanism and market for lenders to sell interests in their loans to secondary buyers. This syndication of leveraged loans, the existence of a robust secondary market and the participation of investors in leveraged loans such as insurance companies, hedge funds and pension funds that have been traditionally investors in high-yield bonds are factors that have led to the growing convergence in the terms of leveraged term loans and high yield bonds. Further fueling this convergence has been the persuasive advocacy of corporate borrowers and their influential private equity sponsors that the wide distribution of leveraged term loans make obtaining consents and amendments substantially more difficult and expensive and therefore the deal provisions should be more flexible and permissive. Borrowers and their sponsors appear to have also successfully argued that the cost and management distraction caused by complying with widely divergent term loan and high-yield bond provisions is a drain of resources that exceeds any benefit to lenders.
Some of the important areas in which there has been convergence between the provisions of leveraged term loans and high-yield bonds are:
- Restricted Subsidiaries: It has become fairly common place for leveraged loans to limit the application of the restrictive covenants and the events of default to the borrower and its “restricted subsidiaries” only. This is a retreat from the traditional position of leveraged loan lenders of insisting that all subsidiaries of the borrower, without exception, must be subject to covenants and events of default. Borrowers have been able to convince lenders to permit them to designate one or more subsidiaries as “unrestricted” and thereby gain more operational freedom that comes from such unrestricted subsidiaries having flexibility to invest in projects and lines of business that may be unrelated to a particular borrower’s core business. Furthermore, unrestricted subsidiaries are not required to provide any upstream guarantee of the borrower’s loans or provide any security over their assets for the benefit of the leveraged loan lenders. These freedoms come at a price because typically the borrower is not permitted to count the income generated by its unrestricted subsidiaries (unless actually up streamed in cash) in the calculation of EBITDA for covenant compliance and incurrence purposes.
- "Builder Baskets” for Restricted Payments: Many leveraged loans have dropped the traditional construct of permitting dividend payments, acquisitions of stock, investments and unscheduled prepayments of subordinated debt only out of excess cash flow that was not required to prepay the term loans. Instead, leveraged terms loans have increasingly adopted the “builder basket” concept of high-yield bonds of permitting such “restricted payments” to be made at any time that the borrower is in compliance with specified leverage or fixed charge coverage ratio out of a notional basket typically comprising of 50% of the borrower’s consolidated net income (or 100% of loss), proceeds of issuance of qualified capital stock and equity contributions. This development is largely the result of advocacy by the borrowers and their sponsors that it is more efficient and cost effective for the borrower to be subject to the same “restricted payment” calculations under both its leveraged loan and high-yield covenants.
- Events of Default. In a few large syndicated loan deals that have at least a single-B rating, the events of default in the term loan agreement are very similar to events of default in bond indentures. The consequence has been that restrictive covenant defaults under the loan agreement get the benefit of a 60-day grace period (instead of no-grace periods), breaches of the representations and warranties do not result in an event of default and there is a cross-acceleration default instead of a cross-default provision. The requirement that an event of default under the term loans occurs only if the holders of some other material debt actually accelerate such debt puts the term loan lenders at the mercy of unrelated third parties. Not only must the frustrated term loan lenders wait for such a third party to accelerate its loans, the lenders may even be placed in a position where funds are given to that third party before they can properly exercise their rights. Often the mere threat of those rights can be employed to bring delinquent borrowers to the negotiating table in order to restructure the business and mitigate a creditor’s losses. The inclusion of a cross-acceleration event of default provision, coupled with the creation or extension of previously nonexistent or token grace periods, adds to the erosion of lender protections and bargaining power.
Consequences and the “Covenant Bubble”
In their pursuit of yield, investors appear to have materially increased their appetite for risk by accepting increasingly weaker and looser covenant packages. This has caused at least one major ratings agency, Moody’s, to recently issue a special report that warns investors of the formation of a “covenant bubble.” In this report, Moody’s makes the following important observations that are reproduced below:
- “Signs of a “covenant bubble” emerge. Robust issuance of covenant-lite loans and high-yield bonds with weak investor protections suggest a “covenant bubble” that could leave fixed-income investors vulnerable in a credit cycle downturn. The quest for yield is driving looser covenant terms that may not reflect debt issuers’ underlying credit fundamentals. In a distressed situation, these looser covenants would limit creditors’ rights. As strong issuance narrows credit spreads, investors may not be fully compensated for the risks they are taking on.
- Risks remain in the background for now. While covenant-lite loans and weakening bondholder protections pose risks, investors are unlikely to face a reckoning owing to weak covenants in the next 12 months. Our proprietary indexes of speculative-grade liquidity, covenant stress and refinancing risk all point to favorable conditions for leveraged finance, including solid liquidity and a very low default rate.
- Conditions could change suddenly. While we do not consider the “covenant bubble” to be a near-term concern, conditions could change suddenly. The Federal Reserve’s eventual shift to tighter monetary policies and higher interest rates could weaken liquidity in the leveraged finance market and place more stress on low-rated companies. Recoveries on defaulted covenant-lite loans were relatively high in 2009 due to the significant influx of liquidity from the Fed and a cushion of subordinated debt, but the policy response is unlikely to be as robust in the next downturn. Investors’ acceptance of weak covenants today could lead to lower corporate family-level recoveries in future defaults. The cov-lite lenders generally would be protected by layers of subordinated debt, while subordinated bondholders would likely suffer the deepest losses.”
In addition to the foregoing points, the Moody’s report makes the following insightful observation that tempers the risks presented by massive covenant-lite issuance: “While cov-lite issuance volume has increased dramatically, much of the increase represents refinancing and repricings of existing debt. Just 17% of cov-lite loans issued during the first quarter of 2013 were “new money,” according to Thomson Reuters. The high proportion of issuance represented by refinancing of existing debt shows that while cov-lite lenders are forgoing protections, most are doing so without materially increasing borrower financial leverage.”
Of-course, not everyone agrees with Moody’s and one blogger for Reuters encourages his readers not to worry about covenant-lite loans and makes the case the covenants are “. . . generally much more trouble than they’re worth . . . they increase the probability of default.”
The continuing turning of the world, the passage of time and the advent of the next credit cycle will likely provide evidence to support (or not) one of the above theories. But there are certainly important consequences of covenant-lite loans and the convergence between term loans and high-yield bonds for both borrowers and their lenders.
- Benefits to Borrowers: One of the greatest benefits to borrowers is that the elimination or watering down of financial maintenance covenants permits the borrower to keep all its debt arrangements in place even during periods when its financial performance is extremely challenged and even slipping severely. This affords the borrower tremendous flexibility in weathering adverse business and financial cycles without the danger that a technical default or temporary dips in financial performance will trigger events of default and effectively hand the reins of control to its lenders who may have widely divergent views and goals about how to deal with the borrower and its business at such time. Of-course, this is not always true and the borrower’s financial performance may be in irreversible decline and still not trigger any event of default. That is bad for its lenders.
- Risks for Lenders: The risks to lenders are material and manifold. One of the most material risks to lenders arises in instances where the covenant-lite term loan does not contain any financial maintenance covenants or customary visitation rights. This eliminates the early warning system and access to the borrower that lenders would otherwise enjoy and puts them in a position of helplessly standing by even if the financial performance of the borrower deteriorates rapidly. The inability to force the borrower to sit down and compel a restructuring of the debt arrangement at an early stage, when things have not gone “completely south,” can materially reduce recoveries for even senior lenders who may have enforceable claims against the borrower only when it is on the precipice of bankruptcy or worse into the abyss. These risks are exacerbated when the loan terms do not contain a cross-default provision and instead only a cross-acceleration provision because it ties the hands of lenders from taking remedial actions even in an instance where there is an event of default under other debt of the borrower.
In recognition of the inherent risks, covenant-lite loans of the past were usually issued to more credit-worthy borrowers. Should they become more widely available to borrowers with significantly lower credit ratings, covenant-lite loans’ high performance relative to their more traditional counterparts may not be sustainable. In addition to the lenders making the loans, loan market participants who buy an interest in loans with these kinds of flexible covenants inherit the types of risks that are more closely associated with the high-yield bond market.
New and emerging markets always present unique investment opportunities. Investors’ desire for growth must always be balanced against their tolerance for risk. The relatively young secondary market for leveraged syndicated loans is best traversed with the knowledge that the more traditional characteristics of term loans that provided substantial covenant protections as compared to high-yield bonds may not be as prevalent in contemporary loan agreements. Borrowers’ aggressive negotiations have combined with the syndication and increased liquidity of term loans to promote more flexible loan agreements than have previously been observed. Those factors have driven a convergence between term loans and high-yield bonds, financial products that have traditionally been rather easily distinguished from one another. Weaker affirmative and negative covenants, strictly defined event of default provisions, and the adoption of more flexible structural conventions have given borrowers more freedom to conduct their businesses, but their enterprise has a greater potential to become a lender’s loss. While purchasing an interest in such loans could still present opportunities for growth, if the terms within loan agreements continue their convergence with those in high-yield bond indentures, they pass on the associated risk to lenders and investors.
For more information concerning the matters discussed in this publication, please contact the authors, John J. Hanley (212-238-8722, email@example.com), Avinash V. Ganatra (212-238-8874, firstname.lastname@example.org) or James Gadsden (212-238-8607, email@example.com), or your regular CL&M attorney. Summer Associate Matthew James contributed to the preparation of this Client Advisory.
Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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