There are growing signs that the US regulators’ patience with bank lending practices in the sub-investment grade market is wearing thin. As Euromoney has reported, guidance from the Office of the Comptroller of the Currency (OCC), the Federal Reserve and the FDIC that banks should not write weakly covenanted loans to corporates that would increase the latter’s leverage to more than six times ebitda has been largely ignored by many banks.
According to S&P, LCD total debt levels for US LBOs have hit 6.62 times in the third quarter of 2014 – higher than the 6.23 times they were in 2007. And we all know how that panned out.
In a sign that the gloves are now coming off, the Federal Reserve wrote a ‘Matters requiring immediate attention’ letter to Credit Suisse over the summer, demanding that it rein in lending that does not comply with the guidelines.
The Swiss bank is seen as among the most aggressive lenders in the leveraged finance market and has lent to a series of transactions that do not meet the requirements.
Matters requiring attention
The letter is also a sign that the Fed – which regulates foreign banks in the US – is reacting to criticism from domestic lenders that it has not applied the lending guidelines as stringently as the OCC has. Other non-US banks have received less serious ‘Matters requiring attention’ letters from the Fed.
As the US regulators get tougher on leveraged lending there are signs that European corporates are also taking on board the strong message being sent from across the Atlantic – unfortunately not on leverage though, but on weaker loan documentation. While leverage in Europe has yet to reach the heights regained by the US leveraged finance market, there has been a sharp increase in the volume of covenant-lite lending in the region.
By July this year cov-lite issuance in Europe had hit €14.6 billion according to S&P LCD. In 2007, just before the market crash, cov-lite lending for the entire year in Europe was only €8.1 billion. Indeed, by July 2014 39% of institutional loans issued in Europe year to date had no maintenance covenants – up from 21% in 2013 and 7% in 2007.
So far, so predictable. Where the US leads, Europe usually follows. Between 15% and 17% of outstanding leveraged loan inventory in Europe is now cov-lite (at the end of 2013 it was just 6%) while in the US it is more like 50%. Nearly 40% of new loans in Europe are cov-lite (These figures will have been heavily influenced by the €3.7 billion of cov-lite loans that formed part of Numericable’s acquisition of SFR) – in the US new issuance is now nearly 70% cov lite – indeed, since 2007, the percentage of outstanding leveraged loans containing three or more maintenance covenants has decreased from 43% to 12%.
“Cov-lite issuance is growing in Europe and it will be a material part of the calendar,” says the head of DCM at a large US bank in London. “Such loans are fine for larger LBOs where there is liquidity, but are not suitable for smaller deals.”
|Thierry de Vergnes|
The challenge in Europe is that a lot of deals are small. And if investors are going to hold small, illiquid loans they might be better off holding amortising, covenanted term loan As rather than bullet cov-lite term loan Bs. In the US, the loan market is very similar to the bond market in that there is free tradability of debt, while in Europe cov-lite loan investors need to look very carefully at restrictions on the tradability of these instruments.
“Loan market characteristics are moving towards bond market characteristics,” says Thierry de Vergnes, managing director and head of debt fund management at Lyxor Asset Management in London. “If we continue to see this convergence, it will be super-concerning. If you have a liquid market for loans, then cov-lite isn’t a problem. In Europe the loan market is not liquid for all loans. Therefore you have to select cov-lite loans which are large enough to be sufficiently liquid.”
In July this year German pharmaceutical company Aenova Group refinanced existing senior debt incurred when it was acquired by BC Partners from Bridgepoint in August 2012 via a €470 million six-year cov-lite term loan B arranged by Deutsche Bank and JPMorgan. The cov-lite refinancing also included a £30 million six-year term loan B. The refinancing was used to pay a dividend to BC Partners and follows on from their timely exit from UK mobile phone distributor Phones 4U last September.
Also in July Belgium-based consumer foods business Continental Foods, which was purchased by CVC Capital Partners in October 2013, refinanced €320 million of senior acquisition debt with a €425 million cov-lite loan to finance a €160 million dividend to CVC.
There is oft-cited evidence to support the view that the move from covenanted to cov-lite loans doesn’t matter: since 2008 cov-lite loans have defaulted at a rate of 14%, compared with 17.6% for loans with traditional financial maintenance covenants. No BB-rated cov-lite loan has ever defaulted, while BB-rated loans with traditional financial maintenance covenants have a 5.2% default rate. De Vergnes argues that these figures provide false comfort.
“Covenant-lite is a bit of a challenge, and we look at it very carefully,” he warns. “The universe of issuers has expanded in the new wave of cov-lite post-crisis. Cov-lite loans performed well during the crisis because they were for strong issuers who were able to run at peak leverage for a short period of time and fix their problems. However, are all the companies that have issued cov-lite now strong? If we go into another recession will it be short-lived?”
That is a question that not only investors but regulators are now asking, if the OCC rhetoric is anything to go by. But the growth in cov-lite lending – particularly in the US – can partly be laid at the regulators’ own door. The Volcker Rule removes the ability of a CLO to invest in bonds and, therefore, by default boosts the demand for loans with which to ramp CLO pools. This boost to loan demand is what is driving borrower-friendly cov-lite documentation in the market.
“Under the Volcker Rule CLOs cannot buy securities so they can only have loans in the pool,” claims one leveraged finance banker. “They are therefore making their cov-lite baskets bigger as so much of the loan market is cov-lite. Thus, cov-lite issuance is being encouraged as a direct consequence of regulation – the regulators are supporting the formation of cov-lite loans.”
Cov-lite buckets are now a feature of most new CLOs in both the US and Europe. Given the sharp increase in cov-lite issuance they are, unsurprisingly, getting bigger and bigger. In the US average buckets for cov-lite loans have increased from 51% in 2013 to 57% today, while in Europe buckets are now increasing from 20% to as high as 30% to 50%, according to Fitch Ratings – albeit with restrictions on the number of cov-lite loans rated below double-B.
In mid-October signs were emerging of lender pushback against the growth of borrower-friendly loan structures in Europe. Belgian aluminium windows maker Corialis has been forced to revise the term sheet on its €483 million leveraged loan twice since launch after failing to attract lenders to the cov-lite structure. In addition to adding a leverage covenant the company, which is being bought by Advent International, had to dispense with a €30 million incremental debt basket that would have pushed leverage to 6.5 times ebitda. A €5 million restricted payments basket was also halved and the margin widened by 25 basis points to 500bp. The deal was underwritten by Jefferies, Rabobank and UBS.
“Doing a cov-lite deal in itself isn’t a fundamental problem for the right sector and credit,” says Mark Donald, partner at Weil, Gotshal & Manges in London. “However, if you push all the flexibility in the structure to the limit, you can end up with problems. Each point in itself can seem innocuous, but you need to consider all the terms as a whole and whether or not they will be acceptable to the market.”