US leveraged loans have proved an attractive investment this year. The S&P/LSTA US Leveraged Loan 100 Index gained 5.3% in the first 11 months of 2013.
The main reason for that performance – but one which presents considerable problems of its own – is a fundamental supply and demand mismatch. Although there was a healthy pipeline of refinancing in the first quarter of 2013, since then the absence of M&A to support new supply has ensured a thirst for paper that has defined the market.
While US$50bn of new paper came to market in 2012, with US$60bn coming up behind it in the first three quarters of 2013, that has not been sufficient to sate demand.
Broader M&A activity – the lifeblood of the leveraged loan market – remains weak, so it is unlikely that supply will keep pace with inflows into loan mutual funds. In addition, equity markets are enjoying a sustained period of strength, meaning valuations do not look enticing for private equity managers to lead the way with enough public-to-private transactions to make a dent in supply.
The fact that CLOs tend to buy and hold paper further exacerbates the pinch, while much issuance that would once have gone to the loan market now arrives in the form of high-yield bonds.
The resulting pent-up demand has created very favourable conditions for primary market issuance, enabling large deals with relatively aggressive terms to get done. Borrower-friendly megadeals in 2013 include those from Heinz (the largest of the year at US$9.5bn), Dell (the second largest at US$9.1bn), Community Health Systems (US$6.8bn) and Virgin Media (US$4.9bn).
“We are seeing a bifurcation in the market. Story credits have needed to offer lower leverage and additional yield to clear. The buyside is not blindly buying credit as it was before 2007. Fund managers are more discerning. If a borrower has a history of credit issues, an additional spread of up to 300bp may be needed relative to attractive borrowers”
The big questions, then, are: Are investors bending too far to issuers’ whims in their enthusiasm to bring deals in? And are credit standards falling as a result?
“2013 looks like it may come to be seen as a watershed year, the way the market is accelerating,” said Robin Miles, partner at law firm Bracewell & Giuliani, who sees worrying echoes with the 2005–07 period. “At some point the banks are going to run out of quality borrowers to lend to.”
Haven’t we been here before?
Certainly deal structures are starting to resemble those seen before the crisis. “I’ve seen more second-lien deals, with less collateral coverage than investors would ideally want,” said Miles. “It seems like some investors will turn a blind eye to anything if the yield is high enough.”
Covenant-lite terms, allowing leverage of up to six or seven times, flexibility of additional indebtedness and flexibility on repayment at first glance appear unattractive to investors, especially with such widespread uncertainty about the global economy. Yet most large deals this year have incorporated such features and have had little difficulty attracting investors.
The difference is which borrowers are able to access cash on such terms, according to Jeff Cohen, co-head of syndicated loan capital markets at Credit Suisse. “This year has been an issuer’s market, but the market has been disciplined,” he said. “Covenant-lite has become the norm for healthy businesses, but such terms are not offered to issuers that don’t deserve them.”
Before the crisis investors were less discerning about the quality of companies they lent to, and today poor quality companies either have to pay through the nose or simply can’t get financing at all.
“We are seeing a bifurcation in the market,” said Cohen. “Story credits have needed to offer lower leverage and additional yield to clear. The buyside is not blindly buying credit as it was before 2007. Fund managers are more discerning. If a borrower has a history of credit issues, an additional spread of up to 300bp may be needed relative to attractive borrowers.”
New deals continue to incorporate cov-lite features because they inevitably use the structure of recent deals as a starting point, said Alan Davies, a partner at law firm Debevoise & Plimpton. “The high-yield market is a precedent-driven market. There has rarely been a sudden shift, and the terms of a high-yield deal, both in the US and in Europe, are generally based on the 10 deals that preceded it,” he said.
Gradually the terms have been made increasingly issuer-friendly but once ground has been given on covenants it is very difficult to take it back, Cohen said.
In this sense it is misleading to think of the erosion of covenants as cyclical, with terms ebbing and flowing according to supply and demand pressures. Rather, the gradual erosion of covenants is more likely one-way traffic.
Even in 2010–11, when the market was still reeling from the aftermath of the crisis and few deals were being done, there was little clawback on covenants, said Raman Bet-Mansour, a partner at Debevoise & Plimpton. “The clawback in the high-yield market, particularly in Europe, was on the structure of the debt, not the covenants,” he said, with things like the subsidiary guarantees, the collateral and which level of the company structure issued the debt the main battlegrounds.
Everyone’s a winner?
The erosion of covenants has been irresistible, but they remain contentious. Advocates insist the increasingly pro-issuer terms prevailing on deals have not been at the expense of investors.
“Covenants give investors the option to reprice a loan in the event performance deteriorates,” said Tom Cole, co-head of US leveraged finance at Citigroup. “In today’s market, most investors would rather have additional yield instead of covenants. You could make the argument that investors haven’t been paid much to give up this option, because they have had to be aggressive to get the allocation they want on deals.”
“When the covenants were in place they didn’t ultimately offer much protection with large companies; they were rarely triggered before liquidity became an issue,” said Cole.
Bet-Mansour makes a similar point: “A loose covenant doesn’t protect a company from bankruptcy, it determines when the conversation between the borrower and the bank will happen.”
Events during and after the crisis also provoked a change of attitude to the value of covenants.
Many predicted a wave of bankruptcies from companies which had staved off bankruptcy longer than they should have because of weak covenants, Bet-Mansour said, but that never happened. In fact, few of the companies that had LBO debt in 2006–07 experienced bankruptcy.
“Some of the big LBOs from pre-2008 actually benefited from having cov-lite term loans,” said Cole. “If they had stronger covenants they might well have been pushed into default. As it was they had more time to work things out.”
There is of course another explanation about why banks have not been able – or willing – to reintroduce stricter covenants in the aftermath of the crisis, and it is one favoured by Bracewell & Giuliani’s Miles.
“I was surprised banks didn’t claw back some of the terms they ceded in the pre-crisis years,” said Miles. “Partly that is down to the relationship that exists between banks and the sponsors, which is not as arm’s length as perhaps it should be. You see private equity houses which use the same lead arranger on all their deals, so that might explain why those favourable terms survived.”
“The only thing that is going to reverse that trend is if a large deal collapses, which could shock the system into changing direction,” said Miles. “Other than that the market has too much momentum; things won’t change.”
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