Investors in European syndicated loans have come to accept the decline in the incidence of financial maintenance covenants – a trend which has accelerated over the last few years. Debt Explained analyses these trends across four deal sizes as categorized in our Representative Loan Terms (RLT) database.
As indicated in our European Leveraged Loan Market Update: 2016, cov-loose (leverage only) and cov-lite (springing leverage only) dominated during 2016.
Taking a closer look at the data in terms of tranche sizes produced the predictable result that larger loans tended to include more borrower-friendly covenant packages, including with respect to financial maintenance covenants.
For example, during 2016, approximately 25% of deals below 250m included a “traditional” LMA-style financial maintenance covenant package (of 3-4 financial covenants) while the equivalent financial maintenance covenant package was largely absent in 2016 deals above the 250m threshold, regardless of governing law, and was contained in just one deal in the 500-1,000m deal size.
The 250-500m segment has shifted largely to cov-loose (leverage only), being seen in around 60% of all deals in 2016, with just over 30% of comparable deals being cov-lite (springing leverage only). Loans of 500m - 1bn are split almost equally between cov-loose deals (being deals which only contain a leverage maintenance covenant, or deals which contain 1-2 financial maintenance covenants) and cov-lite deals (springing leverage only), save for the stand alone deal containing a traditional financial maintenance covenant package, although there is some variety seen in the type of cov-loose packages as shown in the graph below.. Above 1bn springing leverage covenants dominated in 2016 (being found in over 60% of deals).
The absence of financial maintenance covenants in the sub 250m segment illustrates how much lender protection has eroded as these smaller deals have very little liquidity. To put this in context, cov-lite loans originated in the US market which differs to its European counterpart in a number of respects. First, the US market has long been dominated by institutional investors whilst relationship banking remains important in Europe. Secondly, the US market offers a much deeper pool of capital. As a result, there is a high degree of liquidity which allows lenders the ability to sell their loans in anticipation of distress.
Covenants are only half the picture
Investors focusing on the absence of financial maintenance covenants are missing the bigger picture however as the protection afforded by financial maintenance covenants can be eroded in other, perhaps even more important, ways.
Firstly, by increasing the amount of headroom and/or, in the case of springing leverage covenants, by increasing the threshold at which the covenant will be tested, as discuss further below; secondly, by using flexible definitions of the components in the covenants (particularly EBITDA); and, finally, through the availability of equity cures.
Springing the Leverage Covenants
Historically, the springing leverage covenant was tested when 25-30% of the revolving credit facility was drawn. Data drawn from RLT shows that this threshold has increased over the last few years.
In 2015, the average testing threshold for the springing leverage covenant was around 32%. This crept out to just under 36% in 2016. On closer inspection, we can see that the majority of deals have a threshold of either 30% or 35%. However, there are two significant outliers in 2016 where the threshold was set at 50% and 67.5% respectively. Without these two deals, the average slides back to 33%.
The downside in this trend to increase the threshold at which the leverage maintenance covenant “springs”, is that it can disguise potential issues in the borrower group by pushing out the requirement for the borrower to comply with a leverage maintenance covenant. Breach of a financial maintenance covenant is an early warning sign, which if not addressed may mean the lenders have less time to take corrective action, if required, before a payment default arises.
EBITDA and Equity Cures
EBITDA is the most significant constituent of the covenants as it appears in the ratios for leverage and interest cover and, as it is also the point of departure for calculating cash-flow in the LMA precedent, has some bearing on that covenant too. A full discussion of this topic is outside the scope of this article but suffice to say the loan market has imported various borrower-friendly trends from the bond markets, principally the ability to add-back business optimization expenses and/or “anticipated synergies” not only from M&A activity but from any bona fide cost savings initiative (i.e. unconnected with M&A activity).
Equity cures enhance a borrower’s ability to defer action by lenders although it could be argued that the injection of cash does indicate that the owners have confidence in, and are willing to support, the borrower. As indicated in our 2016 Loan Market Update, EBITDA cures were allowed in around 50% of all deals.
Covenant erosion – why it matters
The attrition on financial maintenance covenants obviously affects the lenders ability to take action if the business starts to experience financial difficulties, although lenders may still have the option to sell their loans and minimize their losses. What less experienced investors may overlook is that the covenants or the components of the covenants themselves cascade through the loan affecting a wide range of matters. Leverage ratios are used for incremental debt incurrence, cash sweeps and margin ratchets whilst grower (or scalable) baskets based on EBITDA may be used for, inter alia, general debt baskets (and perhaps the ability to secure or guarantee debt) and the guarantor coverage test.
About This Report
This report summarises a research report on developments in the leveraged loan market. The data is drawn from Debt Explained’s Representative Loan Terms (“RLT”) database, tracking information from syndicated leveraged loans in the European market.
This report refers to four tranches of deal size 0-250m; 250-500m; 500-1,000m; and 1,000m+. Each deal is captured within the database in its original currency, by total commitment size, and the data can be split accordingly. For the purposes of this article, the deal sizes refer to deals in US Dollars, Sterling and/or Euros.
The report is based on deals reviewed by Debt Explained and no distinction is made between deals with different governing laws unless otherwise stated.
Debt Explained’s Market Maker and RLT databases offer unique oversight of the European high-yield bond and leveraged loan markets, with more than 550 and 350 searchable terms respectively. A staple resource for all leveraged finance market participants – including capital markets bankers, legal advisors and asset managers – Debt Explained data reacts to the market in real time: subscribers receive detailed deal snapshots on new issues as information is released.
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