The past few years have proved an exciting if torrid time for investors in leverage loans. Although issuance of loans (and bonds) has seen strong growth, this has failed to cope with the strong and increasing demand from the buy-side. This disparity between supply and demand has created an extremely borrower-friendly climate for all but the most difficult credits and even some of these have managed to come to market (I am not going to name names here to avoid creating needless offence).
These developments have occurred against the backdrop of two significant and related trends; first, the rapid development of the high yield bond markets in Europe and second, the increasing presence of US based funds in Europe. These twin trends have forced convergence between loan and bond terms or, to be more precise, loan terms increasingly mimic terms found in high yield bonds.
Whilst there are numerous examples of this convergence, the aspect which has received the most attention (notoriety would be the description by lenders) has been the emergence of Cov-Lite loans. This term is itself misleading since it doesn’t mean that loans no longer include any covenants; rather that now they no longer feature the typical package of 3-4 financial maintenance covenants as recommended in the LMA leverage precedent. Over the last few years the Debt Explained Representative Loan Terms (RLT) database has tracked this steady decline in the incidence of financial covenants and many large loans now only include a leverage covenant or increasingly, and more commonly, a springing leverage covenant.
Springing leverage covenants arrived a few years ago but have gained steady acceptance into the leverage loan vernacular. In essence they could be said to be an optical illusion; a covenant that is more apparent than real. They answer the question ‘How does one include a covenant with little or no teeth?’. They are effectively a crafty marketing ploy and allow issuers (and their advisors) to access buy-side funds, who can only invest in deals with covenants, to invest. In this vein they are similar to TLBs that boast 1% amortisation per annum.
How do they work in practice? These covenants are based on leverage ratios in much the same way as a conventional leverage test but with one crucial difference. They do not apply unless the RCF is drawn above a specific threshold at the relevant testing date (i.e. quarterly). This threshold was initially around 25% however this has increased over time and has increased dramatically since then with half the deals in 1H2017 at 36-40% and just under half at 50% or more. At the same time the leverage test has increased from around 6.5x in 1H2015 to 8x in 1H2017; so investors have experienced a double whammy (leaving aside - if one can - the debate around EBITDA add backs and subsequent effect on leverage). How these elevated ratios can be reconciled with the ECB’s Guidance on leverage loans is another matter which will no doubt be addressed in due course. The Guidance (covered in my last blog) takes effect on 16 November and requires ECB regulated credit institutions to ensure that, where leverage is greater than 6.0x at inception, it is only in exceptional and justifiable circumstances (undefined).
Breach of the springing leverage covenant does not of itself grant any rights to term loan lenders. The covenant is not for their benefit. If the RCF lenders accelerate then that triggers a term loan default. My view is that when working capital lenders withdraw facilities the game is truly up as the “going concern” basis on which these deals are valued and done is over and there will be little left for lenders.
Finally as I have mentioned before more deals are allowing a “cure” of any leverage covenant breach should the “spring” apply (in itself hard to imagine other than in a disastrous situation) by paying down the RCF to disapply the “spring”.
Springing leverage covenants remind me of the tale about the Emperor’s new clothes!
-- Stephen Mostyn-Williams, Chairman of Debt Explained
Stephen founded Debt Explained in 2009, following a 25 year career in leveraged finance. He has held senior positions at Cadwalader, Wickersham & Taft LLP; Shearman & Sterling LLP and Ashurst. Stephen co-founded the European High Yield Association and served as its chair for the first three years of its existence.
Further data is available from our recent article on springing leverage covenants (along with my last blog) on our website and also on our database.