Covenant Lite. Just the name makes this type of lending sound like a relic of the pre-crisis era. But it turns out that was just the beginning.
With lackluster merger activity steering more capital into collateralized loan and collateralized debt obligation funds, lenders are racing to come up with a supply of new loans to keep pace with demand. The stiff competition for deals is pushing lenders to make concessions on terms enough so that covenant-lite loans are more prevalent now than they were at their pre-recession peak.
"If you look at the volume of covenant-lite leveraged loans, 2007 was the highest year ever, and last year was almost double that," says Jeremy Swan, a principal with CohnReznick Advisory Group in New York.
After falling to as low as $520 million in 2010 and recovering somewhat in 2011 and 2012, M&A institutional loan volume for covenant-lite loans came roaring back in 2013, when volume topped $106.2 billion, according to data from S&P Capital IQ Leveraged Commentary & Data. In 2007, the previous record high year for covenant-lite deals, total volume was $74.2 billion.
The shift back to covenant-lite loans which eliminate lender protections such as restrictions on third-party debt and ratios governing leverage and interest coverage represents a change for banks, which lately have had the upper hand in lending discussions.
"The power has shifted to the company seeking financing, or the private equity firm that's leading the transaction," Swan says.
One reason why is the past several years of sparseness of middle-market mergers and acquisitions.
So far in 2014, dealmakers have indicated an increase in early-stage deal flow, which could lead to an uptick in completed deals. But for now, deal investors are having a hard time finding places to put their money. Middle-market deal volume, reflecting M&A transactions of less than $1 billion, was even lower in 2013 than it was in 2012, sinking to 2,141 deals from 2,447 deals, according to data from Thomson Reuters. Deal value also decreased, falling to $281 billion in 2013 from $289.5 billion in 2012.
The slow deal flow has helped to push capital into CDO and CLO funds, which in turn is influencing the loan market.
"When you have so much money chasing very few deals, it's going to translate into lower pricing and looser structure," says Jim Hudak, president of the Livingston, N.J.-based lender CIT Corporate Finance, part of CIT Group Inc.
Investors are now being forced to concede on terms "where they otherwise might have had more leverage to insist on covenants," says lawyer Steve Rutkovsky, a New York-based partner at Ropes & Gray LLP.
Though lenders wouldn't necessarily take a positive view of their more limited recourse and rights, their willingness to loosen up loan structures is "indicative of good things that happened in the market," Rutkovsky says. "There's a lot of cash being deployed into the loan market, which is good for companies and good for investors."
Banks have been able to reduce their risk by syndicating the loans out into the CLO market. "A lot of banks will underwrite the facility, and then they will syndicate out almost the entire facility, so they've made a fee, and they really have not risked their own balance sheet," says Hudak.
Those banks are moving into the middle market for deals and, depending on the transaction size, bringing their covenant-lite structures with them. "It's more the large banks coming down to the middle market that are the main providers of covenant lite," says Madison Capital managing director Tricia Marks. "That's what they're used to doing."
But there's something of a natural cap on covenant-lite lending in that there are many barriers to structuring such loans on smaller deals. Indeed, covenant-lite has largely failed to penetrate the lower end of the middle market. That's partly because of the risk profiles of smaller borrowers; lenders are simply less likely to do a covenant-lite deal for companies with less than $50 million in EBITDA (earnings before interest, taxes, depreciation and amortization).
The lack of liquidity available in smaller deals also has helped to create a floor within the middle market.
"Lenders will make the judgment call that they don't have covenants in the deal, but they have a lot more liquidity" in larger covenant-lite deals, making them relatively easy to get in and out of and therefore a less risky proposition, Hudak says. But "once you get below $40 million or $50 million in EBITDA there's not as much liquidity."
Regulation is another factor that has kept covenant-lite deals generally confined to the upper end of the middle market. Banks looking to make these loans are governed by the Federal Reserve's leveraged lending guidelines, which address expectations for credit policies, outline the need for well-defined underwriting and valuation standards, and reinforce the importance of credit analytics and pipeline management for leveraged lending.
"Regulators seem to be stepping up their enforcement of those guidelines and ratcheting up the pressure on banks to be more cautious in underwriting covenant-lite loans," Rutkovsky says.
If a smaller business lacking critical mass, even a well-run one, is given a covenant-lite loan, the lender has less flexibility in terms of strategic options if that small company runs into a hiccup. The Fed's guidelines "are making banks think about deals in the middle market and how much leverage they can put on companies," Hudak says.
If a company started out with a loan that leverages it four times, and its EBITDA then decreases, the amount of leverage placed on that company increases. In that situation, "from a lender's perspective, if you don't have covenants in there, there is little you can do to try to help right the ship if a borrower underperforms and misses its financial plan. You can't call the company into default," Hudak says.
Swan mentions similar concerns. "One lesson I hope we learned from the 2007 time frame is that if there is another credit crunch and the markets turn sour, the fact that these deals are so covenant lite, the banks or whoever is the holder of that debt will be significantly restricted in their ability to step in and make changes in that business to protect their capital," he says.
But some experts are quick to point out that just because a loan is covenant lite that does not necessarily mean the loan is less likely to be repaid. "There's no real data that suggests that having a covenant protects lenders against payment defaults," says Ropes & Gray's Rutkovsky.
That's especially the case now, with many covenants providing thick cushions to give borrowers more leeway on their ratios, making it less likely that they wind up in technical default. CIT's Hudak has a term for this: "covenant-loose."
For banks, he says, it might even be smarter to do a covenant-lite deal that they can trade out of, instead of having to wait for a borrower with a large cushion to default.
"They might find that they're better off doing some covenant-lite deals because the liquidity coming out of those outweighs a very weak covenant package," he says.
So is there an end in sight for the revival of covenant-lite?
Rutkovsky suspects the trend already is nearing a pivot point. "We are starting to see a reduction in inflows in the asset class, as well as an increase in supply, and the supply-demand imbalance is starting to clear," he says.
But it may take a substantial pullback in the CDO market to really trigger a reversal.
"Unless people stop investing in those, banks don't have the incentive to tighten the covenants," Swan says, "because their risk is minimized through the syndication of the debt."
Allison Collins is a reporter at Mergers & Acquisitions, which is owned by SourceMedia, the publisher of American Banker.
