Great yield, less covenants: They're "covenant-lite" loans, and institutional investors are lining up for more.
Named for their lack of standard financial covenants-requirements and restrictions placed on a borrower in a loan agreement-these loan-bond hybrids are fast becoming a regular feature of the leveraged-lending landscape. Just this week Donaldson, Lufkin & Jenrette brought a $75 million loan to market for chemical producer Pioneer Americas that uses the covenant-lite structure.
Donaldson Lufkin and BT Alex. Brown, which introduced the structure in March, have successfully syndicated eight loans featuring covenant-lite tranches this year.
"As long as there is continued growth in the amount of institutional investors in the loan market, there's going to be a very good flow of these deals," said Stephen P. Hickey, managing director and head of loan syndications, sales, and trading at Donaldson.
But buyer beware is the message some loan market observers have for bank and institutional investors committing to covenant-lite tranches.
"You need to know what you're buying," said Randy S. Szuch, director in the loan products group at Fitch Investors Service LP, which is set to issue a new report on hybrids today.
For more traditional bank loan investors, covenant-lite tranches offer little or none of the control over a credit normally provided by loan covenants. But they pay a premium compared with more traditional covenant- heavy loan pieces.
"The high yield (investors) see more advantages in it than the traditional lenders see," said Robert Barmore, a managing director at Meenan, McDevitt & Co., a Harrison, N.Y.-based loan brokerage boutique.
Issuers of hybrids "don't think they're going to force the banks to buy this as much as they've got the high-yield guys ready to buy it," he added.
Bond investors are accustomed to receiving higher yields on their investments in return for accepting a subordinate position in an issuer's capital structure. With hybrid loans, these investors get the additional security of equal footing with lenders in respect to a loan's collateral.
But if a loan becomes distressed, investors in the hybrid tranche must rely on lenders in other tranches that do have covenants to repair the loan or liquidate the collateral.
Critics accuse Donaldson Lufkin of cannibalizing what would otherwise be normal institutional term loans to create the hybrids. But Mr. Hickey said the firm is creating loan products out of debt that would have otherwise gone into the bond market.
"Every covenant-lite deal we've done to date at DLJ would have been a convertible bond or a high-yield bond, but for the fact that we showed the company this idea," said Mr. Hickey.
While BankAmerica Corp. and Bank of New York Corp. have co-agented hybrid issues, so far only Donaldson and BT Alex. Brown have structured them.
Most commercial bankers will buy the more standard tranches of a credit before investing in a hybrid tranche. They will commit to covenant-lite when they want additional yield or seek bigger pieces of popular loans, said Mr. Hickey.
The new $75 million loan for Houston-based Pioneer is structured as a 9.1-year term loan that has no financial maintenance covenants. But it is secured by the same assets as Pioneer's other senior secured credits on an equal footing. Pricing has not yet been set. It will be accompanied by a new $175 million high-yield bond issue, and both loan and bond have been rated B2 by Moody's Investors Service.
Like most of the hybrids issued to date, the new Pioneer loan funds an acquisition: Pioneer's $236 million cash purchase of chemical businesses from ICI Canada Inc. and ICI Americas Inc.
While the need for hybrid loans to offer good credit fundamentals is just as strong as with any other loan, investors said that examining the motivations for an issuer to use the structure is also important.
"I want to understand the dynamics as to why it serves that issuer's purpose to do a hybrid," said Michael DiRe, a managing director and head of high-yield bank loans at PPM America, who manages a multimillion dollar loan portfolio that includes some hybrid loans.
"Generally speaking, it's going to be some flexibility in terms of getting rid of that layer of capital or refinancing it at some point down the road," he added.