Private equity firms have slowly started to push loans that have restrictions on which investors the debt can be sold to, limiting the amount of bargaining that can take place. Stephen Hazelton, Founder and CEO of Street Diligence, explores with Finance Monthly the long-term impact eroding this protection for investors will have.
Despite the rapidly moving trend toward covenant-lite leveraged finance transactions, which are expected to continue well into 2017-18, many investors are concerned about the ongoing impact of the lack of maintenance covenants, historically demanded by lenders to riskier companies.
With private equity firms starting to push loans with aggressive covenant language that essentially restricts lenders’ bargaining power in times of distress, Stephen Hazelton, Founder and CEO of Street Diligence, a leading provider of fixed income analytics on bonds and bank loans, explores the long-term impact of these eroding lender protections.
The landscape for loan issuance and direct lending of late has shifted in significant and impactful ways for, both, corporate debt issuers and lenders. The implications are not only material but long term, in that covenant terms and conditions negotiated today will have an impact in good times and in bad.
How Did We Get Here? Let’s first explore the market shift and the reasons behind it. The financial crisis of nearly a decade ago resulted in a fundamental shift in the regulatory environment. Credit investing and bank lending at the bulge bracket, global banks became challenging, resulting in a capital flow into less regulated investment vehicles, including business development corporations (BDCs) and private direct lending investment vehicles. With so much capital shifting to these vehicles, and the subsequent blurring of lines between large-cap syndicated loans and traditional middle market direct lending, the increased competition has led to new entrants and a flood of capital chasing deals. The result meant more leverage for corporate issuers and their private equity sponsors to negotiate and drive better terms.
Deal Term Implications. The resulting landscape has meant a deterioration in negative covenant protections and the loosening of other key terms and conditions. This has led to more flexibility for financial engineering at the CFO’s office of these loan issuers, better “base case” return scenarios for private equity sponsors and, conversely, declining return expectations for bank loan investors, direct lenders and their own investors.
Loosening Covenant Protections. Broadly speaking, the changing covenant terms in this market boost issuers and their sponsors by eroding lender returns in the event an issuer executes on its plan and doesn’t come close to an event of default. Additionally, in the event all doesn’t go to plan and the issuer struggles, deteriorating recovery rates for lenders can be expected under these looser conditions. Let’s have a look at a few key trends.
Mandatory Prepayments: Lenders typically recover a small portion of the loan annually in the form of a prepayment, which depending on various factors can mean up to 10-15% of the face value is repaid prior to maturity. This repayment hedge in favor of the lender has been declining of late, meaning a smaller cumulative prepayment amount. This hurts lenders, as it removes one of their monitoring tools to force struggling issuers to the negotiating table and benefits issuers in the form of more advantageous cash flows.
Excess Cash Flow (ECF) Sweep: The ECF Sweep provision mandates that excess cash flow, as defined by the deal documents, must be apportioned, in part, to early repayment of the loan obligation. Typically, the ECF sweep requires 50% of excess cash flow be repaid to lenders in advance of maturity. Additionally, in most cases, as an issuer deleverages its balance sheet, the ECF sweep requirements also decline from 50% to 25% and, in some cases to zero. This market is pushing ECF sweep requirements down on a percentage basis in addition to softening the requirements for the stepdown over time. Consequently, with relatively minor improvements in credit profiles, issuers are retaining more cash if they so choose.
Equity Cure: When issuers are operating under stress or distress, the equity cure provision provides private equity sponsors with a “get out of jail” card to use in an effort to avoid an event of default. When used, the equity cure allows a sponsor to provide a cash infusion to the issuer. Critically, this infusion can be treated as EBITDA for the purposes of calculating the issuer’s maintenance covenants, namely their financial covenants. The violation, or threat, of a violation of a financial covenant is a common impetus for a lender renegotiation, so a solid equity cure provision can be valuable in times of stress. Equity cures typically provide for an annual limit and a lifetime limit, the latter of which is increasing from the standard 3 to 4 times, which can be an acute advantage to an issuer in trouble.
EBITDA Definition: Not all EBITDA definitions are created equal. In fact, each issuer generally customizes their definition for the purposes of calculating covenant thresholds and maintenance tests. Herein lies an opportunity for the issuer to insert soft add-backs to their EBITDA equation and soften the depending covenant restrictions. We are seeing increasingly aggressive add-backs, particularly as they relate to future costs savings, business optimization expenses and other pro-forma line items. The add-back caps (as a percent of total EBITDA) that lenders use as levers to combat this are trending in favor of the issuer.
Deal terms are ever-changing, sometimes in subtle ways, but the trend in this market is clearly in favor of the issuer and their sponsor-led private equity deals. As an issuer, the climate is ripe for new issuance and refinancings through a competitive underwriting process.