The strange case of the disappearing covenant

  • 23 Jul 2004
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Forced into ever greater concessions, loans bankers could one day find themselves regretting the way in which covenants and other lender protections disappeared during the exceptionally liquid market of the last nine months. Adam Harper reports.

In the loans banker?s nightmare, a weaker investment grade borrower with one or two minor credit issues is able to secure a five year loan with little in the way of protection for lenders because of banks? desperation to lend. In a couple of years, the minor issues have become major ones ? the company has levered up through a series of unwise acquisitions and issued billions of euros in bonds to finance its adventures.

As its debt spirals out of control, the economic environment takes a turn for the worse and the company?s earnings shrink. The company loses investment grade status and, ultimately, can no longer afford to service its debt. It goes into default, leaving senior lenders with the unpleasant prospect of owning worthless equity or assets they do not want. And there is nothing they can do to oblige the company to sit down and negotiate a restructuring before it is too late because the loan agreement does not give them the legal right to do so.

That is the very worst case eventuality, but some of the conditions that could make it possible are already in place. An improving credit cycle, coinciding with stronger balance sheets in the banking sector, fewer but larger refinancing deals and a lack of event-driven financings have forced lenders to give ground on pricing, tenors and ? most worryingly ? documentation.

There is particular concern among bankers that the availability of loans with highly favourable pricing and conditions is moving down the credit curve, from double-A and single-A into the high triple-B area. Whether deals without financial covenants and material adverse change (MAC) clauses can filter down any lower is not yet clear, although many bankers think not.

?Companies at BBB+ are the lowest with no repeating MAC or covenants,? says Fergus Elder, co-head of loan capital markets at JP Morgan in London. ?But there will be BBB deals out there with repeating MAC but no covenants.?

But with Eu70bn-Eu80bn of excess capital in the European banking system, according to one head of syndications? estimate (and which can be multiplied by 12 as potential loans), there is clearly a lot of money under pressure to be employed.

Milking the market
These conditions are working entirely in borrowers? favour and they are milking banks for every last concession. As yet, there is no sign of the situation changing, says Richard Basham, head of European loan distribution for Citigroup in London.

?At some point something will cause the market to pause and reflect, but that has not happened yet,? he says. ?Parmalat has come and gone without affecting the loan market and, with the absence of large M&A deals to soak up liquidity, there is not much that can put a brake on the market.?

No lender likes giving away controls and many syndications bankers complain bitterly in private at the terms of some of the deals they feel they are being forced to accept in order to compete.

The Eu1.4bn acquisition facility for German retailer Tchibo at the end of the first quarter was a very public example.

Houses including ABN Amro, Deutsche Bank, HVB Group and Royal Bank of Scotland walked away from arranging and underwriting the deal because they could not stomach the loan?s slim margin and ? in particular ? its lack of financial covenants. Yet all of those four banks except Deutsche turned up as participants in the syndicate, which closed oversubscribed.

?People are giving away covenants and the market is buying it,? says Richard Munn, co-head of loan capital markets at Deutsche Bank in London. ?Where?s the spine among the banks to resist? If people aren?t comfortable with the risk, they should go and do something else with their capital.?

But another head of syndications lays the blame squarely at the borrowers? door. ?For me, it is pure arrogance,? he says. ?Why not accept financial covenants? If a company gets into problems or has to change its balance sheet, it must be interested in talking to its lenders.?

Driving out MAC
High quality borrowers started the trend of reducing lender protection by driving MAC clauses out of syndicated loan agreements in the wake of September 11 2001, bankers say. Worried that disasters of this kind could cut off their supply of liquidity by triggering MACs, companies have been pushing for their removal for around two years.

At the same time, the rating agencies have been pushing for the eradication of conditionality from companies? credit lines. While Standard & Poor?s says it does not consider it critical or realistic for most borrowers to negotiate the removal of MACs, its insistence on committed facilities has certainly helped borrowers to argue for their removal.

But more recently, lenders? most prized form of protection, financial covenants, have started disappearing from investment grade standby deals. In the past, banks might have insisted on a minimum interest cover covenant or ? preferably ? a maximum net debt to Ebitda ratio covenant for any but the very best borrowers.

Return of the MAC as Putin puts the squeeze on Yukos

Just as Loan Market Review went to press, lenders to Yukos invoked a MAC clause on the Russian oil company?s $1bn three and five year loan ? a turn of events rarely seen except in connection with disasters such as 9/11.

Agent bank SG CIB declared an event of default on Monday July 5 after it received a request from the majority of the 10 banks in the syndicate to do so. Event of default means that banks can demand repayment at any time, but the lenders have not yet done this, waiting instead to see how the situation develops.

The crisis at Yukos has been caused by the arrest and imprisonment of its chairman, Mikhail Khodorkovsky, the freezing of its assets by the Russian government and an order to pay a Rb99bn ($3.4bn) tax bill for 2000 and 2001. Yukos appealed against the tax bill, but the appeal was rejected on Wednesday June 30 and the company was given five days to pay.

However, on Tuesday July 6, Russian government officials hinted that Yukos could be given more time to find the money to pay its tax bill. Furthermore, Russian president Vladimir Putin has said he does not want to see Yukos go bankrupt. Shortly before the existing tax bill deadline of midnight on Wednesday July 7, the stand-off between the Kremlin and Yukos had not been resolved.

Yukos has some cash reserves, but not enough to pay the bill, according to loans bankers in London, and its bank accounts have been frozen in any case. It is prevented from raising money through disposals because of the asset freeze. The Russian authorities have not yet indicated whether these rulings could be relaxed or some arrangement made that would enable Yukos to pay.

?At the moment, this is being seen as a personal dispute between Putin and Khodorkovsky, so it hasn?t had an impact on the loan market so far,? says one banker. ?But if the situation ended in Yukos going bankrupt, that would have a serious impact on Russia as an attractive place to do business and I don?t think Putin wants that.?

Yukos, which produced 591m barrels of oil last year as Russia?s largest producer of crude, continues to make money at an operating level. ?The fact that its assets are frozen is not stopping Yukos from doing business,? notes one banker. ?It is producing oil and generating enough revenue to repay the interest on the loan.?

The $1bn loan for Yukos last September was arranged by Citigroup, HSBC and SG CIB.

?The erosion of documentation terms is cyclical,? says Tim Ritchie, head of global loans at Barclays Capital in London. ?When the credit environment improved and liquidity returned, some clients were inevitably in a position to reassess agreements they signed up to in a different environment. It?s not the first time we?ve been here and I?m sure it won?t be the last.?

Borrowers follow the market carefully and are well aware of what they can achieve during this stage of the cycle, however. They will push as hard as they can while the going is good. ?Every prudent treasurer will want as much flexibility as possible because you never know what might happen next,? says David Bassett, head of global loan markets at Royal Bank of Scotland in London.

?Ideally, every treasurer would want a promissory note without any conditions. The financial covenants act as brakes, and as limits on what the company can and can?t do. Naturally, borrowers want to avoid that.?

Alex Bolis, head of treasury and capital markets at Baa2/BBB+/A- rated Telecom Italia, achieved a 50% oversubscription on the borrower?s Eu6.5bn three year deal in April. There were no financial covenants or repeating MAC clauses.

?You want bank lines to provide true commitment without any conditionality on the banks? behalf,? says Bolis. ?It has been possible for companies to obtain such lines because both borrowers? and banks? balance sheets are stronger ? everything has liased to create this situation.?

A treasury official at a leading German utility makes borrowers? objections to financial covenants and other restrictions clear. ?The main reason companies are so keen to eliminate financial covenants, MAC clauses and the like where possible is the desire to run businesses the way you want and without constantly having to worry about the impact of any change on your bank facilities. Companies may also seek to reduce the administration involved in servicing the loan,? he says.

Many bankers see the Eu3.5bn five year facility for French water, waste, energy and transport conglomerate Veolia Environnement as the deal that really pushed back the boundaries for BBB+ borrowers.

After negotiating improved terms on the financial covenants on its previous facilities at the end of 2002 and the blowout success of its Eu700m 30 year bond last November, the company was ready to push for even greater freedom in February this year, says Philippe Messager, group treasurer at Veolia Environnement in Paris. The company kicked off this process by holding one-on-one meetings with around 20 relationship banks.

?What we did at the end of 2002 was achieve more flexibility,? he says. ?But what we did in 2004 was completely different. We cancelled all financial covenants, removed the repeating MAC clause and exchanged cross-default clauses for cross-acceleration ones. Although we now have no covenants, we did however put in place a pricing grid linked to net debt to Ebitda.?

Explaining Veolia?s motivation for eliminating these controls, Messager says: ?We think it?s a good signal to all financial markets that lenders are ready to take Veolia risk without any financial covenants.? He adds that their absence also makes for easier compliance with new accounting rules that come into effect in France in 2005. Veolia will not have to make difficult forecasts of net debt or net financial charges.

Peer pressure
The practice of removing lender protections can easily proliferate as well, says Richard Hill, head of European distribution for WestLB in London. ?Borrowers undoubtedly benchmark against their peers,? he says. ?When company A gets away with an interest cover ratio only, company B will try to get rid of that too. There is a lot of peer pressure between borrowers.?

Yet despite their unwillingness to abandon the protection offered by financial covenants, many bankers admit the value of covenants is usually theoretical rather than practical. ?If companies run into difficulties, they do so with or without covenants,? notes Richard Cartledge, head of syndicated finance at HSBC in London. ?The covenants just give you some early warning ? the dangers you face without them are no different, you just don?t see them as early.?

Martyn Powell, global head of loan markets at ABN Amro in London, is resigned to the absence of repeating MAC clauses for investment grade credits, but also sees the main value of covenants in the advance warning they provide.

?While it?s worring that repeating MAC is on the way out, it?s something of a tick box exercise,? says Powell. ?I am more concerned about the disappearance of covenants for second tier credits. I don?t think it?s good for the companies themselves ? if banks get an early warning they can help the company sort things out.?

Powell also sees the existence of covenants in a loan agreement as vital to communication between banks and the borrower. ?Without financial covenants, some companies may feel they don?t need to talk to the banks, which could lead to bad debt problems in the future. Perversely, that would bring back covenants with a vengeance.?

For the time being, though, it seems unwise for banks not to acquiesce to deals without covenants and repeating MAC, since banks are using liberation from these controls as a bargaining chip when pitching for mandates.

?If you don?t go into a long term, thinly priced revolver without covenants for an investment grade company, the relationship could be terminated for four years,? points out Royal Bank of Scotland?s Bassett. ?Banks have to take the view that nothing too egregious will happen in that time, that they trust the management team and that if the worst happens, they will probably be approached to help out anyway.?

The highly liquid market can often place syndications teams in a tricky position, bankers point out. Credit committees resist weaker documentation, while relationship managers push for the bank to be more competitive in pitching, while the syndications team tries to accommodate both impulses. ?The middle position of loans teams is difficult,? says one head of distribution in London. ?But it is not as difficult as calling the pace of this market. Prices are falling and structures are growing weaker faster than ever.?

The alarm loans bankers feel at losing the comfort of having strong documentation in place will no doubt continue until the credit and liquidity cycle turns again. Dietmar Stuhrmann, head of Europe, Middle East and Africa loan syndicate at Dresdner Kleinwort Wasserstein in Frankfurt, insists, however, that banks should concentrate on fundamentals through this period ? covenants or no covenants.

?Having a well structured portfolio and knowing your clients well are better protections than having financial covenants on deals for weaker credits in the triple-B area,? he says.

But Veolia?s Messager warns banks it will be hard to go back. ?It would be very difficult to accept financial covenants or ratings triggers now, having been among the first European corporates to move from having them to not having them.? 

  • 23 Jul 2004

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 24 Oct 2016
1 JPMorgan 317,793.98 1355 8.72%
2 Citi 301,114.13 1092 8.26%
3 Barclays 259,580.63 846 7.12%
4 Bank of America Merrill Lynch 258,842.43 934 7.10%
5 HSBC 224,273.23 905 6.15%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 25 Oct 2016
1 JPMorgan 32,854.00 58 6.73%
2 BNP Paribas 31,678.29 142 6.49%
3 UniCredit 31,604.22 138 6.47%
4 HSBC 25,798.87 114 5.29%
5 ING 21,769.65 121 4.46%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 25 Oct 2016
1 JPMorgan 14,633.71 80 10.23%
2 Goldman Sachs 11,731.14 63 8.20%
3 Morgan Stanley 9,435.23 48 6.60%
4 Bank of America Merrill Lynch 9,229.95 42 6.45%
5 UBS 8,781.68 42 6.14%