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People and MarketsCommentGC View

Blame private equity for the state of levfin


Central banks and international financial institutions have raised a storm over vanishing investor protection covenants in leveraged loans. But most warnings about the market have avoided assigning blame where it is richly deserved — to the private equity industry.

The Bank of International Settlements, the Federal Reserve, the Bank of England, the International Monetary Fund, former Fed chair Janet Yellen, and Mario Draghi, president of the European Central Bank, have all sounded the alarm about the state of the leveraged finance market in recent weeks.

In the words of the financial policy committee of the Bank of England, “the €1tr global leveraged loan market is larger than, and is growing as quickly as, the US subprime mortgage market had been in 2006.”

It's not just the size. More than 75% of that €1tr of loans lack financial maintenance covenants — in the language of the industry, they are cov-lite.

Other developments are also worrying industry participants. As leveraged finance analysts at DebtExplained said in an October report, “Ebitda definitions have come under attack with 82% of deals in Europe allowing recurring, aggressive, uncapped add-backs. But the cumulative effect of the attacks on all areas of the restricted payments and affiliate transactions covenants have had the most impact in lowering standards.”

When the business cycle changes tack and monetary policies normalise, said the Bank of International Settlements, defaults may increase. 

Then, investors will be less protected than ever before. Cov-lite loans were less than 20% of the market six years ago. 

“These dynamics may affect not only investors holding these loans, but also the broader economy by blocking the flow of funds to the leveraged credit market,” according to BIS.

The International Monetary Fund spoke of a worrying loan market “fuelled by strong investor demand, looser underwriting standards, and compressed spreads”.

None of the warnings, however, assign blame for the parlous state of the market. However, they should point the finger firmly at private equity firms and the borrowers they own and sponsor.

It's not you, it's me

Private equity firms are by far the most powerful players in the leveraged finance markets, particularly in Europe, where the industry is more concentrated than in the US.

Market sources, from investors and specialist lawyers to leveraged finance bankers, have pointed at them in several conversations with GlobalCapital since May, as pushing for flexibility that even their advisers consider excessive.

The financial grids they send to prospective underwriters, with pricings and financial terms, include now a larger ‘grey area’ with the most aggressive terms that once were universally rejected by investment banks, which are supposed to act as gatekeepers to the market. 

This strategy sparks competition, and paves the way for more underwriters than ever to accept those terms in the hope of grabbing a piece of the deal.

The early feedback private equity firms and their underwriters increasingly have available for investors has also a conflicting result. Fund managers who want to buy into deals that are bigger than average, and are set to be more liquid, feel less able to express their reticence over loose covenants if they expect to preserve this special relationship.

Combine these levers, and the PE firms are firmly in the driving seat. Of course, they have an interest in borrowing on easier terms — and cheap money, spineless underwriters and enabling advisers have encouraged them.

But just because they are able to get certain terms away, it doesn't mean they should. Big banks and big law firms are used to listening to the mood music from regulators, and adjusting their business accordingly, though perhaps not as much as their supervisors would like.

Private equity firms, meanwhile, have no such tradition of public engagement and probity. But moderating their terms on leveraged loans could be a good place to start.

Better to limit their demands now than wait until some of these situations get ugly, and risk ruining the market for everyone.