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Cov-lite has gone pretty well so far

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The coronavirus pandemic has subjected the European leveraged loan market, where ‘cov-lite’ documents reign supreme, to a brutal test. The early results are positive.

For a certain kind of financial doom-monger, covenant-lite leveraged loans are a disaster waiting to happen. Consider the following from Frank Partnoy, a law professor at the University of California Berkeley School of Law:

We already know that a significant majority of the loans in CLOs have weak covenants that offer investors only minimal legal protection; in industry parlance, they are 'cov lite'. The holders of leveraged loans will thus be fortunate to get pennies on the dollar as companies default — nothing close to the 70 cents that has been standard in the past.”

(Click here if you feel your blood pressure is too low and you want to read the full, lengthy scaremongering romp about how CLOs are going to collapse the financial system.)

The rating agencies, and many investors, agree that recoveries could well be lower this time around, with cov-lite perhaps part of the problem.

Data will probably never be conclusive, since, unlike an ordinary credit cycle, Covid-19 related restructurings or insolvencies will likely affect businesses that saw their revenues evaporate overnight, rather than businesses caught with a little too much debt at a time of rising interest expense.

That might well mean lenders to once-healthy businesses recover only pennies but it’s hard to see how taking the keys to an empty shopping centre or a closed chain of restaurants earlier on would have helped.

For companies that have been in Covid-related distress, the combination of a cov-lite term loan and a revolving credit facility with maintenance covenants has worked more or less as advertised.

When the pandemic first hit, companies with stretched finances (or a prudent approach to cashflow) drew down on their revolving credit facilities, maximising their own cash balances going into the scariest portion of the first phase of lockdowns.

This activated the springing covenants in the revolvers, which required companies to maintain a certain debt to Ebitda ratio. For some companies, there was no “spring”, just a hard leverage cap always present in the revolver.

With a sharp fall in Ebitda expected, stressed companies looked set to breach these ratios at the next test point, so they quickly contacted their revolver lenders (typically a smallish group of commercial banks) and began to negotiate.

These negotiations overwhelmingly went in the same direction: a waiver of maintenance covenants for the next several test dates in return for some combination of dividend restrictions, amendment fees, and “minimum liquidity” or “minimum cash balance” tests. Cineworld, and several UK pub companies are among many companies to have taken this approach.

Banks knew companies could not meet the leverage test, but wanted reassurance that a company could pay its short-term obligations, and wouldn’t send any cash out to shareholders. 

Institutional lenders holding term loan 'Bs' had no say in the matter, because their instruments had no maintenance covenants. They weren't in the room, or even on the Zoom call.

As a thought experiment, then, how would this process have been different if institutional lenders had been in a position to hold companies to maintenance covenants?

First off, all of the waiver processes would have been longer and harder. Corralling 40 institutional lenders is harder than corralling four banks, especially when negotiations are under way across 100 different companies at once.

Creditor committees would have become unwieldy and impossible to steer; views would have varied on the details, and the specialist restructuring lawyers and advisors, already working flat out since March, would have had less bandwidth still.

Since creditworthiness and recovery is a function of confidence, a waiver and amendment process that lasts four months is a lot worse than one which lasts four weeks — and many firms could have run into technical default at their June covenant test date.

Second, there would be holdouts. Certain lenders might have refused to waive, or demanded exorbitant fees to do so. Healthy but stretched companies might have been pushed over the edge by a few determined hedge funds to the probable detriment of the rest of the lending group.

The point of cov-lite is not exclusively to make life easier for private equity sponsors, it’s a reflection that a term loan 'B' is now an institutional product held mostly by funds, as close as possible to a bond but in a private loan-shaped wrapper.

Sometimes, covenant fans acknowledge the problems above but value maintenance covenants as a way to get to the negotiating table quickly in a potential restructuring. It’s certainly true that bank lenders (the only ones with covenants) had the first chance to negotiate with troubled companies.

But a quick look at how restructurings work in reality reveals that companies work hard to get their institutional lenders to the table as soon as possible. Identifying and contacting creditors is one of the first tasks a restructuring advisor will do.

The reason is obvious — there’s a first mover advantage in a restructuring. If the company can get a good proportion of senior lenders to support a reasonable proposal for debt reduction, it has the best chance of getting its preferred scheme passed. Hiding from lenders with a restructuring in the works is a recipe for creditors to combine against shareholders and for the equity to wind up losing the keys.

Covenant-lite is sometimes used as a lazy synonym to capture all of the documentary degradation which has occurred in high yield bonds and leveraged loans over the last several years, but we can draw a clear and bright distinction.

The absence of maintenance covenants in institutional loans is enough to make them cov-lite.

But a borrower of cov-lite loans may also have bond and loan documents that allow fantastical Ebitda add-backs incorporating huge imaginary future synergies, along with gigantic dividend capacity, subtle legal trickery, plentiful priming opportunities, and flexibility to whip security away from 'secured' creditors. 

That has the potential to be a real problem as the second Covid wave hits and another round of restructurings await — but it’s not the same as cov-lite.

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