How I learned to stop worrying and love useless documentation
The tide of leveraged finance docs has gone out, and it isn’t coming back in. Lenders have only the comforting embrace of sponsors to rely on. But that’s the game today, and you have to play it.
Your correspondent has been covering leveraged finance since early 2019, when the market was getting back on its feet after the sell-off at the end of 2018. At that time, the LBOs of Refinitiv and AkzoNobel in the autumn of 2018 stood out as a low point for investor protection, with a laundry list of egregious flexibilities and weakened concepts.
Since then, though, things have gone from worse to even worse — even as investor attention on documentation has increased, aided by specialist review services and organisations such as the European Leveraged Finance Association.
A large cap LBO by a brand name sponsor will, for all practical purposes, impose almost no limit on the sponsor’s day one freedom of action. Flexibility rules, and big private equity shops will tolerate no restraint on their possible business plans.
The sell-off in December 2018 pressed pause on the deterioration, as did the initial phase of the Covid crisis, but the downwards ratchet soon cranked once more, with ThyssenKrupp Elevators marking a further new low, despite cosmetic push-back.
Perhaps the pendulum will swing back when the credit cycle turns — but when will that be?
Calling the top has been a mug’s game for a decade, during which time credit markets have evolved and changed. Leveraged loans and bonds have converged, non-banks rule the roost, alternative credit firms sprawl across loans, high yield, special situations, distressed and private debt, and CLO issuance keeps hitting new highs.
Even in sections of the market where old-hat concepts like leverage maintenance still exist (certain sections of private debt and unitranche), levels are often set so high as to be meaningless. The evaporation of Ebitda during Covid for many firms provided the perfect excuse for further adjustments, creating headroom and corporate flexibility. There’s nothing special or sacrosanct about measuring Ebitda but the trend remains always to more freedom for sponsors and less protection for lenders, be they bond or loan investors.
And yet… disaster has yet to strike. The pandemic pushed a wave of firms into debt restructurings, and many more into stressed situations. Many of these have now wrapped up, with surprisingly little acrimony, and some of the stressed companies have already returned to capital markets. Distressed debt buyers are sitting on monster-sized funds with a paucity of opportunities.
The pessimists will note that many of the firms falling into distress last year didn’t have the very worst of modern documentation on their debt, having put in place their capital structures in the halcyon days of 2016 and 2017. But there were also few attempts to use the maximum flexibility afforded by existing deal docs. Consensual restructuring injection of new money is always going to be less painful — if it’s on the table, why go the hard route?
The game of levfin investing has now become, in some ways, simpler. The docs are not going to protect you, or limit the sponsor’s activities, so it’s about good old fashioned corporate credit analysis, with a layer of sponsor behaviour on top. No point pushing for a docs term to be ditched — just make sure you get paid enough to take on the risk.
The incentives for private equity firms are not mysterious and unknowable — they want to buy companies, mostly with other people’s money, and sell them on for more than they paid. Even if they can incur another three turns of leverage right after the initial acquisition debt, it would be deeply strange behaviour to do so.
Sponsors do not want to sell on a notorious basket case, struggling to stay one step ahead of its creditors through legal chicanery. Just like lenders, they want to be involved in a deleveraging firm with credible growth that generates cash. They’re also putting in hefty equity cheques — admittedly, because earnings multiples in equity markets are getting silly — meaning they have a lot of skin in the game.
While the details of debt documentation have become riddled with holes, the economic terms remain hotly contested. Credit spreads have compressed, as they have everywhere, but the European high yield universe still spans yields from 2% to 10%. Deals get done, but not at any price. In loans, investors have had some success holding the line on margin ratchets, with several recent deals rowing back from initially aggressive terms as lenders baulked.
That’s a signal — investors are saying, loud and clear, that sponsors can take their controls and safeguards away, but don’t mess with their margins. Documentation might be increasingly worthless as a constraint on equity, but with enough coupon, who really cares?