TKE underlines the toxicity of the covenant wars

All eyes were on TK Elevator’s financing from the moment it launched. A giant LBO signed just before coronavirus closed leveraged markets, it was by far the largest of the ‘hung bridges’ sat on bank balance sheets waiting for capital markets to recover their composure throughout March, April and May.

But when the banks unveiled the deal, anticipation turned to horror among investors and credit analysts as the bond documentation marked a new low in flexibility and sponsor-friendliness.

Money could pour out of the structure into the hands of equity almost without limit, even technical default and debt limit calculations were toothless and gameable. Any ratio or provision that could be stretched was at or beyond previous precedents.

That gave investors a dilemma. The underlying business had plenty of good points, recurring revenues, strong market position, while the sheer size, index weighting and liquidity offered their own compelling arguments for investment.

But the documents were a horror show, and worse, would set a clear precedent for the post-Covid market. Instead of a reset, as might have befitted a major financial crisis, the downward march was set to resume where it left off.

But the sponsors backed down and withdrew all of the most egregious terms. There was still plenty of flexibility built in, and there was no question of a return to old style maintenance covenants in the loan tranches, but it was squarely on-market for a large LBO — a deal everyone could live with.

But this process illustrates exactly why the back and forth over covenants has become such a toxic topic over the last few years.

Most market participants accept that hot markets mean looser debt terms.

That’s true of commercial real estate, structured credit, securitization, leasing, mortgages and any other debt market where collateral and cashflows are pledged to lenders. Supply and demand move both the prices and the terms of credit — so far, so uncontroversial.

But high yield bonds, in particular, have been subject to something like a ratchet in debt terms for the past several years, and TKE illustrates exactly how it works.

For a large cap, heavily trailed benchmark deal, there is almost no downside to starting out with weak investor protection. The sponsors may not need the flexibility, and may be willing to give it up, but there’s no harm, from their perspective, in trying for the widest possible latitude.

If it clears, then fantastic — a new precedent has been set from which the next large cap mega LBO can start. If it does not, then simply row back a little, redraft the docs, price the deal and move on. For a deal like TKE, loose docs are a free option, to be exercised if conditions are right and allowed to expire if not.

But there is no offsetting option on the other side. Investors can pass on deals, push back, or even band together and fight. But they can’t do so deal after deal, termsheet after termsheet, to work steadily back in the other direction. They’re paid to put money to work, not to uphold an abstract ideal of market purity.

Besides, as the old adage goes, it’s not covenants that pay you back, it’s companies — meaning, in effect, pick companies that aren’t going to be backed into positions where they need to square off with bondholders in a restructuring.

The high yield covenant wars have also been peculiar for their focus on obscure gamesmanship. While the trade-offs between flexibility and security, supply and demand, price and terms are age old, in some markets the debate seems more mature — issuers ask for the flexibility they need, not everything they can get.

They may even ask lenders explicitly for the flexibility in question. In high yield, however, slipping it deep into a 500 page bond document is de rigeur, and flexibility itself might come from seemingly minor changes to calculations or time periods elsewhere.

Thanks to various covenant review services and diligent investor counsel, most of these are picked up, but the process is expensive, time consuming, and needlessly adversarial.

Some of that comes from simple market structure. Other forms of secured debt typically have far fewer counterparties involved than a big, public high yield deal.

A commercial real estate loan or a unitranche might be done with a single lender, or a handful, rather than possibly hundreds of accounts. Even in a public market instrument like a securitization, the junior tranches, where documentation discussions are most acute, often sell to just a small club of investors.

That promotes good faith and open discussion, which is much harder to achieve in the anonymous scramble for a small slice of an €8bn debt stack.

But sponsors' reputations can and do follow them from deal to deal. Some investors are a hard “no” on Apollo LBOs, for example, while the storming success of Blackstone’s Refinitiv buyout may have bought it extra credibility the next time it wants to do a similarly covenant-impaired LBO.

There’s surely room for at least one private equity shop to be the good guy — disclose flexibility up front, explain why it’s needed, market the terms it wants and not just what it can get away with — and drag itself, slowly but surely, into a world where its leverage costs less, it wins more auctions, and its returns are better.

Until that unlikely scenario comes to pass, though, the covenant wars continue. TKE was a crucial battle for the immediate post-Covid market, and investors did well to hold the line. But there will be another deal, in another market, which will push docs even further.