CLOs escape cov-lite stricture by borrowing from revolvers
Although European CLOs have a standard limit on the proportion of covenant-lite loans they buy, the definition of ‘cov-lite’ means that almost every term loan with a revolving credit facility elsewhere in the capital structure remains eligible for purchase by these vehicles.
New CLOs this year from Partners Group, Investcorp, and a deal announced on Friday for PGIM have a limit suggesting that a maximum of 30% of the portfolio can be invested in covenant-lite instruments.
Most CLOs have similar limits, placing restrictions on the proportions of second lien investments, bonds, unsecured loans, and loans rated below B3/B-. The aim is to give investors in the CLO tranches confidence that the CLO manager will stick to its investing plan and not deviate too far from the market mainstream in search of yield.
But a real limit on ‘cov-lite’ loans, at least with the definition used by most of the market, would leave managers unable to buy almost the entire market. According to Fitch Ratings’ Leveraged Loan Chartbook, more than 90% of the European leveraged loan market was covenant-lite in the nine months to September 2019, with the remainder described as ‘covenant loose’. This is a marked deterioration in investor protection. In 2013, when the European CLO market restarted post-crisis, more than 70% of deals had a full set of covenants.
Where borrowers do choose to raise money with maintenance covenants in place, this typically reflects their weakness as companies — meaning a hard limit enforced on cov-lite loans can actually push CLO managers to buy the worst-quality loans in the market.
Managers that have cov-lite limits but no revolver-based route around the limit have sought to alter deal documents as part of resetting deals, to bring them into line with market practice in new issues.
The term ‘cov-lite’, as commonly used by the market, doesn’t mean a general lack of investor protection. Rather, it specifically refers to maintenance covenants, which allow a lender to enforce security if a borrower breaches certain debt or leverage limits at any time.
Covenant-lite deals, however, only have the “incurrence covenants” seen in high yield bonds, limiting the ability of a company to take on new debt or perform certain corporate actions if debt levels are too high at that point in time.
This protects a company from the effects of declining Ebitda at a given debt level — in a deal with maintenance covenants, a rough spell in the underlying business can mean lenders take away the keys of the business, while incurrence covenants only block taking on new debt.
Inevitably, it gets more complicated — many borrowers now have extensive abilities to manipulate the calculation of Ebitda, increased flexibility to change the asset security package of lenders, and surprising levels of flexibility even when in distressed territory.
The trick with CLOs, however, is that the limit on “covenant lite” loans has an extra provision in — where this loan is pari passu and cross-defaulted with another loan that does contain maintenance covenants, such as a revolving credit facility, it doesn’t count as cov-lite.
This means that almost all of the institutionally targeted leveraged loans escape the limit. Most companies include a revolving credit facility in their financing structure, since rating agencies value the liquidity support, and because it offers useful flexibility.
“If the facility has cross-defaults to the revolver, it’s still a meaningful cap,” said a CLO lawyer. “It’s an indirect protection but it’s still a protection, and this blocks true cov-lite.”
Effectively, CLO managers holding covenant-lite term loans are outsourcing the protection of maintenance covenants to the banks that provide revolving credit facilities.
Before this 30% limitation (and the accompanying definition), the market standard was for no limitation on covenant-lite loans baked into CLO documents, reflecting the fact that cov-lite loans were relatively rare.