Covenant-Lite Loans: Recent Trends for U.S. Middle Markets ...media.straffordpub.com/products/covenant-lite-loans-recent-trends-f… · 28/8/2014 · covenant-lite loan. – The

Covenant-Lite Loans: Recent Trends for U.S. Middle Markets and European Markets Analyzing Elements of Cov-Lite Loans for Borrowers and Lenders

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THURSDAY, AUGUST 28, 2014

Presenting a live 90-minute webinar with interactive Q&A

Stephanie S. McCann, Partner, McDermott Will & Emery, Chicago

George M. Houhanisin, Attorney, McDermott Will & Emery, Chicago

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August 28, 2014 Stephanie S. McCann & George M. Houhanisin

Covenant-Lite Loans: Recent Trends

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Outline

What are Covenant-Lite Loans?

Analysis of Current Market Conditions Favoring Covenant-Lite Loans

Elements of Covenant-Lite Loans in 2014

Covenant-Lite Loans in the U.S. Leveraged Loan Middle Market

Covenant-Lite Loans in the European Leveraged Loan Market

What Are Covenant-Lite Loans?

Traditional Leveraged Loans – Typically contain financial maintenance covenants tested on a monthly

or quarterly basis.

– Lenders rely on these covenants to provide protection in case the borrower has financial difficulty.

– In the case of a breach of a financial maintenance covenant, lenders may take enforcement actions against the borrower to ensure repayment of their loans.

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What Are Covenant-Lite Loans?

Covenant-Lite Loans – No financial maintenance covenants under a term loan credit facility

(i.e. no periodic testing) and springing financial maintenance covenants under a revolving loan credit facility.

– Covenant-lite loans use high-yield bond style incurrence-based negative covenants which require the borrower to take affirmative action before the covenants are tested.

– By refraining from a particular action, the borrower can control triggering the testing and breach of such covenants.

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Current Market Conditions

– Since 2011, covenant-lite loan issuances have increased dramatically. • $381 billion of

covenant-lite loans were newly issued in 2013.

• Newly issued covenant-lite loans were $95 billion in Q1 2014 and $35 billion in Q2 2014 through early June.

• Q1 & Q2 2014 together were higher than 2007.

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$ bn

*Q2 2014 results through early June

Covenant-Lite Loans Are Back in Vogue

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

2005 2006 2007 2008 2009 2010 2011 2012 2013 Q1 2014

Q1 & Q2

2014

Newly Issued Covenant-Lite Loans


Number of Covenant-Lite Loan Issuers Increasing – 38 Borrowers issued covenant-lite loans in Q1 2014.

– The same period in 2013 saw 35 Borrowers.

– Q1 2014 represents the highest number of covenant-lite loan issuers during Q1 since data tracking began in 1995.

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Covenant-Lite Loans Now Majority of Institutional Loans – Covenant-lite loans made

up 63.3% of new institutional loans in the first half of 2014, topping prior year records of 32% in 2012 and 57.5% in 2013.

– As of May 2014, 53.3% of S&P/LSTA Index loans were covenant-lite loans, up from 46.4% at end of 2013

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CLO’s Are Increasing Covenant-Lite Loan Holdings – So far this year, the

average CLO basket for cov-lite loans has increased from record 2013 levels of 51% to 57%

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Overall Reduction of Financial Covenants in Leveraged Loans – Since 2007, the percentage of leveraged loans containing three or more

maintenance covenants has decreased from 43% to 12%.

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Market Conditions Going Forward

Covenant-Lite Going Forward – As the leveraged loan market continues to receive more inflow from

mutual funds and CLO issuances, the covenant-lite phenomenon will likely continue.

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Elements of Covenant-Lite Loans

No Financial Maintenance Covenants Under Covenant-Lite Term Loan Credit Facilities – The key difference between covenant-lite term loans and traditional

leveraged term loans is the absence of financial maintenance covenants. – Financial maintenance covenants typically require borrowers to be tested

at regular intervals to provide the lender with advance warning of potential financial difficulties.

– Common financial maintenance covenants in traditional leveraged term loans include: • Maximum Leverage Ratio. Restricts the borrower from exceeding a specified

ratio of debt to EBITDA and is applicable to any or all tranche(s) of debt. • Minimum Interest Coverage Ratio. Requires the borrower to maintain a

minimum specified ratio of EBITDA to interest expense. • Minimum Fixed Charge Coverage Ratio. Requires the borrower to maintain a

minimum specified ratio of EBITDA to fixed charges.

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Incurrence-Based Negative Covenants Covenant-lite loans contain incurrence-based negative covenants,

which are only tested upon the occurrence of an event.

By not taking a certain action, the borrower can avoid breaching the incurrence-based negative covenant.

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Covenant-Lite Revolving Loan Credit Facilities Have “Springing” Financial Maintenance Covenants – Traditional revolving loan credit facilities have financial maintenance

covenants, the same as or similar to traditional term loan facilities.

– Covenant-lite revolving loan credit facilities include the same incurrence-based negative covenants as covenant-lite term loans and financial maintenance covenants which are only triggered once revolving outstandings exceed a negotiated threshold.

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Benefits to Borrowers – The loosely structured incurrence-based negative covenants provide

the borrowers with two main benefits:

• Greater Flexibility. The borrower is not subject to fixed-dollar basket amounts for restricted transactions (e.g. incurring additional debt, entering into an acquisitions, paying a dividend or pre-paying subordinated debt).

– Because negative covenants are tied to pro-forma compliance at the time of the transaction, the borrower can engage in an unlimited amount of restricted transactions so long as pro-forma compliance is maintained.

• Greater Control. The borrower has more control over the fate of the company when allowed to operate unhindered.

– Because lenders cannot immediately call the loan – as there are no financial maintenance covenants – the risk of default is vastly decreased.

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Looser Incurrence-Based Negative Covenants – A borrower may take the following actions subject to compliance with a

test at incurrence:

• Incur Additional Debt. – Instead of imposing a fixed dollar cap, a borrower is permitted to incur unlimited

debt if it can comply with maximum leverage ratio at the time of such incurrence.

– The borrower may also be permitted to secure such additional debt, if it is able to comply with a maximum secured leverage ratio.

• Pay Dividends. – Typically tested with limit based upon percentage of EBITDA or net income at

any given time.

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Looser Incurrence-Based Negative Covenants (Cont.)

• Make Acquisitions. – Instead of limiting acquisitions to a fixed amount, per acquisition, annually or

over the life of the deal, a borrower is permitted to enter into unlimited acquisitions as long as the borrower is in pro forma compliance with a specified financial maintenance covenant.

– Revolving loan credit facilities may test pro forma compliance of financial maintenance covenant at that time, regardless of whether covenant is required to be compiled with at that time.

– Term loan credit facilities may test with maximum leverage ratio or senior leverage ratio set out specifically in acquisition covenant.

• Repay Junior Debt. – A borrower is permitted to repay second-lien, subordinated or unsecured debt

subject to compliance with a specified incurrence test.

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Costs to Borrowers – Covenant-lite borrowers are typically charged a premium for the more

lenient, borrower friendly loans, e.g.:

• McGraw-Hill Education LLC borrowed $688 million in the form of a covenant-lite loan.

– The lender charged McGraw-Hill 5.75%, which was 550 basis points higher than the 3-month LIBOR benchmark.

• Supervalu re-priced its covenant-lite term loan facility worth $1.485 billon with pricing at L+350 and a 1% LIBOR floor.

• Univision Communications Inc. refinanced its covenant-lite term loan facility worth $3.4 billion with pricing at L+350 and a 1.25% LIBOR floor.

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Benefits to Lenders – In exchange for looser credit terms, borrowers are willing to pay a

premium in the form of higher interest rates.

– Therefore, the lenders can earn a higher yield in a historically low interest rate environment.

– The extra interests costs for borrowers can go as high as 0.25%

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Costs to Lenders – Lenders give up early warning trip-wires in the form of financial

maintenance covenants.

– Lenders may be unable to re-price credit risk.

– Lenders may have difficulties re-structuring a problematic loan.

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Default Risk – Historically, default rates for covenant-lite loans have been lower than those of

loans with traditional financial maintenance tests. Since 2008: • Cov-lite loans have defaulted at a rate of 14.0% (compared to a 17.6% rate for loans with

traditional financial maintenance tests)

• No BB rated cov-lite loan has defaulted (compared to a 5.2% rate for BB rated loans with traditional financial maintenance tests)

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Covenant-Lite Loans in the U.S. Middle Market

The “Trickle Down” Effect – Covenant-lite loans began their resurgence in the bulge-bracket

market in 2010 and have since trickled down into the middle-market.

– The contributing factors of the shift include surplus debt capital, lower volume of completed deals and lenders searching for higher yields.

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Covenant-Lite Middle Market Volume Is Increasing – Middle-market cov-lite issuances for all of 2012 was

$4.75 billion.

– Middle-market cov-lite issuances through first three quarters of 2013 was $6.94billion.

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Covenant-Lite Beginning to Enter Lower Middle Market – Companies with EBITDA of less than $50 million are beginning to receive

covenant-lite loan terms.

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Learfield Communications

Hemisphere Media Group, Inc.

Sprint Industrial Holdings

Market Middle-to-Lower Middle-to-Lower Middle-to-Lower

EBITDA $50 million $40 million $38 million

Size of Cov-Lite Loan

$330 million $175 million $220 million

Lenders Deutsche Bank, GE Capital

N/A N/A


Covenant Loose & the Lower Middle Market – Even if covenant-lite is unavailable to lower-middle market companies,

some covenant-lite like features have begun to spread in this segment of the market, e.g.:

• Enhanced covenant cushions on financial maintenance covenants which allow borrowers to miss projected financial targets by 30% to 45% and still be in compliance (as opposed to 10% to 20% before 2013).

• Fewer total amount of financial maintenance covenants

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Historic Tendency – Historically, European risk appetite and secondary market for

covenant-lite loans is much more modest than U.S.

– However, as cov-lite has increased in U.S., European market is more willing to enter into cov-lite loans.

– Contributing factors:

• Return to the “originate and distribute” model of loan arrangement;

• Increased liquidity and depth in European leveraged loan market; and

• Demand of debt investors (including CLOs).

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European Covenant-Lite Loan Issuances Follow U.S. Trends Covenant-lite loans now represent 14% of all European institutional loans, a

significant increase over the mere 1% outstanding at the end of 2013.

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– Cov-lite volume in July 2014 alone was €4.7 billion, the highest issuance month in seven years.

– 2014 YTD cov-lite volume is €14.6 billion, exceeding any prior full year issuance including 2007 which in comparison only issued €8.1 billion.

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Covenant-Lite Loan Volume has Skyrocketed in Europe


Much of European cov-lite issuance volume is driven by cross-border transactions

However, many issuances are purely European, e.g. – Continental Foods

– Ceva Sante Animale

– Deoleo

– GHD Gesndheits

– Aenova

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Some European issuers are using covenant-lite for dividend recapitalizations and refinancing existing indebtedness – E.g. Continental Foods, a Belgium-based consumer foods business

purchased by London based private equity firm CVC Capital Partners in October 2013.

• Initial acquisition was financed with €320 million of senior debt.

• Refinancing allocated on July 30, 2014 with €425 million covenant-lite loan to fund €160 million dividend to CVC.

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Even European cov-heavy deals are seeing reductions in the average number of covenants tested in Europe – Excluding cov-lite issuances, newly issued European leveraged loans

YTD averaged a record low of 2.5 tests, a decrease from an average of 3 tests in 2013 and 3.6 in 2008.

– However, still more than U.S. where 2013 average was 1.7 tests and the U.S. average from 2008 to 2012 was 2.5 tests.

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Takeaways

Current market conditions of robust demand for new credit and supply of investors in search of higher yield favor covenant-lite.

Incurrence-based negative covenants instead of fixed baskets are becoming more common.

Cov-lite is expanding beyond the large cap U.S. market into the U.S. middle market and European market.

Cov-lite is a win-win for borrowers and lenders today but lenders should only lend to borrowers with balance sheets and earnings to support cov-lite loans, otherwise current trends could result in a bubble.

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Contact Information

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Stephanie S. McCann McDermott Will & Emery 312-984-3671 [email protected]

George M. Houhanisin McDermott Will & Emery 312-984-3367 [email protected]

Documents

Covenant-Lite Loans: Recent Trends for U.S. Middle Markets ...media.straffordpub.com/products/covenant-lite-loans-recent-trends-f… · 28/8/2014 · covenant-lite loan. – The