In the first part of our four-part blog series on cov-lite lending and beyond, we look at the evolution of the European leveraged loan market and the expansion of covenant-light, or ‘cov-lite’, lending.
The European leveraged loan market has reached a new level of maturity in the last three years. This evolution has brought some unwelcome features including the dilution of structural protections, like maintenance covenants. It has also brought some benefits, like the advent of multi-billion corporate issuers and an active secondary market.
Cov-lite loans made up around 70% of total issuance in Europe in the first half of this year, broadly in line with the US. This is unprecedented. Even at the height of the credit expansion phase, in 2007, cov-lite loans accounted for just 5% of total loan issuance in Europe, disappearing again before gaining ground from 2012.
The proliferation of cov-lite loans
Source: S&P Capital IQ LCD, 30 June 2018. Institutional covenant-lite volume as a % of total issuance.
Even when maintenance covenants have been preserved, they have typically been reduced from the once-standard four to a single (leverage) test as may be seen below.
Average number of maintenance covenants per transaction has fallen
Source: S&P Global Market Intelligence, LCD quarterly leveraged lending review 2Q 2018.
What has been driving the increase in cov-lite lending in Europe’s leveraged loan market? The search for yield has undeniably been one of the main drivers of increased investor appetite for the asset class in the years following the financial crisis. Institutional investors – rather than banks – currently make up around 80% of the European loans market. This in turn, has given borrowers the upper hand to dictate loan terms, pushing for similar terms to US borrowers or high yield bond issuers.
What is the difference between covenanted and cov-lite loans?
A borrower promises – or covenants – certain things to lenders in its loan documentation: not to make disbursements to junior stakeholders unduly; to provide regular, meaningful information to lenders; not to pledge assets in favour of any other party. Such promises are hardwired for life and remain commonplace in all loans. In addition, there will routinely be at least one financial covenant with which a borrower must comply, typically a leverage ratio (a debt/EBITDA cap) that must not be exceeded.
Whereas this limit once applied at all times (requiring a borrower, proactively, to prove to lenders that it was maintaining compliance), more typically in today’s loans, that test becomes live only when a borrower attempts to raise new debt. In this way, the financial covenant may no longer be described as ‘maintenance’, but rather as ‘incurrence’ and essentially takes the form of a high yield bond covenant. When this is the case, the loan is described as ‘cov-lite’.
In addition to the removal of maintenance covenants in loan documentation, attempts by private equity firms, underwriting banks and law firms further to weaken documentation have not gone unnoticed. We highlight some of the specific changes that have crept into loans over recent years, including information provision and disclosure, dividend-taking, corporate carveouts and financial-metric ‘modifications’ such as proforma EBITDA and add-backs, and why lenders need to be cautious when evaluating each loan.
In part two of this series, we will take a closer look at EBITDA adjustments and the things lenders need to watch out for.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested.