.svg)
THE SLIPPERY SLOPE LEADING TO 100% COVENANT LITE
Over the last decade, much has been made of the ongoing erosion of financial covenants in leveraged loans and high yield bonds. Thanks to the incessant hunt for yield, these degradations continued to be accepted by investors desperate for higher-yielding paper. Whereas at the onset of the global financial crisis 30% of US leveraged loans were considered covenant lite (cov-lite), by the beginning of the most recent rate hike cycle this rate had risen to more than 90%1.
The statistics for US leveraged loans issued in conjunction with LBOs are even worse with 100% of loans issued in 2021 classified as cov-lite. And to add fuel to the fire, issuers have become ever more creative in constructing mechanisms that allow them to dilute lenders or strip collateral away from the intended security pack.
In Europe, developments have taken a similar path. Cov-lite was effectively non-existent prior to the global financial crisis, but has quickly ramped up over the last 15 years to the point where at the end of 2021, effectively every European leveraged loan could be classified as such.
DISTRESSED LENDERS TAKE ADVANTAGE OF LOOSER COVENANTS
Historically, senior-secured leveraged loan investors would expect to receive between 70-80% in recoveries upon default of the borrower. With looser debt documentation in place, current borrowers can exploit loopholes that allow them to restructure their business at the expense of creditors. This uptiering strategy came under the spotlight in 2020, when a simple majority of lenders to mattress maker Serta Simmons agreed to provide new money in exchange for a more preferential creditor ranking, at the expense of non-participating lenders.
With looser debt documentation in place, current borrowers can exploit loopholes that allow them to restructure their business at the expense of creditors
Major investment powerhouses Apollo Global and Angelo Gordon were left out of the deal and sued Serta, but have recently lost in court with the bankruptcy judge stating ‘… and this litigation ends with each party receiving the bargain they struck — not the one they hoped to get.’ Since then, numerous bankruptcies and corporate defaults have exposed the lengths to which borrowers (and the PE firms backing them) will go to protect themselves.
In a recent case GenesisCare, an Australian health care provider, obtained a ‘debtor in procession’ financing, including $200m in new debt that disadvantaged existing creditors. The European loan, which additionally suffers from a ‘whitelist’ that restricts the number of possible distressed loan buyers, currently trades at around 14 cents.
Investors that participate in the restructuring can expect to do substantially better than hold-out creditors, with Bloomberg recently positing the below lender recoveries.
The Bank of England estimated that around 45% of non-bank leveraged loan holdings are held by CLOs. Most CLOs are precluded from investing more money during the restructuring of a defaulted borrower. As a result, aggressive hedge funds and distressed debt funds have been targeting the distressed loans owned by CLOs, in order to take advantage of simultaneously the tighter controls imposed on structured credit vehicles, as well as the loosening of controls in outright corporate lending standards.
DEFAULTS AND RECOVERIES
Leveraged loan defaults are increasing – European leveraged loan 12-month trailing defaults are at 1.7% through July ’23 according to Fitch Ratings. This rate is expected to increase to 4.5% by year-end given the number of issuers that have engaged restructuring advisors, while in the US this is already at 3% (compared to only 1% in mid ‘22). At the same time recoveries appear to be substantially lower than previously observed, with strategists expecting this year’s defaults to see around a 25% recovery, and some 50% in the long term.
SCIO’S SECURED ASSET-BASED LENDING – A KEY DIFFERENCE IN APPROACH
The deterioration in leveraged loan lending standards has been long and widely covered, and its implications anticipated by the market. Borrowers are often backed by some of the most sophisticated players in the market (PE houses), which have substantial budgets and (critically) time to prepare loan documentation. In contrast, investors, desperate for yield, were often given mere days (or on occasion hours) to sign up to a new issuance deal with limited scope for document negotiations. This mismatch in resources has in part resulted in the predicaments that creditors now find themselves during a default.
SCIO’s loan facilities, in contrast, tend to be small bilateral transactions where we experience limited competition from other lenders, permitting us more time for full scope analysis. During the process SCIO usually engages external legal representation who will be the drafting party of the loan documentation. During this process, SCIO always strives to be commercial and fair with the borrower, but strict requirements are incorporated in order to protect our investors’ capital.
Asset-based security is meant to be for the benefit of the lender when needed, rather than stripped away in the interest of the borrower. Higher returns are good to aim for, but for any lender the return of capital should always come first.
We are always happy to receive your thoughts on this topic and welcome the opportunity to discuss in greater detail. Thanks for reading!
1. Source for Cov-lite data: LCD Morningstar
