Lenders have been forced to become more flexible with loan requirements as their competition remains intense, with an abundance of debt capital and few completed deals. This has led to the resurgence of covenant-lite loans, which experts say are more prevalent in the upper middle market than they were in pre-recession 2007- the last time lenders frequently used the structure.(See related graphic.) Watch related video below, or click here.
So far in 2014, dealmakers have indicated an increase in early-stage deal flow, which could lead to an increase in completed deal flow. But following a few years of sparse middle market M&A, deal investors are still having a hard time finding places to put their money.
Deal volume in the middle market, for M&A transactions of less than $1 billion, was even lower in 2013 than it was in 2012, sinking to 2,141 deals from 2,447 deals, according to data from Thomson Reuters. Deal value also decreased in 2013 from 2012, moving down to $281 billion from $289.5 billion.
Collateralized debt obligation and collateralized loan obligation funds, also known as CDO and CLO funds, have attracted investor money because of slow deal flow, experts say. The inflows into the CLO market caused demand to outpace the supply of new loans, forcing investors to concede on terms "where they otherwise might have had more leverage to insist on covenants," says Steve Rutkovsky (pictured, left), a New York-based partner at law firm Ropes & Gray LLP.
Inflows into the CDO and CLO markets, combined with lender competition due to lack of deals, have contributed to the resurgence of the covenant-lite loan. The loans, which strip out many of the usual protections for lenders, have reached record levels in the broadly syndicated and upper middle-market spaces.
"We are seeing far fewer M&A transactions in the middle market," says Jim Hudak (pictured, right), president of Livingston, NJ-based lender CIT Corporate Finance, part of CIT Group Inc. (NYSE: CIT). "When you have so much money chasing very few deals, it's going to translate into lower pricing and looser structure."
In 2007, the previous record high year for covenant-lite deals, M&A institutional loan volume for covenant-lite loans was $74.17 billion, according to data provided by S&P Capital IQ Leveraged Commentary & Data, or LCD. In 2013, M&A institutional covenant-lite loan volume was $106.28 billion, according to the LCD data, a sharp increase from 2007. M&A institutional covenant-lite loan volume was at its lowest level in recent years in 2010, at about $520 million, LCD data shows.
"If you look at the volume of covenant-lite leveraged loans, 2007 was the highest year ever, and last year was almost double that," says Jeremy Swan, a principal with New York adviser CohnReznick Advisory Group.
Covenant-lite loans eliminate lender protections such as restrictions on third-party debt, leverage ratios and interest-coverage ratios. The move is a change for banks, which used to have the upper hand in lending discussions. "The power has shifted to the company seeking financing, or the private equity firm that's leading the transaction," Swan says.
From a company standpoint, having no covenants is better than having covenants, according to Koenig, but from a lender standpoint, "it's not an attractive investment because you have much more limited recourse and rights."
Though lenders do not necessarily view the loan structure as a good thing, it is "indicative of good things that happened in the market," Rutkovsky says. "There's a lot of cash being deployed into the loan market, which is good for companies and good for investors."
"There's money coming from everywhere," says Warren Feder, the co-founder of New York advisory firm Carl Marks Advisors. "There's a ton of money flowing into CLOs, and these covenant-lite loans are the type of loans that they like to buy into," says Feder.
Banks have been able to reduce risk by syndicating the loans out into the CLO market. "A lot of banks will underwrite the facility, and then they will syndicate out almost the entire facility, so they've made a fee, and they really have not risked their own balance sheet," says Hudak.
Those banks are moving into the middle market for deals, and depending on the transaction size, bringing their covenant-lite structures with them. "It's more the large banks coming down to the middle market that are the main providers of covenant lite," says Madison Capital managing director Tricia Marks (pictured, left). "That's what they're used to doing."
Though these loan structures have made their way into larger middle market deals, they aren't penetrating the lower end of the middle market. "There's a natural ceiling for the amount of covenant lite in the middle market," Koenig says.
Lenders are less likely to do a covenant-lite deal for companies that have less than $50 million in Ebitda, experts say.
"It's far riskier to do it with a lower middle-market company, because $10 million in Ebitda can basically evaporate and it's less likely that $50 million in Ebitda will evaporate," Feder says.
That ceiling has to do with the buyer pool. Large retail funds generally don't buy middle market paper because it tends to be less liquid. But covenant-lite deals are liquid transactions that are traded regularly. "Investors have the ability to get out at a moment's notice given the liquidity of the paper, but buy-and-hold investors don't typically do that," Marks says. "And buy-and-hold investors are the ones who typically buy middle market loans."
The liquidity of the lower middle market is also a problem for the CDOs that buy covenant-lite loans. "Lenders will make the judgment call that they don't have covenants in the deal, but they have a lot more liquidity, and once you get below $40 million or $50 million in Ebitda there's not as much liquidity," says Hudak.
Another reason we're seeing these deals stay at the upper end of the middle market is regulation. Banks looking to make these loans are governed by the Federal Reserve's leveraged lending guidelines. The guidelines define leverage lending, address expectations for credit policies, outline the need for well-defined underwriting and valuation standards, and reinforce the importance of credit analytics and pipeline management for leveraged lending.
"The Fed has put out leveraged lending guidelines, and they are making banks think about deals in the middle market and how much leverage they can put on companies," Hudak says.
"Regulators seem to be stepping up their enforcement of those guidelines and ratcheting up the pressure on banks to be more cautious in underwriting covenant-lite loans," Rutkovsky says.
If a smaller business lacking critical mass, even a well-run one, is given a covenant-lite loan, the lender has less flexibility in terms of strategic options if that small company runs into a hiccup.
If a company started out with a loan that leverages it four times, but its Ebitda then decreases, the amount of leverage placed on that company increases. In that situation, "from a lender's perspective, if you don't have covenants in there, there is little you can do to try to help right the ship if a borrower underperforms and misses its financial plan. You can't call the company into default," Hudak says.
"One lesson I hope we learned from the 2007 time frame is that if there is another credit crunch and the markets turn sour, the fact that these deals are so covenant lite, the banks or whoever is the holder of that debt will be significantly restricted in their ability to step in and make changes in that business to protect their capital," Swan says.
CIT generally does not consider covenant lite deals to companies with less than $50 million in Ebitda, Hudak says. When the company has participated as part of a larger covenant lite deal, it puts its own internal guidelines in place. "We have a very disciplined credit approach to monitor deteriorating financial performance. We want to stay ahead of the curve and be prepared to ensure that our borrowers can manage in good times and bad," Hudak says.
Companies with less than $50 million in Ebitda are not seeing the covenant lite deals of larger organizations, but they are often seeing fewer covenants as lenders continue to compete. "We're seeing many covenant-loose structures," Hudak says.
Middle market lenders have given some leeway on the covenants, sometimes slimming a loan down so it has just three covenants when previously it would have had five or six, says Feder. The interest coverage ratio, or Ebitda to interest expense ratio will sometimes be dropped on more-loosely structured deals.
"Maybe these deals aren't true covenant lite, but given the significant percentage cushion in the covenant levels, the deals are almost covenant lite," Marks says. Madison will consider doing these deals in certain situations, but rarely, Marks says. Middle market lenders are generally more willing to consider a slightly higher percentage cushion rather than eliminating all covenants, according to Marks.
The cushion that lenders give to companies--a margin of error in relation to a company's budget-was generally between 15 percent and 20 percent before 2013, and now it's 35 percent to 40 percent, Hudak says. The cushion allows companies a certain amount of leeway if Ebitda decreases before they default on a covenant.
"The covenant packages today are put in place with a lot of cushion - which is so large it's almost meaningless," Hudak says. For banks, it might even be better to do a covenant-lite deal, which they can trade out of, instead of having to wait for a borrower with a large cushion to default. "They might find that they're better off doing some covenant-lite deals because the liquidity coming out of those outweighs a very weak covenant package."
Experts are quick to point out that just because a loan is covenant lite that does not necessarily mean the loan is less likely to be repaid. "There's no real data that suggests that having a covenant protects lenders against payment defaults," Rutkovsky says.
If cash stops flowing into CDO market, we could see a decline in covenant lite loans. "Unless people stop investing in those, banks don't have the incentive to tighten the covenants because their risk is minimized through the syndication of the debt," Swan says.
"I think we're going to see the trend reverse," Rutkovsky says. "We are starting to see a reduction in inflows in the asset class, as well as an increase in supply, and the supply-demand imbalance is starting to clear."
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Corrected May 20, 2014 at 12:03PM: 3562975018001