Covenant-lite loans are back but investors hope to limit mistakes of the past

This article is provided to FT.com readers by Debtwire—the most informed news service available for financial professionals in fixed income markets across the world. www.debtwire.com

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In the wake of the global economic crisis covenant-lite loans quickly symbolized the kind of fast and loose leveraged financing that brought the capital market to its knees. Assuming they hung onto their jobs, many portfolio managers who invested in the covenant-lite deals of that era uttered the mantra “never again”.

But fast forward to today, and covenant-lite loan deals are once again popping up in the primary market, getting syndicated to a broad group of investors. Five covenant-lite loan deals - The Sports Authority, Leslie’s Poolmart, Sheridan Healthcare, Petco and Amscan Holdings – came to market in the last month. Several more are expected to burst through the deal pipeline before year-end, two leveraged finance bankers and two loan portfolio managers told Debtwire.

Covenant-lite loans don’t offer lenders the protection of financial maintenance covenants. Financial covenants require the borrower to comply with certain ratios, like a maximum allowable leverage ratio or a minimum required interest coverage ratio, on a quarterly basis.

While some investors decry the downside risk that a new covenant-lite trend presents, others take a view that today’s market is adjusted from past mistakes, and cov-lite terms are only being given to seasoned issuers at a pricing premium, according to the two bankers and nine loan investors.

Paper Push

Corporate debt investors are constantly pressed to demand deals struck at favorable terms with adequate protections. But today’s loan market is for the most part a seller’s environment, where investors are flush with cash they need to put to work, all the sources noted. Loan funds have received positive net inflows in all but three weeks of this year, for a total net inflow of USD 8.9bn year-to-date, according to LipperFMI.

The ramped-up demand for new paper makes some market participants concerned that the market is heading back to the heady days of 2007 when a CLO explosion pushed deal terms too far in the favor of issuers. Moreover, some investors buying the covenant-lite deals are not solely loan investors, so in their hunt for high-yielding paper, covenant concerns are a low priority, two PMs said.

“It does feel like we are coming back around to peak-market structures much faster than in past cycles,” said an analyst at a CLO. “The need for yield makes the greed side of the equation much stronger than the fear.”

Pricing Power

Nevertheless, there are a few striking differences between today’s covenant-lite deals and their predecessors. For one, covenant-lite deals in this new cycle have largely been the province of highly rated issuers with existing bank groups, the sources noted. Their use of proceeds is also mainly limited to refinancing already manageable capital structures, as opposed to financing LBOs or dividends, one of the bankers said.

Skillsoft’s loan, issued back in May, is the only one of 12 covenant-lite loans tracked by Debtwire that launched this year - including one still in syndication - to back an LBO for a new loan issuer. The remainder of the deals have been issued by veteran high yield borrowers, as proceeds from eight of the 12 are being used to refinance or add onto existing covenant-lite deals.

This time around investors are also getting superior compensation for the concession. Those issuers currently attempting to refinance existing covenant-lite loans with new covenant-lite facilities will likely pay at least 400bps in additional interest.

The Sports Authority closed on a USD 300m TLB on 12 November to refinance its existing USD 275m TLB that pays Libor+ 225bps with no Libor floor. Arranger BofA Merrill Lynch initially launched the new loan with price talk at L+525bps-550bps along with a 1.5% Libor floor and 98-99 OID, but after a chilly reception increased price talk to L+ 600bps with a 97 OID.

Another issuer to close a covenant-lite loan deal this month, Leslie’s Poolmart, paid 50bps-75bps more than two competing deals with the same BB-/Ba3 ratings, but that came with covenants, according to Debtwire data. Leslie’s TLB freed to trade earlier this week with pricing at L+ 450bps. In contrast, Getty Images’ priced at L+ 375bps and Fifth Third Processing Solutions’ priced at L+ 400bps. All three companies offered a 1.5% Libor floor and 99 OID.

Underscoring the premium being paid by Leslie’s, the 6.12% implied yield to maturity on its new seven-year loan is actually in line with similarly rated bond deals. Consumer products maker Jarden priced a 12-year BB-/Ba3 unsecured senior note this month to yield 6.125%.

“In our market now, at a price, most anything is going to clear,” noted one of the PMs. “Whether it’s covenant-lite, or has an aggressive use of proceeds, there is a price at which it will clear because people have such a need for yield,” he said.

Indeed, the market made Asurion pay up last month. But the outcome of that deal could lead banks to think twice about underwriting covenant-lite dividend deals. The cell phone insurance provider issued an add-on term loan to its existing covenant-lite deal at a discount of 96, three points lower than initial talk and also lower than where the Barclays-led syndicate underwrote it, said the bankers and three lenders.

The lack of financial covenants was not the only aggressive aspect to the Asurion deal, as it was funding a sponsor dividend and primed existing second-lien holders.

“Clearly that will make people more cautious about how they approach [underwriting],” a banker said. Most opportunistic deals like refinancing and dividend deals continue to be done on a best-efforts basis, the sources added.

The Asurion and Sports Authority deals also illustrate that the ball is in the investor’s court, said one of the bankers and several portfolio managers.

“At the end of the day, you have to be able to sell the product to investors. If investors begin to accept covenant-lite with no premium, you will start to see covenant-lite with no premium clear the market,” stated the banker.

Many investors’ biggest complaint about covenant-lite deals is that they don’t trade well in the secondary market. Brickman Group served as the poster child for the “covenant-lite discount” as its 2007 vintage TLB never traded any higher than the mid- 90s up until it was refinanced in August, according to Markit. The company issued a new covenant-lite facility that took out the previous loans and paid a USD 243m sponsor dividend. The loans have traded above 101 ever since. The new TLB pays L+ 550bps with a 1.75% floor, compared to the old TLB pricing of L+ 200bps with no floor.

“I’ll view the market as getting overheated when we start printing deals with no real differentiation in yield between the covenanted deals and covenant-lite deals,” the banker said.

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