Protections have gotten so lax in the $1 trillion market forU.S. leveraged loans that if an offering comes with decentcovenants, lenders take it as a sign that something's wrong withthe deal.

“You do have to think twice when you see a loan with a covenantthese days,” says Thomas Majewski, managing partner and founder ofEagle Point Credit Management.

It's not a crazy assumption in a market where 75% of new loansare now defined as “covenant-lite,” meaning a company could, forexample, rack up as much debt as it wants regardless of itsperformance. In such a lenient atmosphere, the reasoning goes, aloan must be a stinker if a borrower has to resort to promisingeven standard protections.

“It's basically the worst it's ever been in terms of loancovenant protections,” says Derek Gluckman, senior covenant officerat credit-rating firm Moody's Investors Service. And that includesthe heady precrisis year of 2007.

A covenant-lite loan refers to debt where the issuer doesn'thave to meet periodic performance goals, known in the trade asmaintenance covenants.

It might make sense to cut some slack for bigger, more stablecompanies, but investors are raising the alarm on loans tomiddle-market borrowers with Ebitda under $50 million that haveless room to bounce back from a mistake. Many small companies areunproven, first-time issuers, and the risks are even greater iftheir business is cyclical.

At the same time, lenders are giving up compensation for therisk they're taking by accepting skimpy yields and turning a blindeye to accounting maneuvers that downplay leverage.

Take SnapAV, which sells its own brand of audio-visual equipmentto businesses that in turn install the equipment in people'shomes.

Private equity firm Hellman & Friedman raised $265 millionin covenant-lite loans last month to fund its acquisition ofthe Charlotte-based business. Investors agreed to forgo theprotections even as the new owner used an accounting method knownas add-backs to reduce a measure of the company's leverage, whichmakes it look more creditworthy. The add-backs, which take intoaccount things like deferred revenues, boosted Ebitda by about athird, to $50.1 million, from $37.5 million. That reduced thecompany's leverage to 5.4 times from more than seven times,according to loan documents sent to investors.

Still, SnapAV attracted enough willing lenders to sell the loansslightly cheaper than was initially discussed—with no financialmaintenance covenants.

The adjustments have become so prevalent that Ian Walker, ananalyst at Covenant Review, says he can't remember a privateequity-backed deal done without them. Walker estimates 85% ofloan deals for bigger companies backed by large private equityfirms are now considered covenant-lite.

Junk-bond pioneer Michael Milken said this month the ability todo these types of deals was contributing to a “golden age” forprivate equity firms. “You can leverage, you can borrow withoutcovenants, and so for equity holders it affords you very unusualrates of return,” Milken said in an interview with BloombergTelevision in Singapore.

Less Influence

In June, Golub Capital, a nonbank lender, arranged a $205million loan for private equity firm Gridiron Capital to buy RoughCountry, which makes off-road accessories and suspension productsfor trucks, SUVs and Jeeps.

It was “one of the smallest covenant-lite issuances to date,”Jason Van Dussen, Golub's head of capital markets, said at thetime. That means the 20-odd lenders who bought the deal effectivelywill have no bargaining power if Rough Country ever drives off afinancial cliff.

Representatives for Hellman & Friedman and Golub declined tocomment. A representative for Gridiron didn't respond to requestsfor comment.

Just because a loan is light on covenants, that doesn'tnecessarily mean it's always going to be riskier, according to Bankof America Corp. analysts led by Neha Khoda.

“Cov-lite issuers tend to be bigger and better capitalstructures, perhaps the reason why they were able to attract enoughinvestor demand in the first place, despite having no maintenancecovenants,” the analysts wrote in a report this week. Leveragedloans have returned just above 2% this year, according to indexdata.

But if the company gets into trouble, holders of term loans mayfind they're at a disadvantage to lenders who extended othertypes of debt and did insist on covenants, such as banks thatprovided revolving credit lines. A broken covenant could entitlethe latter to extract concessions, but term lenders wouldn't havethat negotiating lever, says Covenant Review's Walker.

The risks are magnified for middle-market companies because termloans typically are held by fewer investors. Any potential losseswould be shared among a smaller group, and selling out the holdingis much harder.

“If you agree to this, you're handing over control of yourdestiny,” Walker said.

From: Bloomberg News

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