DEBT MACHINE: ARE RISKS PILING UP IN LEVERAGED LOANS? / THE FINANCIAL TIMES

Debt machine: are risks piling up in leveraged loans?

In the first in a series, regulators fear that looser lending standards for lowly rated companies could precipitate the next downturn

Joe Rennison and Colby Smith in New York


© Adam Simpson


With 18.7m followers and a roster of fans that includes the Kardashians and Naomi Campbell, the Instagram page of beauty company Anastasia Beverly Hills offers crafty demonstrations of how to use its products to get the perfect eyebrows and lips. In one image, a model has a tiny heart carved into her manicured eyebrow.

The successful social media account is more than a marketing tool, however, for the cosmetics business owned by Romanian-born billionaire Anastasia Soare. It was also listed as one of the company’s “general intangible” assets in documents for a $650m loan to fund a partial buyout by private equity firm TPG Capital, according to people familiar with the deal.

Even more striking than the eyebrow-raising collateral, the loan came with few of the investor protections that were once standard in loan documents, such as the ability to potentially move assets out of the reach of lenders. Such provisions have been criticised for undermining investors’ claims on a company’s collateral in the event of financial problems — even an Instagram account.

Anastasia Beverly Hills and TPG declined to comment.

Anastasia Beverly Hills is one of the many companies that have sought cheap financing in recent years through the so-called leveraged loan market, where credit is typically extended to lowly rated, more indebted companies and which has overshadowed the much better known high-yield bond market as a source of financing.

The leveraged loan market has exploded since the financial crisis, doubling in size over the past decade to $1.2tn, according to data from LCD, a division of S&P Global Market Intelligence. With investors of all different types eager for higher returns, companies have been able to borrow money on increasingly favourable terms, giving them greater flexibility should they run into trouble.

Anastasia Beverly Hills’s loan is not the most egregious example, but it is indicative of a market that has eviscerated traditional investor protections and made looser lending standards common. The shift has prompted a rising chorus of voices to warn that the deterioration in underwriting standards could amplify the next downturn.




“All the ingredients are there within this sector of the market for there to be meaningful problems when the economic slowdown does occur,” says Dan Ivascyn, chief investment officer for Pimco, one of the world’s largest asset managers.

Looser lending standards are less important while the economy is robust and the likelihood of companies defaulting is low. But concerns over slowing growth are mounting, and a flash of market turbulence sent leveraged loan prices sliding in December. Although the market has since stabilised, the tumble was arguably a dry run for what could happen in a recession — which some analysts and fund managers say could be within the next couple of years.

The bout of uncertainty has sparked more scrutiny of the leveraged loan market, with organisations such as the Federal Reserve, IMF and the Bank for International Settlements all sounding the alarm about the potential broader risks to the economy.

“If we have a downturn in the economy, there are a lot of firms that will go bankrupt, I think, because of this debt,” Janet Yellen, the former chair of the Federal Reserve, warned last year. “It would probably worsen a downturn.”



Anastasia Beverly Hills, founded by Anastasia Soare, is one of many companies to have sought cheap financing


When the global financial crisis erupted in 2008, central banks around the world slashed interest rates and bought trillions of dollars worth of bonds, pushing yields down. That forced investors to look elsewhere for higher returns. One beneficiary was the leveraged loan market.

Loans had performed relatively well throughout the financial crisis, and investors were attracted by the fact that the debt is backed by assets, unlike the unsecured bond market.

The high-yield bond market — often called “junk” and a traditional source of funding for riskier companies — has also grown, increasingly favouring larger deals. But the balance has gradually tipped toward the leveraged loan market, where many smaller, lower-rated companies that might struggle to issue in the junk bond market, have been able to find suitors. Loan issuance has edged past that of the junk bond market as a result.

In December 2015, as the US economy continued its recovery, leveraged loans received another boost; the Fed began to raise interest rates. One of the attractions of investing in loans instead of junk bonds is that the interest rate paid to investors fluctuates in line with benchmark rates. As the Fed embarked on raising rates, loans became an attractive way to take advantage.




But the combination of rampant investor demand and companies willing to take on more debt has led to a gradual deterioration in lending standards. For a third of all loans issued in 2018, leverage levels crept above six times, according to LCD, exceeding guidance put out by the Office of the Comptroller of the Currency in 2013, an independent bureau of the US Treasury.

So-called financial maintenance covenants — things that would limit the amount of leverage a company could take on, or mandate thresholds for the amount of cash they needed on hand to pay interest on their loans — have close to disappeared. More than 80 per cent of the market is now deemed “cov-lite”, according to LCD, meaning financial maintenance protections have been removed.


PetSmart is embroiled in a lawsuit with its lenders


But the loosening of lending standards did not stop there. Neiman Marcus, the department store, and its thriving Munich-based online retailer MyTheresa, which sells pricey garb from designers such as Versace and Balmain, is a case in point. Since Neiman Marcus bought MyTheresa in 2014, MyTheresa’s sales have nearly tripled.

That’s why creditors to Neiman Marcus were aggrieved when its owners — private equity firm Ares Management and the Canada Pension Plan Investment Board — in September transferred MyTheresa to Neiman’s parent company. This potentially put the assets of MyTheresa out of reach of Neiman’s creditors just before the parent company announced it would need to restructure its nearly $5bn in debt.

One of the attractions of investing in loans instead of high-yield bonds is precisely that the debt sits higher up the capital structure, being repaid first if problems arise and giving investors a claim on assets if things turn sour. Creditors were especially unimpressed by the decision taken by Ares and CPPIB to strip out such a valuable asset as MyTheresa, given concerns about Neiman’s solvency.

“You have allowed, or have turned a blind eye to the sponsors’ not-so-subtle, sleight of hand machinations to lure creditors into a false negotiation meant only to perpetuate their self-serving enrichment scheme,” wrote Daniel Kamensky of Marble Ridge Capital in a letter to the parent company’s board just prior to filing a lawsuit in December.

In a statement to the Financial Times, Neimen Marcus refutes Mr Kamensky’s claims. “This distribution was expressly permitted by the company’s credit documents . . . The company is not in default and has never been in default. There is no reason to believe we will be in default in the future. The company is not insolvent and the organisational change to MyTheresa did not change that.”




Neiman Marcus is not alone in pursuing this tactic. Of the top 20 private equity-sponsored loan deals in 2018 approximately 80 per cent contained a loophole that could see loan investors’ claim on collateral diluted, according to Covenant Review, a credit research group.

Documents underpinning a loan to ailing PetSmart, which sells food and other products for household animals, allowed its private equity backers, BC Partners, nearly “unlimited flexibility”, according to Ian Walker of Covenant Review. Not only did PetSmart move valuable assets out of reach of loan holders in June, it also paid a dividend to a holding company controlled by BC Partners. PetSmart is now embroiled in a lawsuit about the legality of the move with its lenders. BC Partners declined to comment. PetSmart did not respond to a request for comment.


Janet Yellen, former chair of the Federal Reserve, has warned of the potential broader risks to the economy © Getty


For some investors, no deal has drawn as much scepticism as Blackstone’s $17bn leveraged buyout of Thomson Reuters’ financial data business — later renamed Refinitiv. The deal, one of the biggest LBOs since the financial crisis, was financed largely with a mix of leveraged loans.

“To me I think Refinitiv would be the poster child of the peak of the market,” says Craig Russ, a portfolio manager at Eaton Vance, which manages some of the largest loan mutual funds. “It was a very aggressive deal, highly leveraged, crappy docs but people bought it up.”

The Refinitiv deal was seen as one of the most striking examples in the leveraged loans market of the use of so-called “add-backs” to earnings before interest, taxes, depreciation and amortisation. By counting potential cost savings or other ambitious, theoretical efficiency improvements, companies can appear more creditworthy. But if these “add-backs” are not realised, the actual leverage levels can spike dramatically.

At 5.7 times when the deal was issued, Refinitiv’s leverage levels seemed quite modest at first glance. However, to get to this figure, it factored in $650m worth of cost savings within three years. Should Refinitiv fall short of this lofty target, its leverage levels could balloon, according to Minesh Patel, a director at S&P Global Ratings. Blackstone declined to comment.

The private equity firms behind some of these loans say many of these concerns are overblown. For a start, they insist that investors know exactly what they are signing up to — the changes to covenants appear in legal documents. They also argue that no legal safeguards could protect investors from lending money to a bad company.




“The main point is if a manager is bad at credit underwriting, the existence of covenants alone won’t protect you from bad credit risks and eventual realised losses — credit selection is the most important factor,” says Keith Ashton, the co-head of structured credit at Ares Management.

Tighter loan conditions can still help investors, however. Rating agencies say that given the weaker lender protections, the amount that investors can recover will be far lower than in the past if highly leveraged companies begin to default.

The US default rate is now just 1.6 per cent, well below the historical average of 3.1 per cent, says Ruth Yang, a managing director at S&P Global Market Intelligence. In fact, they could stay this way for some time in part because covenants remain so loose.

“Cov-lite takes away the canary in the coal mine for lenders,” Ms Yang says. “But it also allows borrowers who are struggling but are still well placed financially to keep making required payments on loans to not be forced into default.”

Moody’s estimates that recoveries on so-called first-lien loans — which rank first in a debt workout — would likely fall from the historical average of 77 cents on the dollar to 61 cents. The recoveries on riskier “second-lien” loans will tumble from 43 cents to just 14 cents, the rating agency predicted.

Christina Padgett, senior vice-president at Moody’s, warned last year that a “combination of aggressive financial policies, deteriorating debt cushions and a greater number of less creditworthy firms accessing the institutional loan market” was creating credit risks.


Thomson Reuters chief executive Jim Smith. Blackstone’s $17bn leveraged buyout of Reuters’ financial data business drew scepticism from some investors © Reuters


The first inkling of the potential trouble ahead came in the final weeks of 2018, when investors grew nervous over the combined impact of slower economic growth and higher US interest rates, sending financial markets tumbling.

Loan prices slid more than 3 per cent in December, the worst month for the loan market since August 2011 when the US government was downgraded and lost its coveted triple A rating. Between November 15 and January 2 investors pulled more than $16bn out of loan mutual funds and exchange traded funds. Much of that was concentrated among a handful of dominant players.

But the new year has brought some renewed optimism to the market. The S&P loan index has recovered by 2.2 per cent. Douglas Peebles, head of fixed income at AllianceBernstein and long a leveraged loan bear, now thinks the market is healthier, after the sellout cleared out some of the “weak hands” in the market.

The December sell-off also forced Wall Street banks stuck with unsold loans to offer better terms to investors.

“To get a deal through the market now, it is going to have less leverage, tighter documents and a higher coupon,” says Mr Russ.

But some lawyers say they will still try to keep the balance tipped towards borrowers, especially when it comes to loosening lender protections further.

“Our job is to make sure that our clients have the maximum amount of flexibility to execute [their deals],” says Jason Kanner, a partner at law firm Kirkland & Ellis. “We’ll come up with new stuff.”