WHY "COVENANT LITE" LOANS ARE NOT THE MENACE THEY SEEM / THE FINANCIAL TIMES OP EDITORIAL

Why ‘covenant lite’ loans are not the menace they seem

Risky debt market is dominated by contracts that have investor protections ripped out

Mark Vandevelde


The novelist Richard Ford wrote that a market economy works not by giving people what they want, but by persuading them to feel good about having whatever happens to be available. If that rueful observation hardly matches America’s self-image as the land of freedom and opportunity, it at least makes some sense of the country’s real estate agents and car dealerships, which insist on peddling “shabby-chic” apartments and “pre-loved” cars.

The $1.3tn leveraged loan market has lately developed its own peculiar quirk, which may reveal something about its participants’ material insecurities. Fully 80 per cent of the money that changed hands there last year was extended under what are known as “covenant lite” loans, a polite term for lending contracts that have had most of the investor protections ripped out.

The safeguards in question are legal clauses that once enabled investors to grab the wheel if a company missed its financial forecasts or made other wrong turns. In the credit market frenzy that preceded the financial crisis, private equity firms were briefly able to negotiate exceptions, winning notorious “mulligan” clauses that allowed the company to drop the ball once without consequence. Such permissive deals vanished for a few years when credit markets seized up. But during a decade of expansive monetary policy and loose lending, they have returned to become the norm.

The Bank of England and former Federal Reserve chair Janet Yellen are among the policymakers now sounding the alarm about disappearing covenants and other signs of careless lending. When billionaire investor Howard Marks asked colleagues at his firm Oaktree to dish the dirt on their rivals’ most imprudent deals, they returned with a bulging catalogue. In a letter to investors, he told of one highly indebted company that earned more than half its revenue from a single fickle customer. Another colleague told of a banker who said he had more to fear from losing business to competitors, than from losing the bank’s money on a risky deal.

For asset managers who earn a living channelling cash from pension funds and insurance companies into corporate loans, there is little alternative but to try to make clients feel good. Dwight Scott, president of Blackstone’s GSO credit platform, argued in the Financial Times last week that if a company’s condition deteriorates, investors could in some circumstances forget the covenants and instead sell their loans. That is unlikely to reassure veterans of the long months in 2008 when it was impossible to put a price on many financial assets, let alone find a buyer.

The strongest argument for embracing covenant-lite loans is one the lenders themselves would blush to make: they are often not the best people to run troubled companies. When researchers at S&P Global Market Intelligence tracked down defaulted loans that were issued before 2010 with weak covenants, they found creditors had recovered 78 per cent of the money they originally lent. Loans with traditional protections barely fared any better, suggesting there is little to be gained from parachuting rescue teams in early. The difference is much starker for loans written after 2010, when lenders recovered about half of their original outlays — but the data is too thin to draw firm conclusions.

Blackstone’s private equity business, itself a major borrower, has flirted with disaster and lived to tell the tale, delivering creditors a payback they might not have managed alone. The company’s $26bn acquisition of hotel chain Hilton Worldwide, sealed in 2007, required about $20bn of debt from more than 20 banks and other investors, including Bear Stearns, the doomed investment bank that ceased to exist by 2009. The global recession wiped one-fifth off Hilton’s revenues and an industrial espionage lawsuit from rival Starwood threatened to burn a hole in the company’s balance sheet.

Lenders took some pain, selling back a portion of their Hilton debt for less than the company had originally borrowed, in a rescue brokered by Blackstone that also saw the private equity firm put up more cash. The creditors had few options because Blackstone had insisted on covenant-lite debt. But it is far from clear that loan officers could have obtained a better outcome if they had held more of the cards. By the time Blackstone sold its final Hilton shares last year, it had turned the deal into one of the most profitable private equity trades in history.

While creditors may overrate the usefulness of taking over an ailing company, loose lending hurts them in less dramatic ways. An absence of covenants means missed opportunities to charge fees for waiving violations, shaving a few points off expected returns at a time when debt is already cheap. And bankruptcy lawyers say sloppy drafting has allowed some teetering borrowers to spirit valuable assets beyond the reach of creditors, reducing likely recoveries when they eventually fail.

But with too much capital chasing too few deals, and the Fed shelving plans for interest rate rises that could have given lenders more power to dictate terms, covenant-lite loans remain the only loans there are. Perhaps investors can learn to feel good about them.