‘Covenant-lite’ joins the lexicon of financing

THE TERM ‘covenant-lite’ has cropped into the lexicon of financing in Europe, where it is seen as a manifestation of competition among non-bank lenders. They are filling the void left by banks . . .

HONG KONG — With the prevailing uncertainty hanging over Europe’s economy
in the wake of Britain’s departure from the
European Union, the level of distressed debt in Europe could rise.
Even before Brexit, the level had been worsening — but at a rate slower than in previous decades, thanks to the availability of alternative sources of debt funding.
James Chesterman, a London-based partner of lawyers Latham & Watkins, told ATI that a number of firms involved in energy sector
financing had gone into distress in the past year. The trend, he said, reflects the global
collapse of oil prices, which have already triggered defaults by a growing number of U.S. companies.  “We are also beginning to see companies getting into difficulties in the U.K.,” he said. “As an example, companies in exploration and production in the North Sea have gone into administration.”
However, Chesterman, who was in Hong Kong to address the distressed debt seminar organised by lawyers Latham & Watkins, believes there is a difference between what is happening in this cycle compared with previous downturns  — in that over-leveraged companies have been able to refinance themselves.
“They have gone to high yield bonds — the posh name for the junk bond market, and this has been quite a feature of the last three or four years,” he said.
“We talked about a refinancing cliff, as it
was clear that there would be significant debt
maturities in 2015 and 2016, but many of those maturities have been deferred through refinancing in the bond market.”
As well as the high-yield bond market, borrowers are accessing a ready pool of private debt funding now available through debt funds run by some of the world’s largest private capital groups, such as the KKR, Blackstone, Texas Pacific, EQT and CVC Permira. Platforms such as KKR Credit and Aries Capital Partners are among non-bank lenders in the market.
Chesterman estimates that there are probably around 30 significant debt funds in the market today. They are filling a void left by banks, which are retreating because of capital requirements imposed on their lending transactions.
“Many banks have less incentive to lend than they did in the past,” he said.
“These debt funds are more flexible than banks. They are more likely to accommodate borrowers seeking long maturity or unusually light covenants.
The term “covenant-lite’ has cropped into the lexicon of financing in Europe, where it is seen as a manifestation of competition among non-bank lenders.
In the past, financial covenants would include provisions for quarterly tests of a company’s earnings against their capacity to service debt and repay interest.
Chesterman said repayment would be set to headroom of the company’s earnings forecasts, and, if the covenant was broken, the lenders would have room to manoeuvre.
Five years ago, all loans would have an amortisation schedule, with loans repayable over  the course of their term, usually seven years.
“Now, we rarely see loans which are amortised over the term of the loan. Instead, we are seeking terms for loans to be repaid in a single amount at the end of seven years. These term loans are also known as ‘balloon’ loans.”
Chesterman explains that, in markets like the U.S., the structure of debt funds is such that the lender (investor) does not require repayment during the term of a loan.
These same lenders/investors are also more relaxed about covenants, hence the emergence of ‘covenant-lite’ loans.
He said it is important to bear in mind that these term loans are primarily used to fund
acquisitions or to acquire shares in a company. “Alongside the term loans, you have a revolving credit facility which is a continuing loan that is made available typically for six years, rather than seven. This revolving loan is used to fund general corporate working capital.”
Chesterman said that, in the current market, only revolving credit facilities have the protection of covenants. “So if a company breaches that covenant it is only the lenders in the revolving facility — who are generally banks — who can prevent further drawings.”
In another development, the term “special situation” has crept into the financing world to describe loans made to more distressed or challenged companies —  companies unable to borrow from banks because of the state of their business.
“Private debt managers will have funds for what I call general lending to corporates, and private equity groups also have special situation funds designed both for lending new
money in distressed situations and for investing in distressed loans.”
Such investors might buy the debt at 30 cents in a dollar in the hope that they will get a return greater than 30 cents.
The post-GFC low-interest rate world has meant that many companies which would not have survived 10 years ago have a much higher chance of surviving in this environment. However, Chesterman points out that these companies are not paying 0.5 per cent for their funding. Rather, they pay an all-up rate of between 8.0 and 9.0 per cent.
The development of non-bank lending will continue to grow, he says. “It is an exciting time for development of the debt market. We are seeing much more choice for borrowers than we had 10 years ago.
“It is a good development, with capital available for real estate and infrastructure,” he said, adding a rider, “provided the capital is 
allocated wisely”.