Wednesday, June 13, 2007
The New York Times Dealbook has made posts two days in a row about the perils of "covenant-lite" deals. First, yesterday Dealbook drew parallels between the current problems in the subprime housing mortgage market and "covenant-lite" loans which banks have been providing to private equity shops. "Covenant-lite" loans do not contain the usual heavy restrictive high yield covenants which require maintenance of debt ratios and limit operations and significant transactions. Then today, Dealbook asserted that the possible problems with these loans were leading banks to distance themselves by collateralizing them in the market. Dealbook went on to report that:
Covenant-lite loans have grown to about 15 percent of bank debt outstanding, from 1 percent at the beginning of 2006, Goldman Sachs estimates. But U.S. banks hold 7 percent of the leveraged loans underwritten, compared with 30 percent or more in the mid-1990s, the report noted. Instead, institutional investors, including collateralized loan obligations, hold 75 percent of the high-yield loans, compared with 16 percent in 1995.
Investors have replaced the banks. The amount of collateralized loan obligations rose to $47.3 billion this year, up from $32.8 billion in the same period of 2006, according to S&P’s Leveraged Commentary & Data unit. Collateralized loan obligations rose to a record $47.3 million last year.
Dealbook's posts seem a bit stretched. First, the leverage loan market is populated by very sophisticated parties involving the largest banks and investment banks lending to private equity advisers, analogizing it to the subprime market with its fly-by-night lenders and mortgage brokers and lower income, unsophisticated customers is a bit tenuous. Moreover, Dealbook misses the main point. The most important figures for private equity loans are the leverage ratios and cash generated. It is only when leverage is too high and cash is not generated sufficiently that the ratio covenants truly matter. And here, the reports are indeed a bit worrisome. According to one report, average debt levels are a record 5.9 times cash flow, and debt multiples of eight or nine times are common. And according to the Wall Street Journal:
Companies that have gone private in buyouts are generating cash that exceeds their debt interest payments by just 1.7 times, versus 2.4 times last year and 3.4 times in 2004, according to Standard & Poor's Leveraged Commentary & Data. The ratio is at a 10-year low and shows how the margin for error for companies is shrinking as their profit growth is slowing.
It is in these times that covenant-lite provisions can actually help. They provide flexibility for debtors to avoid default if they enter into a riskier cash-flow situation. True, the downside is that the banks cannot take early action in case of possible default -- but more often then not tripping your debt covenants means simply paying your banks a fee for a waiver, and the banks through inspection and financial statement convenants can still obtain early warning if not take early action. And covenant lite debt provides companies greater leeway to operate more effectively, generate more income, and thereby avoid these credit crunches. Ultimately, this may lead to lower levels of default than if banks exercised early control in these situations -- the companies, after all, likely know best how to operate themselves.
Finally, the second days' point about collaterilization is a non sequitor. Any sophisticated financial institution these days collateralizes its debt as part of prudent risk management and to maintain tier capital requirements for additional loans. The fact that the collateralization rates have gone up over the years speaks to nothing other than the increasing thickness of this market and greater ability for banks to collateralize this debt. Ultimately, the jury is still out on "covenant-lite" deals and likely only to be fully assessed once more information comes in about default rates. For this, we'll have to wait for the next downturn.