Lender Surrender

A broad-based assessment of loan covenants shows that they’re at their weakest level on record, with a Moody’s covenant specialist writing earlier this year that “our scores reflect weaker protections on a year-over-year basis in nearly every risk category we assess. Given the breadth and depth of covenant weakness, existing loans are in uncharted territory”. 

What is Moody’s is referring to are more than just maintenance covenants on interest coverage and leverage: covenant assessments also analyze most-favored-nation provisions, mandatory prepayments from asset sales, exceptions to negative covenant restrictions, restricted payments clauses, definition and scope of allowable EBITDA adjustments, leakage of assets from the collateral pool, caps on investments in or transfers to unrestricted subsidiaries and affiliates, the ability to add senior pari-passu or priority debt, lien dilution by non-guarantor subsidiaries, etc. In other words, the means by which lenders try to prevent issuers and their legal counsel from diminishing lender rights and protections. These are the protections that loan investors are now surrendering at a record pace.

To further understand the degree of unilateral surrender, consider the following three issues: covenant carve-outs in default, EBITDA add-backs and collateral stripping.

Covenant carve-outs in default

Loan covenants historically stipulated that borrowers could only use carve-out clauses to engage in certain corporate actions if they were not in default and had not experienced an “event of default”. This protection is becoming rarer as more loans weaken/eliminate this requirement, increasing the possibility of a “Hail Mary” transaction at the 11th hour.   Moody’s: “When borrowers can make restricted payments, investments, junior debt prepayments or incur new debt even after default, all lenders can do is hope for a satisfactory outcome”.  

EBITDA add-backs

Coverage and leverage measures are artificially boosted by increasing use of “EBITDA add-backs[1]”. This refers to the practice of companies adding back non-recurring expenses and assumed merger synergies/cost savings to earnings, thereby artificially enhancing any measure derived from EBITDA:

• According to S&P, the use of EBITDA add-backs has increased from 10% of all deals to around 30%. In terms of magnitude, S&P reports that such add-backs range from 10%-15% of unadjusted EBITDA. However, according to Moody’s, some deals allow add-backs up to 20%-30% of unadjusted EBITDA, and some deals have no caps at all
• Fitch’s Covenant Review reports that 35% of middle-market loan issuers used EBITDA add-backs. While assumed synergies were usually capped at 10%-15% of unadjusted EBITDA, in some cases there were also no caps, just as Moody’s reported
• According to S&P, around half of all M&A loan issuance in 2017 and 2018 had leverage above 6.0x once the benefits of assumed synergies are excluded (second chart below)
• Moody’s analyzed how successful European companies have been in achieving assumed cost savings. They found that only 45% of EBITDA add-backs were achieved on average, and that nearly 20% of issuers didn’t achieve any of their projected add-back targets

Collateral stripping

Recent reported cases of “collateral stripping” refer to financial sponsors transferring collateral beyond the reach of senior creditors, either to holding companies or related affiliates outside the collateral pool. They have been infrequent so far, but when/if the economy turns, this kind of activity could increase due to the laxity of “restrictive payment” and other covenants outlined above. Examples include J. Crew (TPG, Leonard Green), PetSmart/Chewy (BC Partners) and Neiman Marcus (Ares, CPB). One more comment on financial sponsors: many of them instruct banks arranging their syndicated loans as to which law firm the bank should use as it own counsel, a practice known as “sponsor-designated counsel”. Given all the lender-issuer trade-offs required to negotiate a set of covenants, I would not be surprised if people ask questions about this when/if the cycle turns.

All things considered, these trends don’t argue for higher default rates, those will be determined by the depth of whatever recession occurs, and I believe it will be a much milder one rather than in 2008; the Fed is also now pushing out the timing of a recession by easing. But in my view these trends argue for lower loan recoveries on defaults that eventually occur. Historically, loan recoveries averaged 70% compared to 40% for high yield. The midpoint of 55% is where loan recoveries may end up next time around. In the covenant food fight between issuers and lenders, issuers are winning, hands down.

[1] EBITDA is a proxy for cash flow and refers to earnings before interest, taxes, depreciation and amortization

Note: This LinkedIn post is an excerpt of a longer piece on leveraged loan performance and covenants from the July 15th Eye on the Market, which is available to all clients of J.P. Morgan Asset Management and the J.P. Morgan Private Bank.

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