Not all senior loans are created equal, and the cov-lite form – those with weaker investor protections – are dominating the large-cap segment of the European market. We completely avoid these instruments, focusing instead on covenanted mid-market deals, which offer more attractive returns with stricter risk controls than cov-lite large-cap deals.
The rise of cov-lite loans
The leveraged-loan market has become increasingly competitive in recent years. Strong inflows of capital into private debt funds and collateralised loan obligations, along with improving bank balance sheets, have driven demand for loans higher – particularly in the more easily accessible large-cap segment of the market, which consists of loans to companies with EBITDA in excess of £75m.
In this environment, lenders have competed by offering borrowers higher leverage levels and looser loan terms. Nevertheless, market participants have maintained discipline: the level of average total leverage in the large-cap market has been relatively stable at about 5x EBITDA over the past three years (compared to peaking at an average of about 6x EBITDA in 2007), while the average proportion of equity contributed by private-equity owners is a robust 47% (compared to a low of 32% in 2007)1 .
Despite this, a worrying trend is putting investors’ capital at risk: the rise of so-called cov-lite loans – senior loans that do not provide lenders with the safety of regularly recurring maintenance covenant tests. In 2007, these loans accounted for fewer than 10% of deals in the large-cap market. By July 2017, this figure had climbed seven-fold to 72%2 .
It is vital that private debt investors understand the practical implications of cov-lite deal structures and how they can degrade the risk-reward balance that investors seek from senior loans.
Uncovering cov-lite loans
Cov-lite loans do not contain the once-standard requirement for borrowers to satisfy quarterly recurring financial ratio tests. These tests, known as maintenance covenants, typically consist of debt-to-EBITDA, interest-to-EBITDA or cash-to-debt-service financial ratios. Failure to satisfy any of these tests would constitute a default on the loan.
Maintenance covenants play a very important role in protecting investors. Their primary purpose is to test the trading performance of borrowers and, if this declines, act as an early-warning default trigger. This provides lenders with an opportunity to take protective actions before diminishing corporate performance and enterprise value threaten the recovery of the loan.
Instead, cov-lite loans only contain incurrence covenants, which offer far less protection to lenders. These covenants are tested solely upon the occurrence of pre-specified events, such as a material drawdown on a revolving credit facility or a dividend payment, rather than on an automatically recurring basis. This means that borrowers can avoid the tests by not taking the specific actions which trigger them.
The value of maintenance covenants
Maintenance covenants give lenders strong negotiating powers as soon as trading performance declines and usually before there are any liquidity problems. In such circumstances, the options available to lenders are typically broad and can include the following:
In contrast, under a cov-lite deal structure there is no automatic early-warning trigger. A default may not occur until a late stage in the decline of the business’s performance, possibly when the borrower encounters difficulty making an interest payment or scheduled repayment on its loan. This could be symptomatic of a near-insolvent borrower with significant liquidity problems. There are two key implications for lenders in such a scenario:
Worsening risk-return profile of cov-lite
With these weaker lender protections, it could reasonably be assumed that cov-lite loans would offer greater potential returns. But this is not the case. While large-cap cov-lite loans have historically been priced at a premium of up to 75bps relative to covenanted loans, this premium has been fully eroded over the last two years as cov-lite deals have become more prevalent. Since the second half of 2016, the average yield-to-maturity of large-cap, single-B-rated cov-lite loans has declined to that of their equivalent covenanted deals3.
In our view, for the reasons described above, the current dominance of cov-lite loans may result in higher losses in the large-cap market in the future – particularly for loans in the single-B ratings range, given the lower credit quality of the borrowers. While the overall ability of investors to recover value from defaulting cov-lite loans has yet to be properly tested through an entire economic cycle, a comparison of recovery rates between senior loans (both covenanted and cov-lite) and first-lien secured bonds (which are entirely cov-lite) from 2003-2016 might provide some insight. The average recoveries on loans was 74% versus 52% on secured bonds. This may be informative but cannot be categorically linked to the presence or lack of maintenance covenants given the other differences in the instruments 4.
Avoid cov-lite loans by focusing on the mid-market
We consider effective maintenance covenants to be an essential protection for lenders, so we never lend on cov-lite terms. Instead, we focus on the mid-market – which consists of loans to companies generating £5m-£75m of EBITDA each year – where there has been very limited penetration of cov-lite terms. This is because corporate and commercial banks, which require loans to have maintenance covenants, are the dominant lenders in this part of the market, and borrowers are not large enough to access an alternative source of finance through the bond market.
In our view, the mid-market offers investors a more attractive and sustainable balance between risk and reward. It provides better downside protection than the large-cap market due to maintenance covenants being a standard feature of loan terms, as well as returns that are on average 60bps greater than those provided by large-cap loans.
Tread cautiously in the loan market
Indeed, not all senior loans are created equal: investors need to be aware of the difference in downside risk between cov-lite and covenanted senior loans. While both types of loan provide lenders with first-lien security over the borrower’s assets and operations, the time at which that security can be enforced through a loan default – and its value at that point – could differ significantly.
In addition, the pricing erosion that large-cap, single-B-rated cov-lite loans have experienced over the last two years relative to equivalent covenanted loans suggests that they are comparatively poorly priced at present.
Another consideration for investors is the existence of some loans that are, in theory, covenanted but which have such lax maintenance tests as to make them ineffective as a means of protection. In our view, these loans are simply cov-lite instruments being marketed as covenanted deals – however, some lenders fail to see the difference.
We do not want to expose our investors to the risks presented by cov-lite deals. Instead, we invest exclusively in covenanted loans, found primarily in the mid-market segment, where we believe the most attractive returns for direct lenders in Europe are to be found.
1 “European leveraged lending review,” published in July 2017 by LCD
2 “European leveraged lending review,” published in July 2017 by LCD
3 “Cov-lite now standard format for European loans,” published by LCD in May 2017
4 “2016 Annual Study of European Corporate Recoveries: The Highest Recovery Rate Since 2007, published by S&P Global RatingsDirect on 12 June 2017