The devil is in the details for bad debt investors facing coronavirus defaults

LONDON (Reuters) – Before the coronavirus, yield-hungry investors crammed into corporate loans and subprime bonds with valuable protection for creditors. Now they’re frantically scouring the terms to see exactly what companies can do to survive the fallout.

FILE PHOTO: A chart on the New York Stock Exchange shows the state of the market as markets continue to respond to coronavirus disease (COVID-19) inside the NYSE in New York, United States, on March 18, 2020. REUTERS / Lucas Jackson

At the same time, private cash and fund companies considering lending to them are also scanning the fine print to see how much leeway they have to transfer assets to other creditors, pay dividends, or borrow more while avoiding failure to pay.

As the coronavirus pandemic threatens to trigger an increase in corporate defaults, borrowers and investors in so-called covenant-lite loans and high-yield bonds with poor creditor protection are quickly taking stock.

“The number of questions has just skyrocketed since March 1. People are looking at the documents,” said Charles Tricomi, head of leveraged loan research at Xtract Research in New York City, which analyzes the documents. debt covenants for investors.

Covenant-lite loans are a form of junk debt devoid of so-called maintenance covenants designed to warn investors of potential financial problems ahead for the borrower.

Often used by private equity groups to finance debt buyouts, their prevalence has skyrocketed.

Over the past decade, the leveraged loan market has tripled to approximately $ 1.4 trillion. While only 15% of loans in 2010 were considered to comply with restrictive covenants, more than 80% now lack covenants that could trigger warnings about a company’s finances or prevent it from stripping off assets, according to S&P Global Market Intelligence.

Commitments on European high-yield bonds have also become more than twice as permissive over the past decade, according to financial intelligence provider Reorg.

Tricomi said the main questions for investors frightened by the impact of the crisis on balance sheets were how much more debt borrowers can raise, what assets can be moved out of their reach and what really counts as collateral for their debt. debt.

Graph – The terms of the Europe agreements are becoming more aggressive:


The Bank for International Settlements, the US Federal Reserve and the International Monetary Fund, among others, have all warned of deteriorating lending standards and with defaults of up to 10% according to Moody’s, covenant debt buyers. lite might quickly find out how risky this can be.

“The use of flexible covenants has not been tested in a stressful environment,” said Lisa Gundy, head of restrictive covenants at the rating agency. “What we potentially have is a market-wide test of how (issuers) react.”

The game changer for leveraged investors has been the gradual reduction of sustaining covenants that require borrowers to comply with periodic tests of debt-to-earnings ratios to stay in compliance with loan agreements.

Michael Dakin, a Clifford Chance partner, said it was like driving your car with the oil, gas and engine warning indicators turned off.

“I can ride the road, but if I don’t handle these things separately and one of them goes, it’s a really catastrophic result,” he said.

Rob Mathews, partner at Baker McKenzie, said the problem for investors in covenant-lite debt was that they could only be told about a company’s struggles when there was an actual default or a demand for delay. payment of interest.

“The repercussion of this could be that by the time these flaws are identified, it is too late to take proactive steps to fix things,” he said.

Chart – Covenant-lite loan recovery rate:


Another crucial change to debt agreements has been the change in the definition of earnings before interest, taxes, depreciation and amortization, a measure underlying many tests that borrowers go through to avoid violating the agreements.

Many deals now allow companies to add one-time costs or projected profit increases to their current profits to make them appear financially healthier, or even avoid default.

According to Reorg, 85% of high yield bonds sold in Europe in 2019 allowed for so-called cost additions, up from around 50% in 2016.

Lawyers specializing in leveraged finance deals said corporate clients are now considering how they could use one-time cost additions due to the coronavirus crisis to mitigate the pandemic’s impact on their revenues. .

“They have clear flexibility to do this in a number of the agreements that we have looked at,” said Mathews at Baker McKenzie.

Another point of interest for investors is the debt capacity. While unwanted borrowers have typically used lines of credit first to increase liquidity, covenants also allow them to increase debt which pushes existing lenders further down the repayment queue.

Theme park operator Merlin Entertainments, which had to shut down most of its sites during the health crisis, sold 500 million euros ($ 543 million) of bonds on Friday as subordinate owners of bonds that it was issued only in October with terms that Moody’s ranked among the loosest of all time.

U.S. private equity giant Blackstone and the investment firm that owns the Lego brand, both of which shut down Merlin last year, declined to comment.

While creditors may normally resist being pushed further down the queue, they may feel they need to comply if there is no other way to keep a business afloat during the pandemic.

“If your alternative is for the company to go into liquidation, you may not mind being subordinate,” said David Newman, director of global high yield investments at Allianz Global Investors.


The risk for creditors is that if a business does not survive the pandemic despite collecting more cash, they will be even lower in the pecking order when it comes to trying to save anything.

In addition to adjusting profits and taking on debt, some covenant-lite agreements also give companies the ability to withdraw collateral out of reach of creditors. Some may then use the income generated by the dismembered asset to continue paying dividends, or use it again as collateral to increase debt.

Although bankers selling these deals often say the terms are unlikely to be used, there is precedent.

Take the American retailer J Crew. In 2017, she transferred the intellectual property of her brand to a new company, stripping investors who had loaned against the asset of their collateral.

He was so infamous that terms added to subsequent funding deals to avoid a repetition are now known as “J Crew Blocker”.

J Crew did not respond to requests for comment.

A partner at a London law firm, who asked not to be identified, said at least two clients recently asked if they could withdraw assets from creditors, just as J Crew did . In one case, the goal was to use the dismembered asset as collateral to raise more money from a new investor.

Lawyers said it was too early to say to what extent businesses and private equity firms could test the limits of how they can use covenants, as the full impact of the pandemic was not. still clear. But they said the longer it lasts, the more likely they are to be aggressive.

“There is a lot of money being written off right now, so there is a huge reason for sponsors to try to withdraw as much collateral as possible,” said Azhar Hussain, Global Credit Manager at Royal London Asset Management.

Some bankers said investors hungry for high yields took on debt relief even though they had doubts about the terms, allowing the arrangers to strike ever more favorable deals for borrowers.

“We were engaging with people on the basis of being serious and trying to get around some of their issues. And then we got a lot more jaded, ”said the syndication manager of a European bank that has bond deals with weak covenants.

“When the rubber met the road in terms of book building and we became gangbusters, they would come in anyway. “

Chart – Firms with Weakest Restrictive Covenants:

Reporting by Yoruk Bahceli; Editing by David Clarke

Carol M. Barragan

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