Fool Me Once, Shame on the Covenants
July 1, 2009
Imagine a lender somewhere rocking out to The Who’s “Won’t Get Fooled Again.” That person is probably thinking back to the covenant-lite era, when borrowers could obtain financing while offering little in return—a strong motivator for the state of covenants in today’s market. Since the onset of the recession, lenders have been going through credit agreements with a fine-tooth comb, tightening more common covenants and adding new ones that haven’t been seen in a while, such as those related to buybacks.
Clearly, lenders have become much more conservative in terms of how they look at common covenants, such as those that determine how levered a company can become, what percentage of its income it can use to service its debt or how much cash it can use for an acquisition. For example, the maximum amount of leverage allowed under a borrower’s leverage covenant might have been 5x two years ago, while the leverage cap today is more likely be 3.5x. Moreover, equity cures—a device popular with private equity firms that was used to avoid breaching a covenant by injecting equity into the borrower—have been much tougher to come by and have come with less flexibility.
“There is a lot of focus on cleaning up the documents, getting all the looseness out of [covenants] that has built up over the years,” a Boston-based investor said. “This includes tighter definitions of a borrower’s Ebitda levels, getting rid of incremental facilities, tighter restrictions on payments and investment baskets, restricting a company from issuing additional debt and getting rid of equity cures.”
Beyond that, though, lenders have begun to call for covenants that virtually disappeared during the buyout boom—rarer covenants such as most-favored-nation and change-of-control clauses and covenants related to debt buybacks.
The Big Buyback
Buyback covenants have been reappearing because so much debt has been trading at historically distressed levels. And lenders have begun to make sure loan credit agreements are properly structured to protect themselves, according to a June 25 Credit Sights report. An early motivator for lenders came in March 2008, when Citadel Broadcasting amended its credit agreement, allowing it to buyback its debt below par. Credit agreements universally allow a borrower to buy back its debt, but require them to do so at par.
After Citadel, other companies followed suit, causing lenders to look for ways to change the loopholes in the buyback agreements, one of which was to allow a subsidiary of the borrower to buy back the parent company’s debt at below-par levels.
“While buyback programs can be tightly defined in credit agreements at the outset of a deal, just allowing them in is a movement onto a slippery slope,” one analyst said. “There is no shortage of examples where lax lending terms have resulted in unintended outcomes for lenders. The unintended outcomes are often not the result of any one ability left open to the borrower, but instead the result of a mosaic of carve-outs and lax covenants.”
If buyback covenants were once hardly talked about, the most favored nation covenant—a type of clause that is designed to give investors favorable terms when the company has assets in different countries—is one covenant that was even more obscure. But lenders have now begun to focus on this covenant, specifically tweaking it to prohibit multi-national companies from issuing debt in another country at a price lower than where existing debt is trading on the secondary. When a company does that, it causes the trading price of the existing debt to fall.
“Most [existing credit facilities] don’t have MFN covenants in them,” a New York-based banker said. “But now, lenders are making sure MFN protections are in new deals.”
Lenders are also taking a hard look at change-of-control covenants—a type of covenant that requires a borrower to repay its outstanding loans or bonds if a third party takes control of its board (LFN, April 16, 2009). Historically, these types of covenants rarely appeared in the bond indentures or credit agreements for high-grade borrowers, though the market is seeing that now.
“In 2007, the conversation was, ‘what was the maintenance covenant—or lack of one—for this sponsor’s last leveraged buyout?’” said Adam Cohen, founder of Covenant Review, an independent research provider. “Now, investors and borrowers are both being more realistic about what are the appropriate metrics for the particular situation.”
For loans on the primary, a weak credit agreement can be a strong deterrent. “It was the looseness of the QVC credit agreement that made it an unattractive loan for us,” the Boston-based investor said. “Among other considerations, [the loose credit agreement] was one of the key reasons why I think the loan failed. On the other hand, the relative soundness of the Ashland credit agreement made it a winner.”
Size Matters
Bank of America began shopping a $500 million term loan B due 2015 for QVC last week (LFN, June 26, 2009) but pulled the deal Monday. Price talk on QVC’s term loan was at Libor plus 350 bps, with an OID between 98 and 98.5. The term loan also featured a 2% Libor floor. QVC, a West Chester, Pa.-based television home shopping company, planned to use the proceeds from the term loan for general corporate purposes and to repay existing debt.
Bank of America was also involved in the Ashland deal. In May, the bank syndicated an $830 million term loan B at Libor plus 450, with an OID at 98.5 for the Covington, Ky.-based chemical company.
While borrowers like QVC and Ashland have their credit agreements picked through as if they were going through airport security, some borrowers with existing loans have found their credit agreements unruffled for the most part. This, however, depends on the size of the credit facility.
A borrower with a larger loan may find lenders to be more accommodating because they don’t want the company to breach its covenants and want to make sure it doesn’t default on its loan.
“This is a variant of the ‘too big to fail’ theme applicable to large the banks,” a Chicago-based investor said. “Some large loans may also be ‘too big to call,’ so covenants have to be built around existing performance.”
For borrowers with smaller loans that are near or out of compliance, the options are less appealing. The company can refinance that loan with a new facility or reduce its leverage with existing lenders by raising junior capital. However, this process often triggers a change-of-control covenant seeing how, in many cases, the only way to attract junior capital is to sell a controlling position in the company.
For more on this see the dictionary definition of Catch 22.
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