Last month news emerged that, following a review of $429 billion-worth of leveraged lending in the US, the Office of the Comptroller of the Currency had determined that 42% of those loans were classified as having “a deficiency that might lead to a loss”. The regulator has therefore sent letters to a number of banks in the market giving them 30 days to tighten up their lending standards to borrowers of leveraged loans.
This comes after a record year for covenant-lite issuance in the US. According to Bloomberg, $168.8 billion of cov-lite loans were issued in the US between April and mid-November this year, compared with $100.8 billion for the whole of 2012. Roughly 55% of all new leveraged loans in the US are now cov-lite. “There has been a demonstrable change in covenant quality,” says Gary Herbert, portfolio manager at Philadelphia-based Brandywine Global. “The ability for corporates to issue covenant-lite loans is very strong. Investors are seeking out corporate exposure rather than rates or credit-sensitive govvies, and we are seeing deals oversubscribed by two to three times.”
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The volumes for 2013 have been boosted by bumper transactions such as the buyout of computer maker Dell by Michael Dell and Silver Lake Partners in September. That deal involved $6 billion of dollar-denominated cov-lite loans and a €700 million cov-lite facility. The 6.5-year term loan B was priced at 375bp over Libor with a 1% floor. Following the LBO the company now has a debt-to-ebitda ratio of six times. Cov-lite issuance in Europe has so far largely been limited to euro tranches of US deals, but there is speculation that it will grow and many expect a pure European cov-lite loan by next year. But the appetite for such deals is not the same in Europe. “So far, European banks, which account for a large percentage of the leveraged loan investor base in Europe, have been very disciplined about refusing to buy covenant-lite loans,” says a European CLO manager. “This should keep the growth of covenant-lite lending in Europe in check at least in the short term.”
The weight of money chasing leveraged finance is having an impact on investor protection in the high-yield bond market as well. And conversely it is the bond market in Europe that is seeing more aggressive terms. Principal among these is the issue of portability. This is the growing trend of watering down the change of control clause in a bond deal to reduce the investor’s ability to put the bonds back to the company if it is taken over.
“The introduction of portability is one of the key changes we have seen in the European high-yield market,” says Alan Davies, partner at law firm Debevoise. “It didn’t exist in 2006, but now it appears in some form in most European high-yield deals. It is often accompanied by a leverage test that stipulates that the change of control put can’t be exercised if leverage is below a certain level.” Change of control protection is a key consideration for high-yield investors – particularly given the predominance of financial sponsors in this market in Europe. “We absolutely hate portability,” one high-yield investor tells Euromoney.
The leveraged finance market has been the primary target of the chase for yield that has been triggered by low interest rates, so it should be little surprise that the balance of power has moved sharply away from investors.
“I am a bit sceptical about the extent to which people realize how much central banks are distorting the capital markets,” says Herbert. “In the May sell-off as yields were backing up the excess spread premium didn’t compress as it should do. That was very unusual – the extra risk premium should have provided protection.”
Signs of caution
So, despite the intervention of the US regulator, credit conditions are such that investors in leveraged finance in both the US and Europe should get used to aggressive terms, higher leverage and lower-rated issuers. There are, unsurprisingly, signs of investor caution.
“Default rates are very low and investors are still being paid excellent spreads for high-yield risk,” says Marc Warm, managing director in high-yield capital markets at Credit Suisse. “Dedicated high yield continues to see inflows, but there is definitely a view from most investors that they want to move down the curve to get shorter duration. Historically the spread differential between eight-year and 10-year high-yield paper has been around 25bp, but it is now seen wider.”
According to figures released in July, 37.9% of European high-yield issuance this year is double-B rated, as is 30% of US issuance. However, 35% of new issues in Europe have been single-B-rated compared with 27.7% in the US. But in Europe just 2.4% of high-yield issuers this year have been triple-C rated while in the US the equivalent figure is 10.3%.
Some in the market argue, however, that five years of financial crisis have made investors far more sophisticated about the risks they face in this part of the capital market. “We are about one ebitda turn below the levels that we saw in 2007,” says Raman Bet-Mansour, partner at Debevoise in London. “The mentality is, however, rather different. In 2006 we were getting to the end of a long boom period, not knowing that we were headed towards the crisis, whereas today we are still at the early stages of recovery. Whether or not investors are prepared to take risk, they are aware that it is there – they are going into investments with their eyes open.”
