Covenant-Lite Loans: Recent Trends for U.S. Middle Markets and European Markets

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Covenant-Lite Loans: Recent Trends for U.S. Middle Markets and European Markets Analyzing Elements of Cov-Lite Loans for Borrowers and Lenders THURSDAY, AUGUST 28, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Stephanie S. McCann, Partner, McDermott Will & Emery, Chicago George M. Houhanisin, Attorney, McDermott Will & Emery, Chicago The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.

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4 Covenant-Lite Loans: Recent Trends August 28, 2014 Stephanie S. McCann & George M. Houhanisin Boston Brussels Chicago Düsseldorf Frankfurt Houston London Los Angeles Miami Milan Munich New York Orange County Paris Rome Seoul Silicon Valley Washington, D.C. Strategic alliance with MWE China Law Offices (Shanghai) 2014 McDermott Will & Emery. The following legal entities are collectively referred to as "McDermott Will & Emery," "McDermott" or "the Firm": McDermott Will & Emery LLP, McDermott Will & Emery AARPI, McDermott Will & Emery Belgium LLP, McDermott Will & Emery Rechtsanwälte Steuerberater LLP, McDermott Will & Emery Studio Legale Associato and McDermott Will & Emery UK LLP. These entities coordinate their activities through service agreements. This communication may be considered attorney advertising. Previous results are not a guarantee of future outcome.

5 Outline What are Covenant-Lite Loans? Analysis of Current Market Conditions Favoring Covenant- Lite Loans Elements of Covenant-Lite Loans in 2014 Covenant-Lite Loans in the U.S. Leveraged Loan Middle Market Covenant-Lite Loans in the European Leveraged Loan Market 5

6 What Are Covenant-Lite Loans? Traditional Leveraged Loans Typically contain financial maintenance covenants tested on a monthly or quarterly basis. Lenders rely on these covenants to provide protection in case the borrower has financial difficulty. In the case of a breach of a financial maintenance covenant, lenders may take enforcement actions against the borrower to ensure repayment of their loans. 6

7 What Are Covenant-Lite Loans? Covenant-Lite Loans No financial maintenance covenants under a term loan credit facility (i.e. no periodic testing) and springing financial maintenance covenants under a revolving loan credit facility. Covenant-lite loans use high-yield bond style incurrence-based negative covenants which require the borrower to take affirmative action before the covenants are tested. By refraining from a particular action, the borrower can control triggering the testing and breach of such covenants. 7

8 Current Market Conditions Covenant-Lite Loans Are Back in Vogue Since 2011, covenantlite loan issuances have increased dramatically. $381 billion of covenant-lite loans were newly issued in Newly issued covenantlite loans were $95 billion in Q and $35 billion in Q through early June. Q1 & Q together were higher than $ bn $450 $400 $350 $300 $250 $200 $150 $100 $50 $0 Newly Issued Covenant-Lite Loans Q *Q results through early June 8 Q1 & Q2 2014

9 Current Market Conditions Number of Covenant-Lite Loan Issuers Increasing 38 Borrowers issued covenant-lite loans in Q The same period in 2013 saw 35 Borrowers. Q represents the highest number of covenant-lite loan issuers during Q1 since data tracking began in

10 Current Market Conditions Covenant-Lite Loans Now Majority of Institutional Loans Covenant-lite loans made up 63.3% of new institutional loans in the first half of 2014, topping prior year records of 32% in 2012 and 57.5% in As of May 2014, 53.3% of S&P/LSTA Index loans were covenant-lite loans, up from 46.4% at end of

11 Current Market Conditions CLO s Are Increasing Covenant-Lite Loan Holdings So far this year, the average CLO basket for cov-lite loans has increased from record 2013 levels of 51% to 57% 11

12 Current Market Conditions Overall Reduction of Financial Covenants in Leveraged Loans Since 2007, the percentage of leveraged loans containing three or more maintenance covenants has decreased from 43% to 12%. 12

13 Market Conditions Going Forward Covenant-Lite Going Forward As the leveraged loan market continues to receive more inflow from mutual funds and CLO issuances, the covenant-lite phenomenon will likely continue. 13

14 Elements of Covenant-Lite Loans No Financial Maintenance Covenants Under Covenant-Lite Term Loan Credit Facilities The key difference between covenant-lite term loans and traditional leveraged term loans is the absence of financial maintenance covenants. Financial maintenance covenants typically require borrowers to be tested at regular intervals to provide the lender with advance warning of potential financial difficulties. Common financial maintenance covenants in traditional leveraged term loans include: Maximum Leverage Ratio. Restricts the borrower from exceeding a specified ratio of debt to EBITDA and is applicable to any or all tranche(s) of debt. Minimum Interest Coverage Ratio. Requires the borrower to maintain a minimum specified ratio of EBITDA to interest expense. Minimum Fixed Charge Coverage Ratio. Requires the borrower to maintain a minimum specified ratio of EBITDA to fixed charges. 14

15 Elements of Covenant-Lite Loans Incurrence-Based Negative Covenants Covenant-lite loans contain incurrence-based negative covenants, which are only tested upon the occurrence of an event. By not taking a certain action, the borrower can avoid breaching the incurrence-based negative covenant. 15

16 Elements of Covenant-Lite Loans Covenant-Lite Revolving Loan Credit Facilities Have Springing Financial Maintenance Covenants Traditional revolving loan credit facilities have financial maintenance covenants, the same as or similar to traditional term loan facilities. Covenant-lite revolving loan credit facilities include the same incurrence-based negative covenants as covenant-lite term loans and financial maintenance covenants which are only triggered once revolving outstandings exceed a negotiated threshold. 16

17 Elements of Covenant-Lite Loans Benefits to Borrowers The loosely structured incurrence-based negative covenants provide the borrowers with two main benefits: Greater Flexibility. The borrower is not subject to fixed-dollar basket amounts for restricted transactions (e.g. incurring additional debt, entering into an acquisitions, paying a dividend or pre-paying subordinated debt). Because negative covenants are tied to pro-forma compliance at the time of the transaction, the borrower can engage in an unlimited amount of restricted transactions so long as pro-forma compliance is maintained. Greater Control. The borrower has more control over the fate of the company when allowed to operate unhindered. Because lenders cannot immediately call the loan as there are no financial maintenance covenants the risk of default is vastly decreased. 17

18 Elements of Covenant-Lite Loans Looser Incurrence-Based Negative Covenants A borrower may take the following actions subject to compliance with a test at incurrence: Incur Additional Debt. Instead of imposing a fixed dollar cap, a borrower is permitted to incur unlimited debt if it can comply with maximum leverage ratio at the time of such incurrence. The borrower may also be permitted to secure such additional debt, if it is able to comply with a maximum secured leverage ratio. Pay Dividends. Typically tested with limit based upon percentage of EBITDA or net income at any given time. 18

19 Elements of Covenant-Lite Loans Looser Incurrence-Based Negative Covenants (Cont.) Make Acquisitions. Instead of limiting acquisitions to a fixed amount, per acquisition, annually or over the life of the deal, a borrower is permitted to enter into unlimited acquisitions as long as the borrower is in pro forma compliance with a specified financial maintenance covenant. Revolving loan credit facilities may test pro forma compliance of financial maintenance covenant at that time, regardless of whether covenant is required to be compiled with at that time. Term loan credit facilities may test with maximum leverage ratio or senior leverage ratio set out specifically in acquisition covenant. Repay Junior Debt. A borrower is permitted to repay second-lien, subordinated or unsecured debt subject to compliance with a specified incurrence test. 19

20 Elements of Covenant-Lite Loans Costs to Borrowers Covenant-lite borrowers are typically charged a premium for the more lenient, borrower friendly loans, e.g.: McGraw-Hill Education LLC borrowed $688 million in the form of a covenant-lite loan. The lender charged McGraw-Hill 5.75%, which was 550 basis points higher than the 3-month LIBOR benchmark. Supervalu re-priced its covenant-lite term loan facility worth $1.485 billon with pricing at L+350 and a 1% LIBOR floor. Univision Communications Inc. refinanced its covenant-lite term loan facility worth $3.4 billion with pricing at L+350 and a 1.25% LIBOR floor. 20

21 Elements of Covenant-Lite Loans Benefits to Lenders In exchange for looser credit terms, borrowers are willing to pay a premium in the form of higher interest rates. Therefore, the lenders can earn a higher yield in a historically low interest rate environment. The extra interests costs for borrowers can go as high as 0.25% 21

22 Elements of Covenant-Lite Loans Costs to Lenders Lenders give up early warning trip-wires in the form of financial maintenance covenants. Lenders may be unable to re-price credit risk. Lenders may have difficulties re-structuring a problematic loan. 22

23 Elements of Covenant-Lite Loans Default Risk Historically, default rates for covenant-lite loans have been lower than those of loans with traditional financial maintenance tests. Since 2008: Cov-lite loans have defaulted at a rate of 14.0% (compared to a 17.6% rate for loans with traditional financial maintenance tests) No BB rated cov-lite loan has defaulted (compared to a 5.2% rate for BB rated loans with traditional financial maintenance tests) 23

24 Covenant-Lite Loans in the U.S. Middle Market The Trickle Down Effect Covenant-lite loans began their resurgence in the bulge-bracket market in 2010 and have since trickled down into the middle-market. The contributing factors of the shift include surplus debt capital, lower volume of completed deals and lenders searching for higher yields. 24

25 Covenant-Lite Loans in the U.S. Middle Market Covenant-Lite Middle Market Volume Is Increasing Middle-market cov-lite issuances for all of 2012 was $4.75 billion. Middle-market cov-lite issuances through first three quarters of 2013 was $6.94billion. 25

26 Covenant-Lite Loans in the U.S. Middle Market Covenant-Lite Beginning to Enter Lower Middle Market Companies with EBITDA of less than $50 million are beginning to receive covenant-lite loan terms. Learfield Communications Hemisphere Media Group, Inc. Sprint Industrial Holdings Market Middle-to-Lower Middle-to-Lower Middle-to-Lower EBITDA $50 million $40 million $38 million Size of Cov-Lite Loan $330 million $175 million $220 million Lenders Deutsche Bank, GE Capital N/A N/A 26

27 Covenant-Lite Loans in the U.S. Middle Market Covenant Loose & the Lower Middle Market Even if covenant-lite is unavailable to lower-middle market companies, some covenant-lite like features have begun to spread in this segment of the market, e.g.: Enhanced covenant cushions on financial maintenance covenants which allow borrowers to miss projected financial targets by 30% to 45% and still be in compliance (as opposed to 10% to 20% before 2013). Fewer total amount of financial maintenance covenants 27

28 Covenant-Lite Loans in the European Leveraged Loan Market Historic Tendency Historically, European risk appetite and secondary market for covenant-lite loans is much more modest than U.S. However, as cov-lite has increased in U.S., European market is more willing to enter into cov-lite loans. Contributing factors: Return to the originate and distribute model of loan arrangement; Increased liquidity and depth in European leveraged loan market; and Demand of debt investors (including CLOs). 28

29 Covenant-Lite Loans in the European Leveraged Loan Market European Covenant-Lite Loan Issuances Follow U.S. Trends Covenant-lite loans now represent 14% of all European institutional loans, a significant increase over the mere 1% outstanding at the end of

30 Covenant-Lite Loans in the European Leveraged Loan Market Covenant-Lite Loan Volume has Skyrocketed in Europe Cov-lite volume in July 2014 alone was 4.7 billion, the highest issuance month in seven years YTD cov-lite volume is 14.6 billion, exceeding any prior full year issuance including 2007 which in comparison only issued 8.1 billion. 30

31 Covenant-Lite Loans in the European Leveraged Loan Market Much of European cov-lite issuance volume is driven by cross-border transactions However, many issuances are purely European, e.g. Continental Foods Ceva Sante Animale Deoleo GHD Gesndheits Aenova 31

32 Covenant-Lite Loans in the European Leveraged Loan Market Some European issuers are using covenant-lite for dividend recapitalizations and refinancing existing indebtedness E.g. Continental Foods, a Belgium-based consumer foods business purchased by London based private equity firm CVC Capital Partners in October Initial acquisition was financed with 320 million of senior debt. Refinancing allocated on July 30, 2014 with 425 million covenant-lite loan to fund 160 million dividend to CVC. 32

33 Covenant-Lite Loans in the European Leveraged Loan Market Even European cov-heavy deals are seeing reductions in the average number of covenants tested in Europe Excluding cov-lite issuances, newly issued European leveraged loans YTD averaged a record low of 2.5 tests, a decrease from an average of 3 tests in 2013 and 3.6 in However, still more than U.S. where 2013 average was 1.7 tests and the U.S. average from 2008 to 2012 was 2.5 tests. 33

34 Takeaways Current market conditions of robust demand for new credit and supply of investors in search of higher yield favor covenant-lite. Incurrence-based negative covenants instead of fixed baskets are becoming more common. Cov-lite is expanding beyond the large cap U.S. market into the U.S. middle market and European market. Cov-lite is a win-win for borrowers and lenders today but lenders should only lend to borrowers with balance sheets and earnings to support cov-lite loans, otherwise current trends could result in a bubble. 34

35 Contact Information Stephanie S. McCann McDermott Will & Emery George M. Houhanisin McDermott Will & Emery