Following the financial collapse, companies no longer were supposed to get big bank loans without stringent financial covenants. But it’s happening again, and it’s (mostly) okay.
I moderated nearly a dozen private equity conference panels in the year after Lehman Brothers collapsed. Each time, I asked if the subsequent credit crunch would have any permanent effects on future private equity deals – particularly given that most private equity deals rely on debt financing (i.e., leverage). And each time I got the same response: “We won’t be seeing cov-light again.”
For the uninitiated, cov-light refers to bank loans that do not include many of the standard investor protections. For example, a typical leveraged loan would require that the issuer meet certain financial performance milestones. Or that you can’t repay debt by securing new debt elsewhere. Most cov-light loans come without such requirements, not to mention less-stringent collateral obligations.
The main beneficiaries of such terms, of course, were the issuing companies and their private equity owners. Disastrous earnings for a quarter or a year? No default, no problem. It’s the kind of thing that was enabled by red-hot capital markets – in which every lender wanted to stay in private equity’s good graces, and in which there was an explosion of hedge funds and other buyers to whom banks could parcel out much of the risk.
Not surprisingly, cov-light was roundly criticized as giving a free pass to underperforming companies, and too little recourse to those whose loans were keeping those companies afloat. So it wasn’t surprising that my conference panelists believed that cov-light was a once-in-a-lifetime opportunity that wouldn’t be coming around again.
But they were wrong.
Cov-light is back with a vengeance, as part of a refinancing wave that is sweeping through the leveraged loan markets. Just take a look at Gymboree, the children’s retailer acquired last November for $1.8 billion by Bain Capital. The company last week announced plans to replace an $820 million term loan with another $820 million term loan whose only substantive difference will be a lack of “financial maintenance covenants.”
There also is talk that cov-light refinancing is beginning to trickle down into smaller companies, just as happened during the “Golden Age” of 2005 to mid-2008.
The most common explanation for the cov-light comeback is that investors are clamoring for yield in a low-interest rate environment. In other words: Don’t blame us, blame Bernanke.
There certainly is some truth to this claim, but it’s hardly a complete accounting. The new Gymboree loan, for example, is structured with the exact same yield as the original loan.
So what else is driving cov-light in 2011? Well, it’s a lot like what we saw in 2006 or 2007: Banks desperate for business, and a growing number of new secondary buyers for the debt (whose formation is being driven, admittedly, by higher yield quests).
In terms of banks, it’s important to understand that issuers are not typically required to maintain a term loan until maturity. Instead, they can choose to repay early, and then take out a friendlier loan from someone else. For the original lender, this poses a dilemma: Either we stick to our original terms and forego the next few years of yield (since the loan has been repaid), or we continue to collect yield by accepting weaker terms. Given that most bankers are coin-operated, the latter scenario is playing out more and more often.
As for new loan funds, this is coming in two forms: Hedge funds and collateralized loan obligation (CLO) funds. Credit Suisse reports that hedge fund inflows were approximately $22.6 billion in 2010, which represents the largest annual inflows since 2010. New CLO issuance only reached $5 billion last year, but Wells Fargo analyst Dave Preston believes it could approach between $12 billion and $15 billion this year (albeit the CLO funds seem to be less levered, thus reducing the risk of leverage on top of leverage on top of leverage).
One of the great ironies of cov-light is that it instinctively provokes revulsion among many of us media types. Kind of like the notion of a no-money-down mortgage. The bill is going to come due for someone, someday. And it’s going to be ugly.
Unlike subprime home loans, however, cov-light has actually worked out pretty well for everyone involved.
Private equity sponsors were able to maintain equity stakes in most of their portfolio companies, thus maintaining value for their investors (pension funds, college endowments, etc.). PE-backed companies were able to stay afloat, thus protecting jobs. And most of the cov-light loan prices have recovered, thus working out ok for creditors whose own liquidity troubles didn’t force them to sell during the 2009 nadir. Moreover, banks were spared the trouble of having to decide whether or not to take action on tripped covenants (a giant hassle that many banks punted on when it came to loans with covenants).
“I believe that cov-light is very much in the interest of creditors,” says Tony James, president of The Blackstone Group. “For whatever reason, it became some sort of talisman, but it helps preserve enterprise value, is good for the economy, is good for sponsors and also for employees.
“Almost every single private equity sponsor had a death or near-death experience in their portfolio in 2009, which influences the way they view capital structures,” adds Randy Schwimmer, a senior managing director with Churchill Financial. “Cov-light was a savior for many of them.”
But while cov-light itself is usually okay, there should be concerns about the larger context. It’s almost as if cov-light could be the benign symptom of a dangerous disease, in which the credit markets overheat to the point of collapse. This is particularly true in the high-yield market, where private equity often plays and in which the term “bubble” has become part of conventional wisdom.
Just remember what happened the last time cov-light was in vogue…
