I have been very concerned about loose loan covenants and poor underwriting standards for decades. Why? Because every time that there is a downturn, creditors and loan investors end up getting hurt when borrowers start breaching loan covenants, paying late or in incomplete amounts, or worse yet defaulting. In addition, borrowers tend to push for loan restructurings and changes in loan documents, when they become stressed as has been happening market or economic downturns.
And here we are again; this time it may be worse because of the devastating nature of the pandemic. A report released today by Moody’s MCO Investors Services, unfortunately, is confirming that I had a reason to worry. Leveraged loan borrowers are reworking the senior capital structure to manage liability in four primary ways: priming existing debt, structurally subordinating existing debt, diluting existing debt and supporting new debt through collateral transfers similar to what J. Crew did.
Since credit agreement terms have deteriorated significantly over the last ten years, borrowers are now using diminished covenant protections and amendment provisions to raise new debt in ways that can be detrimental to existing loan investors. Enam Hoque, Senior Covenant Officer at Moody’s Investors Services, points out that “Liability management transactions, e.g., priming debt, structurally subordinating debt, debt supported by collateral transfers and diluting debt, strike at the heart of what separates a first-lien term loan from other types of debt instruments – mainly, its “senior secured” status.”
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It should be worrisome for creditors and loan investors that changes in the structure of debt can end up significantly impacting what they can ultimately recover when borrowers default. The structure of debt structure is a predictor of instrument recoveries. According to Hoque, “In instances where flexibility in credit protections results in profound changes to debt structure, creditors with diminished priorities should expect lower recoveries in default.” He explained that “When borrowers introduce competing pieces of debt by bifurcating or reconfiguring existing debt, the risk of potential losses shifts to the remaining first lien lenders. Institutional investors face difficulties in addressing documentation weaknesses, while smaller investors face even greater challenges since they are rarely considered, consulted or even invited to participate in priming transactions.”
As the pandemic has intensified, borrowers have challenged diminished protections, especially in covenant-lite leveraged loans. Borrowers have even tested first-lien loan only covenant-lite debt structures, which make up over 25% of leveraged loans. Along with continuing deterioration in credit protections, borrowers are essentially reworking the very top of capital structures. According to Hoque, “When deployed successfully, liability management transactions strike at the heart of what separates a first-lien term loan from other types of debt – its sacrosanct “senior secured” status.’ Moody’s Loan Covenant Quality Indicator (LCQI) continues to show the erosion of credit protection erosions.
According to Hoque, “liability management transactions can introduce priority or pari passu debt at the top of the capital structure to help stressed borrowers that may otherwise not be able to afford the borrowing costs associated with second lien or unsecured debt.” Under current difficult economic climate, it is likely to be difficult to find creditors who will take on second or third positions.
With rising COVID-19 cases in most of the United States and the return of partial-shutdowns in a number of municipalities, existing borrowers especially in retails, airlines, and the hospitality and leisure industry are likely to continue to experience economic distress.
Additionally, the very low interest rate environment will continue to pose problems for the foreseeable future. Creditors, as well as loan and collateralized loan investors are all chasing yield. This will continue to enable companies to continue be more leveraged and with looser loan terms. As has happened in other economic cycles, this is likely to mean increased defaults with lower recovery rates.