Craig has a great, in-depth look today at the "cov-lite" phenomenon
whereby loans are increasingly being syndicated without the restrictive covenants
of yesteryear.
Craig’s piece is excellent because she doesn’t go down the lazy
knee-jerk route of automatically saying that cov-lite loans are toxic and
dangerous and something which pose a massive systemic risk to the international
financial architecture. Instead, she looks at the development in an impartial
manner, and although she doesn’t make any explicit conclusions, it’s clear that
there are quite a few reasons to consider cov-lite loans a good thing.
It’s certainly true that banks with cov-lite loans will have less power over
borrowers than they had in the past. But this is not necessarily a bad thing.
For one thing, many recent cov-lite loans, such as the $16
billion in acquisition financing that KKR is lining up for First Data, or
the same amount that it might borrow to acquire Alliance Boots, are huge. As
a result, any bank creditors committee would be enormous, unwieldy, and would
probably cause more harm than good.
What’s more, many banks with these loans will hedge their exposure in the CDS
market, which means that the real default risk is being borne not by the creditor
of record but rather by any number of hedge funds, CDOs, and the like. In such
a situation, it makes little sense for the bank in question to have serious
control over the debtor company.
It’s also worth noting that if a company doesn’t have restrictive covenants
on its loan, that gives it an extra couple of degrees of freedom should it ever
run into difficulties. The company’s owners can repay its bank debt however
they like, without being second-guessed by their creditors. Most importantly,
volatile financial results are much less likely, in and of themselves, to lead
to receivership or bankruptcy.
Many firms with cov-lite loans are highly leveraged, which means their financial
results are naturally going to be much more volatile. Cov-lite loans simply
make that volatility less likely to result in technical default on the part
of the company, with all the nasty consequences that implies.
And there’s also evidence that banks are receiving a premium for agreeing to
cov-lite loans:
At the riskier end of the spectrum, where more highly leveraged deals are
using deferred repayment instruments such as second lien instead of senior
debt, banks are cautious and likely to demand a higher price for the privilege
of covenant-lite terms.
This is great for all concerned: banks get the yields they’re looking for,
while sponsors get the freedom of action that they’re looking for.
The fact is that cov-lite loans are all negotiated, as it were, between consenting
adults. Maybe the banks, looking at the history of the likes of KKR, have decided
that KKR is actually better at running companies and working out what the smart
moves are than their own loan officers are. Or maybe they just think that they
can boost their total returns by lending cov-lite.
So does this mean there’s no systemic risk associated with cov-lite loans?
I’m not sure. No one seems to think that there’s major systemic risk associated
with bonds, and cov-lite loans are essentially loans which behave quite similarly
to bonds. But the collapse of a bondholder is a lot easier to cope with than
the collapse of a bank. So really it probably all comes down to the question
of how much of this debt is being retained by banks, as opposed to being sold
off or hedged. And that’s something which nobody knows.