Restructuring the next wave of cov-lite debt - With cov-lite financings at record highs, debt holders will need to be proactive in maximising ...
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Restructuring the next wave of cov-lite debt With cov-lite financings at record highs, debt holders will need to be proactive in maximising recoveries
Will the last person leaving
please turn out the lites?
Cov-lite loans can leave lenders with limited restructuring options, but creative lenders will
still find ways to bring debtors to the table, partners Ian Wallace and Christian Pilkington
of global law firm White & Case LLP explain
R
ecent data shows that of conditions in 2005 – 2007 ‘early warning system’ for lenders,
investor protection in loan immediately prior to the credit crunch. enabling them to initiate restructuring
documents has fallen to its The current raft of loans lack even the discussions before the debtor’s
lowest point ever. And yet, leveraged basic financial covenant protection business irretrievably declines. The
loans continue to be issued with no or that existed in the mid-2000s. absence of meaningful covenants
minimal covenants, and considerably These covenants were key leverage in recent deals greatly restricts
reduced protections for lenders points for lenders in a number of lenders’ ability to compel a borrower
generally. The bond market is in a
similar position, with ever-weakening
restructurings in 2008 – 2010. So
what will happen if there is some sort
72% to take action when its business
hits the rocks. To make matters
of restructurings in
terms for bondholders. of forced market correction, and a 2008 – 2010 were worse, lenders’ ability to exit the
Market conditions remain relatively substantial number of these cov-lite triggered by an loan has become restricted, due
actual or potential
benign from a debtor’s perspective, loans become distressed? covenant breach to the increasing use of blacklists,
so the issuance of cov-lite loans Historically, financial covenants whitelists and tighter consent rights
Source: European
continues—in many ways reminiscent have been viewed as a form of on transfers.
restructuring
report ‘Default, When this happens, what options
Restructuring and do lenders have? Are they simply
Recoveries in
2008 – 2010’, left in limbo, unable to mitigate their
Figure 1. Post-credit crunch restructuring triggers Debtwire losses, waiting for the inevitable
default on the repayment date while
the borrower’s business deteriorates?
Or are there options that lenders
11% may be able to turn to in order to
encourage earlier restructuring
discussions, even in the absence
Potential covenant breach
of covenant default?
17% 42% Actual covenant breach
Tight liquidity/
Payment default
Potential covenant breach
& tight liquidity
30%
The current raft of loans lack even
Source: European restructuring report ‘Default, Restructuring and Recoveries in
the basic financial covenant protection
2008 – 2010’, Debtwire that existed in the mid-2000s
1 White & CaseThe current market:
A self-fulfilling prophecy?
Figure 2. The share of covenant-lite leveraged loan issuance has Inevitably, the preponderance of
reached record highs cov-lite debt has led many
commentators to draw analogies
with 2008. In its November 2018
Share of covenant-lite leveraged loan issuance globally and in the UK
Financial Stability Report, the Bank of
Percent of flow England has raised concerns about the
100 loosening of underwriting standards
Global 90 in the leveraged loan market, and has
United Kingdom 80 specifically compared the current
70 leverage lending market with the US
subprime mortgage market of 2006.
60
The percentage of cov-lite loans
50
has reached record highs in 2018
40
(see Fig. 2), and the average leverage
30 of issuers has reached pre-crisis levels
20 and could potentially rise even higher
10 (see Fig. 3).
0
When is leverage not leverage?
2001 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18
One of the increasing market trends
recently has been the use of EBITDA
Source: Financial Stability Report, November 2018, Bank of England
adjustments when the loan is written
that assume future improvements
in earnings. These ‘add-backs’ could
result in substantial overstatement of
EBITDA and, as a result, substantial
Figure 3. The average leverage of issuers has reached pre-crisis levels understatement of leverage. Fig. 3
and could be even higher than reported shows very clearly the potential impact
on leverage, if some or all of the add-
Average leverage of global and UK issuers for new leveraged loans* backs are not, in fact, realised. The
leverage of issuers of cov-lite loans
Average gross debt to EBITDA
Average global leverage
suddenly appears far higher, potentially
8x
Average UK leverage already exceeding pre-crisis levels.
Range of potential leverage** 7x The EBITDA add-backs also have
a couple of additional key effects.
6x One is potentially to permit transfer of
assets from the borrower group or the
5x
incurrence of new debt or security, at
4x a time when the ‘real’ EBITDA of the
group would not support it. Another
3x effect—when there is a maintenance
covenant—is to delay the time when a
0x
2002 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 covenant breach could occur, potentially
resulting in a default occurring under
* Granular data on add-backs only available from 2015 the loan before the lenders are aware
** The greater the proportion of add-backs which are not realised, the higher the actual leverage will be relative of the borrower group’s distress. When
to the reported leverage. The top range assumes none of the add-backs are realised. The bottom of the range combined with the other weaknesses
assumes all of the add-backs are realised.
in debt documentation, the Bank of
Sources: England’s comparison between the
Covenant Review, LCD, an offering of S&P Global Market Intelligence and Bank calculations. leveraged loan market and the US
https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2018/november-2018.pdf subprime mortgage market in 2006
seems prescient.
2 White & CaseFigure 4. EBITDA add-backs in the European high yield bond market
Research shows that EBITDA add-backs are becoming increasingly prevalent in the
European high yield bond market
The remit of transfer
Percentage of European HY bond restrictions has been
89%
81%
deals that provided for cost savings
and/or synergies to be included in extended to cover
EBITDA or pro-forma adjustments
sub-participations,
Percentage of European HY
preventing a bank
74% bond deals that allowed cost from offloading its
66% adjustments to be uncapped
and without time limit exposure and control
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
while remaining
lender of record
2018 2017
Source: Debt Explained Market Update ‘Aggressive Terms in European High Yield 2018’, 22 January 2019
Other debtor-friendly
amendments to loan
New ‘cov-lite’ raises documentation
to 40%—a relatively ‘loose’ trigger
lender concerns Extension of transfer restrictions
potentially open to manipulation by
It seems clear that these EBITDA add- a debtor that can time its cashflows One advantage that lenders had in
backs, and their ability to water down to avoid springing the covenant in 2008 was that they were able to
leverage protection and obfuscate the the first place. exit the loans they were holding.
availability of incurrence baskets, are Even when maintenance covenants This flexibility for par lenders to
a potential problem for lenders in any
upcoming downturn. However, they 89% do remain, the standards applicable
to equity cures have loosened over
trade out enabled these original
lenders to focus on larger problems,
are not the only terms in the latest of European HY recent years. It is now common not which in many cases included their
wave of cov-lite loans and bonds that bond deals in 2018 to include restrictions on the number own balance sheets, and allowed
provided for cost
could be of concern to lenders in savings and/or of cures or the amount by which distressed debt investors to buy
future distressed scenarios. synergies to be a breach can be cured. It is also in at a substantial discount and
included in EBITDA
The start of 2018 had seen the or pro-forma becoming increasingly common for effect a more ‘root and branch’
occasional deal with the more adjustments the cure to be used in prepayment of restructuring. While a number of
traditional three or four maintenance Source: Debt outstanding RCF commitments, which ‘zombie’ companies did continue for
covenants, albeit without ratio- Explained Market removes the future application of the some time, there would arguably
Update: Aggressive
based debt incurrence restrictions. springing leverage covenant. have been many more if par lenders,
Terms in European
However, by Q4 2018, all of the High Yield 2018, The same trends can be with an understandable desire to limit
syndicated European leveraged loan 22 January 2019 observed in the European high yield substantial impairments to their loan
deals were cov-loose (with one or market—a sector that traditionally portfolios, had not been able to trade
two maintenance covenants, or just offers far less covenant protection out, and focused instead on ‘amend
leverage maintenance) or cov-lite (with than loans anyway—as high yield and extend’ short-term solutions.
only a springing leverage covenant). bond issuers have continued to In contrast to the pre-credit crunch
The Debt Explained European achieve favourable terms in their position, all of the newly issued
Leveraged Loan Market Update documentation. EBITDA add-backs European syndicated leveraged loans
Q4 2018 reported that more than 80% have been equally prevalent in high in Q4 2018 contained a ‘whitelist’
of deals fell into the cov-lite category. yield deals, and both the Restricted of permitted transferees, and an
Most commonly in 2018, the springing Payments basket and the covenants ever-increasing number contained
leverage covenant would only apply on Affiliate Transactions have become both a whitelist and a ‘blacklist’ of
when the RCF in the deal is drawn increasingly more aggressive. prohibited transferees. Over time, the
3remit of transfer restrictions has been
extended to cover sub-participations
as well, preventing a bank from Voting thresholds
offloading its exposure and control One key change to loan documentation is the lower thresholds for
while remaining lender of record. majority lender and super majority lender definitions. These have been
When borrower consent is watered down to New York law bond levels, with more than half of
required, an overwhelming majority all loan deals setting the ‘Majority Lender’ level at 50.1%, in contrast
of deals provide that the consent
requirement only falls away in the
85 % to the traditional 66 2 /3% requirement. The ‘Super Majority Lender’
threshold has survived a little more intact, with thresholds mostly in
of all leveraged the region of 80%.
event of a payment or insolvency loans in the UK The threshold for ‘non-major’ changes in the European high
default. Fewer than 30% of European were cov-lite by
the end of 2018 yield bond market was already a simple majority (more than 50%
leveraged loans in 2018 had a consent of outstanding bonds). However, as Debt Explained reported in
right that was disapplied on any other Source: Leveraged “Voting Thresholds: When Security is not so Super”, it is the ‘super
event of default. Data & Commentary
unit of S&P Global
majority’ threshold for release of collateral and/or security that has
Market Intelligence been reduced—in this case to 66 2 /3% of holders—in the majority
Prevalence of ‘light touch’
of 2018 deals. This is in contrast to the more traditional 90% or 100%
security packages
required for other ‘Super Majority’ decisions, which continue in the
Historically, lenders have expected European high yield bond market.
share and asset security—and This change to documentation is a double-edged sword. It is clearly
useful for lenders to be able to avoid holdouts—and the unnecessary
subsidiary guarantees—from all
loss of value to those lenders holding out—when agreeing changes
material group companies, but
to the documents, or a more extensive restructuring of the debt.
recent years have seen a number Equally, though, lower voting thresholds make it easier for a debtor
of limitations or exclusions to the to push through amendments that might have been more difficult to
lenders’ security package being achieve previously.
introduced. This can encompass
the exclusion of certain jurisdictions
Figure 5. Summary of changes in loan document protections over time
Loan document
2003 2007 2019
protections
Existence of Prevalent – both maintenance and Both maintenance and incurrence Few maintenance covenants; most
covenants incurrence covenants, but subject to deals just with incurrence covenants
substantial relaxation and reset
during 2008 – 2010
Strength of Strong – acted as effective early Still effective – relaxation in equity Loose/lite – lots of flexibility,
covenants warning system cure rules and many covenant resets especially around calculation of
after the credit crunch EBITDA. Difficult to actually calculate
leverage of business
Security Strong – substantial share and Strong – little meaningful change Weakening – more reliance on
package asset security, and guarantees from from 2003 share security and single point of
material group companies enforcement. Less asset security and
fewer guarantees
Transfer Strong – no blacklists/whitelists. Strong – little meaningful change Weak – prevalence of blacklists and
restrictions Sometimes no borrower consent; if from 2003; if any change, lenders’ whitelists. Stronger borrower consent
it existed, fell away on default position stronger on transfer rights; often don’t fall away until
payment default
Strong Weakening Weak
4altogether, for example, not any blacklists or whitelists in the
requiring security to be granted documentation. Those amendments
where it is particularly expensive or would enable lenders who want or
cumbersome to do so. need to exit the loan to do so, and
Both security and upstream enable activist distressed investors
guarantees can be restricted when Lenders need to understand the to become involved.
there are issues relating to financial debtor’s business, and be aware Early engagement, and taking a
assistance, corporate benefit, thin constructive and creative approach,
capitalisation, etc.—issues that arise
of the key commercial and legal will be the key to maximising future
under the laws of certain Western pressure points available to them recoveries. While human nature is
European jurisdictions, and beyond.
However, the market trend is to
as leverage to defer difficult conversations until
strictly necessary, getting a seat
introduce further exclusions, with at the table with the borrower and/
the asset-level security limited only or its private equity sponsor, rather
to ‘material’ assets of the borrower than simply sitting there waiting
group, or even for lenders to rely for the doomsday scenario, is the
simply on share pledges over the key best approach.
companies in the group—as a single Improving the documents at this
Carrot and stick: New money/waivers
point of enforcement—and do not relatively early stage can enable a
in return for resetting documents
take asset-level security at all. ‘two-stage’ restructuring to take
While these measures were Improving weaknesses in existing place, with the credit improvements
introduced to provide operational documentation is a priority. A clear instituted in the first stage, allowing
flexibility for the borrower group, the example is if the borrower group a sensible and collaborative
limitations to the security package— needs any formal consents under restructuring to be put in place,
and ability for the borrower group to the documents, or if there is a if needed, at a later date.
require the release of such security— new money requirement. In those
Pressure on directors
clearly carry risks for lenders in the circumstances, lenders should seek
eventual enforcement, and have the to reinstate covenants, relax transfer One of the most well-trodden paths
potential to reduce recoveries in a restrictions and restore as much by lenders seeking engagement
worst-case insolvency scenario. lender power to the documents as with a reluctant borrower is putting
possible, as the quid pro quo for pressure on the borrower’s board
Lenders still have options acceding to the borrower’s request. of directors, and reminding board
There seems to be no indication that Given that such opportunities are members of their duties.
investors will stop making finance by no means guaranteed—due to Directors’ duties vary materially
available on these terms, unless there the inherent lack of protection in the by jurisdiction, but many local laws
is some external economic or political documents—it is critical that lenders have some form of trigger, ranging
trigger with an impact akin to the seek to be proactive and organised. from the requirement for directors to
collapse of the US subprime market in act in the interests of the company’s
Two-stage restructurings
2007. At some stage, lenders will creditors, rather than its shareholders,
have to address the documentary While the balance of power has when in the ‘zone of insolvency’
inadequacies of these loans. What will shifted under the debt documentation, in England or compared to the
they be able to do? it is still open to lenders to approach compulsory insolvency filing rules
Given the weaknesses in debt borrowers with constructive that exist in Germany. Equally, it may
documentation, there are clear proposals prior to a default. For be possible to take advantage of the
limitations on lenders’ rights under the example, lenders could offer new differing rules on directors’ duties
loans. The biggest risk is that lenders money, a payment holiday or even $452bn across jurisdictions of companies
are unaware—or are aware but unable specific sector expertise, in return for in new cov-lite
in the borrower group, to put more
to take any action—until a borrower improved credit support, an equity issuance was pressure on the directors of certain
defaults on a payment due under the injection or revised loan terms that added to the global guarantors. In particular, a reminder
market in 2018
debt. At that point in time, any provide earlier triggers. It would also of the directors’ personal liability,
anticipated recovery will have been be worthwhile for lenders seeking Source: Leveraged if applicable—civil and criminal,
Data & Commentary
dramatically reduced. But it’s not all to improve liquidity in the loan to unit of S&P Global
depending on jurisdiction and the
doom and gloom, and lenders still remove or soften the borrower’s Market Intelligence action being taken—will inevitably
have options. veto on transfers, and remove have a more substantial impact.
Restructuring the next wave of cov-lite debt 5agreement are so ‘lite’ that they
do not trigger a default—it may be
worth exploring the ambit of the MAC
clause. It may be possible, at least for
the purposes of seeking engagement
Early engagement with borrowers, coupled with lenders’ with the borrower group, to consider
its usefulness, even if the lender
constructive and creative approach, is the key to maximising group would still prefer not to call
future recoveries a default on the basis of a MAC
clause alone.
With no ‘early warning systems’,
lenders need to be proactive
It would also be sensible for any insolvency may be more palatable While some commentators disagree
reminder of directors’ duties to be for lenders rather than, for example, on whether the market should be
12
coupled with an express reservation material adverse change. concerned about the prevalence of
of rights regarding any conduct of the cov-lite debt, there can be no doubt
Audit sign-off
group that the lenders or bondholders months of the very substantial amount of debt
consider inappropriate or potentially One clear red flag for lenders—and that has been written in recent years,
in breach of the debt documents. potentially an event of default under with minimal ‘early warning systems’
A period of 12
Lenders should ensure that such the debt documents—is the inability months is considered for its financiers.
reservation of rights is as robust for any company in the borrower the ‘foreseeable Will these cov-lite issuances run
future’ for going-
as possible. group to achieve sign-off by its concern sign-off into trouble? It’s impossible to tell.
auditors of its accounts, on a going- But with the issuance of cov-lite
Balance sheet insolvency test
concern basis. A period of 12 months debt at record highs, and the average
(if applicable)
is considered the ‘foreseeable future’ issuers’ leverage at levels not seen
A number of jurisdictions, including the for going-concern sign-off. since before the financial crisis of
UK, have a balance sheet insolvency While this is clearly out of the 2007/08, a market correction is likely.
test in their legislation, along with lenders’/noteholders’ control, they And when it happens, holders of
the more prevalent cashflow test. If should be aware of the timing and cov-lite debt—whether bank debt
the liabilities of a company exceed process. As it is management’s or bonds—will need to be proactive
the value of its assets, the balance responsibility in the first instance to to ensure that they maximise all
sheet test will deem that company consider whether a going-concern available recoveries.
insolvent. The laws of some basis is appropriate, any pressure that In the years leading up to the
jurisdictions, particularly in Europe, can therefore be brought by lenders/ financial crisis—irrespective of
contain restrictions on the limitations noteholders to show that the group the leverage in the system at the
on guarantees that can be given by a will have cashflow issues and/or time—lenders had the benefit of
company, based on the value of their need to materially curtail operations the ‘early warning system’ of robust
assets. However, these rules do not in the following year will inevitably financial covenants. These covenants
apply in all jurisdictions, which makes put pressure on the borrower/issuer gave an indication of the troubles
balance sheet insolvency more likely. group to engage. suffered by a distressed business and
To some extent, this is a corollary provided lenders with a clear route to
MAC
to the directors’ duties, because a ‘seat at the table’ in restructuring
directors’ duties only become Material adverse change (MAC) or negotiations. That benefit no longer
material adverse effect (MAE) is the
relevant when a company is at least exists in loan documentation.
clause that no lender really wants
prospectively insolvent. If the borrower Today’s lenders need to
to rely on to assert a default. It is
group has companies in jurisdictions understand the debtor’s
notoriously difficult to prove what
with a balance sheet insolvency test, it business, and be aware of the key
is ‘material’ in terms of the impact
may be helpful to increase pressure. In commercial and legal pressure
of the event on the borrower group,
addition, the balance sheet insolvency its ability to perform its financial points available to them as leverage.
test may be an event of default under obligations or the effectiveness Being proactive and organised will
the debt documents—in addition of the lenders’ security package. be crucial if lenders are to overcome
to the ‘cashflow test’ of whether a However, if there are no other events the documentary deficiencies and
company can pay its debts as they fall of default available to lenders—not achieve meaningful restructurings
due. Default based on balance sheet least because the covenants in the while avoiding material impairments.
LON0419084_010
6 White & Case0
Ian Wallace
Partner, London
T +44 207 532 2283
E ian.wallace@whitecase.com
Christian Pilkington
Partner, London
T +44 20 7532 1208
E cpilkington@whitecase.com
whitecase.com
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