REDUCED LEVERAGE LOAN PROTECTIONS, COVENANT REMOVALS & GROWING 'COV-LITES' SUGGEST CREDIT CYCLE NEARING PEAK

 -- SOURCE: 12-27-17 WSJ - "Yield-Starved Investors Giving In to the Demands of Bond Sellers" --
Demand for leveraged loans is allowing private-equity firms to water down legal safeguards for investors
Hellman & Friedman LLC and other investors sought last month to borrow money in the bond market to finance a takeover. The U.S. private-equity firm offered a yield of about 3%, but few of the protections once considered routine.  Still, the investors bought.  Rampant demand for leveraged loans is allowing private-equity firms to water down legal safeguards for investors. Many lawyers and bankers increasingly worry that such changes could result in higher losses for investors during the next downturn, as creditors find themselves with less protection.

Terms on loans from Hellman & Friedman’s takeover of Denmark’s Nets A/S allowed greater flexibility for the borrower to take on more debt, extract cash from the company and even restrict who owns the loans. That, though, is no longer unusual in the loan market.

In the financing of a previous takeover of Nets in 2014, a separate group of private equity borrowers had to prove that debt at the Danish payments company wasn’t rising too quickly. Such a requirement wasn’t present this time.

The move to more borrower-friendly terms has come in both the U.S. and Europe. But the most dramatic shift has been in Europe, where the imbalance between loan supply and demand is most acute.

Investors are clamoring for leveraged loans as years of low interest rates and central banks’ bond buying have pushed down returns elsewhere. Trillions of dollars of sovereign debt, primarily in Europe, continue to sport negative yields, meaning investors pay to lend governments money.

With “far too much cash trying to find too few homes,” private-equity firms “can be more aggressive and lenders will take it,” said Adam Freeman, a partner at Linklaters LLP.

Some of the year’s largest leveraged buyouts in Europe have either removed covenants and legal protections, or allowed the borrower to control who buys its debt.

That included Bain Capital and Cinven’s takeover of German drugmaker Stada Arzneimittel AG, Lone Star LP’s acquisition of German building materials maker Xella Group, as well as the takeover of Nets A/S.

Analysts say that along with low borrowing costs, the weakening of deal terms has helped boost the appeal of loans to private-equity firms. In Europe, around 88% of the debt funding for leveraged buyouts came from loans this year, according to S&P Global Market Intelligence’s LCD unit, up from 73% in 2015. Meanwhile, 81% of loans in Europe this year have been “covenant-lite,” meaning they lack many standard investor protections, up from 21% in 2013, according to LCD.

Among the first changes was the stripping out of so-called financial-maintenance covenants, which are investors’ main defense against borrowers taking on too much debt. They require quarterly tests of a company’s leverage level, allowing lenders to force the firm into default if it rises too high.

Private-equity firms’ desire to make terms ever more flexible comes as the money they themselves invest in deals has risen around 12 percentage points above where it was before the financial crisis in Europe, according to LCD. That means they have more skin in the game should it go wrong.

“We have a fiduciary duty to get the best financing for our investors,” said Nigel Walder, a managing director at Bain Capital.

Some lawyers defend the changes, saying high-yield bonds don’t have such protections and U.S. leveraged loans also have lacked covenants for some time. For their part, private-equity firms argue that giving them more flexibility means their companies are less likely to go bust in a downturn.

Fraser Lundie, co-head of credit at Hermes Investment Management, thinks looser deal terms were at least partly behind the smaller-than-expected number of defaults in early 2016, when a crash in the oil price sent the value of energy firms’ debt tumbling. But Mr. Lundie is also concerned the trend will hamstring lenders’ ability to recover money from troubled companies in the next downturn.

“If you get it wrong today, you are very likely to get close to zero because covenant weakness is allowing companies to survive for longer before default,” said Mr. Lundie.

Other borrower-friendly terms include stringent loan-to-own clauses, which limit investors’ ability to sell to distressed debt funds. Recent loans have placed restrictions against such firms as Elliot Capital Management, Apollo Global Management and Cerberus Capital Management.

Bankers warn that such provisions, along with so-called white lists that detail which funds can buy the loan, could hurt liquidity if investors can’t unload loans in troubled companies to the sort of funds that specialize in taking on this risk.

Some recent deals now set a limit on how much of a loan any one fund can own. In 2016, loans backing Advent International’s purchase of French aerospace supplier Safran SA’s Morpho unit barred anyone from owning more than 10% of the debt. The idea is to prevent any one debt investor from building up a stake large enough to put pressure on the borrowers, lawyers said.

Legal firm Kirkland & Ellis International LLP worked on the Morpho, Xella and Stada deals. Neel Sachdev, a partner at the firm, said he advises clients on the best terms available in the market. Still, borrowers shouldn’t push for the most aggressive documentation on every deal.

“It’s more important for a deal to clear the market” successfully, he said.