Adventures in covenant-stripping, HCA edition

By Felix Salmon
June 24, 2009

During a credit boom, companies can borrow money with few if any covenants, and lenders are happy to give them anything they want in terms of freedom to refinance or restructure their debt in future.

During a credit bust, it seems that in certain cases the exact same thing is true:

HCA is asking senior lenders to give it carte-blanche approval to manage its debt load without having to go back each time for amendments to its existing loan contracts.

As an indication of HCA’s confidence in investors’ willingness to cooperate with its debt-management efforts, the company’s request contained no limits on HCA’s ability to extend loans and didn’t offer investors any fee for approval.

HCA didn’t actually succeed in its request, but it came close, and it seems that HCA’s lenders are cooperating with the company:

In a more normal credit environment, it would seem unlikely that loan investors would give up their ability to control a borrower’s debt-management strategy or grant a company virtually unfettered license to extend maturities without discussing the extension or potential pricing. However, S&P’s Donnelly feels that in this stressful climate, HCA will likely get what it wants after granting concessions to investors who don’t want to be insulted by terms that are too aggressive.

“It’s in everybody’s best interest to chip away at the maturity towers of 2012 to 2014,” Donnelly says.

But what about those pesky CDS, which are currently trading at 20 points upfront? What happened to the notorious dynamic where lenders would hedge themselves in the CDS market and then, in some circumstances, actually want the company to default?

Well, for one thing, I’m not sure that happens nearly as frequently as some people think. But also, HCA is a special case: a very large chunk of its loans are held by CLOs, which might well be much less likely to hedge themselves in the CDS market.

And then, at least according to Vipal Monga, there’s CLO prepayment risk, of all things:

Donnelly says CLOs have a strong incentive to approve HCA’s request because of the size of its loans and the prospect that they might be repaid early if HCA issues more bonds to reduce its senior debt. The company likely won’t need to ask for permission to do this again, given that investors already gave it before its $1.5 billion offering.

Many of the CLO funds, which made up the bulk of investment in the leveraged loan market in the credit boom, don’t want to be sitting on low-yielding cash and would be willing to allow HCA to extend maturities on existing debt to avoid early repayment.

This doesn’t pass a smell test. HCA is a distressed debtor; the CLOs should be ecstatic to be repaid in full. And if they don’t want to sit on low-yielding cash, there’s no shortage of high-yielding leveraged loans they can buy with that cash. Are CLOs not allowed to buy loans in the secondary market, if they have excess cash? That would be very weird indeed.


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Minor disagreement: my experience is that companies in flush times agree to more covenants because they anticipate never having a problem – and also believe, with justification, that their lender will either go with the flow or can be replaced, perhaps with a few bp’s shaved off. Remember that flush times are generally low interest times so larger amounts borrowed may generate lower payments. Covenants may not have as many sharp teeth, mostly in the details like debt-service coverage ratio, but the incentives for both sides are to get the money moving not to concentrate on covenants. Even the best lenders tend in good times to rely as much on their underwriting of the business as on documentation. And that’s sensible.

I know zilch about HCA and how much power they have versus their lenders but the opinions offered about why make little sense to me. I assume HCA is negotiating. The first rule of negotiating is you don’t get what you don’t ask for. Maybe their goal is to get some flexibility. Maybe they’re actually thinking about a particular class or two of debt, but they don’t want to point at it.

Posted by jonathan | Report as abusive

I thought a CLO would generally pass prepayments directly to its investors, but I am very much not an informed source of information on this.

If they don’t want to be prepaid by a distressed debtor, though, I certainly wonder how much more interest they’re collecting from HCA than they would from cash. I wonder whether there’s some agency problem here; perhaps the manager or servicer of the CLO collects fees in proportion to the amount of debt outstanding, or a badly written contract says that the CLO is supposed to avoid prepayments in some manner or another. As with the first paragraph, though, I’m just making things up here.

Sounds to me like the Japanese solution. Roll over bad debts so you don’t have to recognize them.