Talk to a bubblista for more than about five minutes, and you’re bound to hear the phrase “cov-lite” come up in conversation. The argument goes something like this: during the last credit bubble, we saw a large increase in cov-lite loans. Now, we’re seeing the same thing all over again. So, we’re in another bubble!
A recent report from Moody’s sparked the latest round of such commentary: Matt Wirz’s headline (“Beware of the Covenant Bubble”) was only slightly more alarmist than Moody’s own (“Signs of a ‘Covenant Bubble’ Suggest Future Risks for Investors”), while Stephen Foley at the FT took a similar stance.
But the fact is that cov-lite loans — loans unencumbered by various promises made by the borrower to the lender — make perfect sense for all concerned. To understand why, look at Wirz’s article, where the word “investors” appears five times while the word “banks” doesn’t appear at all. All we’re seeing here the natural evolution of the loan market.
Once upon a time, loans were bank loans. A company would go to its bank, negotiate a loan, and that was pretty much that. The bank would typically know the company’s business very well, as well as its officers, and the two counterparties would have a healthy relationship whereby the bank would help the company through rough patches as and when they occurred.
Eventually, however, as both companies and banks started getting much bigger, that model didn’t work any more. Companies wanted multi-billion-dollar loans — the kind of sums no bank could muster for a single borrower. And they started transacting with multiple banks and advisors, to the point at which it could no longer be assumed that the bank would always know when a company was getting into trouble.
The solution to this problem was something known as the syndicated loan. A single borrower, rather than borrowing from a single bank, would instead borrow from a consortium of banks — there could be dozens in a single deal. And because no borrower can be expected to maintain a deep relationship with dozens of different banks at the same time, the trust relationship got replaced with covenants — promises the borrower would make to its lenders. It might promise not to exceed a certain debt ratio, for instance, or it might promise that its cashflows would always exceed its interest payments by a certain amount. If any of those ratios were violated, that would count as an event of default on the loan, and the borrower would be forced to renegotiate with the consortium.
Covenants were a clumsy replacement for simple communication between a borrower and its bank, but they were necessary, especially since the new, syndicated loans had another key characteristic: they were tradable. If Bank A wanted to sell its part of the loan to Hedge Fund B, it could do so whenever it wanted to — even if the hedge fund in question had no relationship at all with the borrower. Essentially, loans were becoming more like bonds: they were becoming debt instruments to be traded between various investors, rather than loans which a single bank would hold to maturity and beyond. Still, most of the time the loans were initially sold to banks which at least aspired to having a lucrative relationship with the borrower in question. It was generally understood, for instance, that you would find it easier to get an advisory mandate if you already had a healthy lending history. And so the loans still felt more like loans than bonds, tied up with covenants and restrictions which brought the borrower and the lenders closer together.
Nowadays, however, the loan market is an investors’ market, and if you’re not a bank, covenants are generally much more trouble than they’re worth. For one thing — and this is very important — they increase the probability of default. Here’s a key chart from a June 2011 Moody’s report, which looked at 104 cov-lite issuers who borrowed in the loan market at the height of the bubble, between 2005 and 2007.
In a period where corporate issuers as a whole were defaulting at a rate of 10.35%, issuers with cov-lite loans defaulted at just a 7.8% rate, while the cov-lite loans individually defaulted at a very low 4.1% rate.
This makes intuitive sense. As the more recent Moody’s report says, “a cov-lite capital structure allows for increased financial flexibility at a time when a company needs it most, potentially allowing it to forestall default while getting through a choppy patch in its business”. Defaults are messy, time-consuming, expensive things; few companies benefit by going through a forced restructuring just when they’re being badly hit by a financial crisis or recession. If they have the financial flexibility one sees in cov-lite loans, that generally helps them rather than hurts them.
But does that flexibility only serve to increase the severity of default further down the road? If banks can’t interfere early, does that mean they’re going to end up taking bigger losses later? As Moody’s puts it, there’s an assumption “that cov-lite issuers are less likely to default, but once they do, value may have deteriorated to a greater degree than it would have if lenders had been able to step in earlier to address a breached covenant”.
Well, it turns out that assumption is wrong as well:
What you’re looking at here is recovery rates, from the wonderfully-named Ultimate Recovery Database. When a debt instrument goes bad, how much value does the lender end up with, at the end of the day? In the case of cov-lite loans, the answer is 89.6%. That compares to recovery rates ranging from 5.6% to 47.2% for all other debt instruments, be they loans or bonds.
Why did cov-lite loans do so well both in terms of default rates and in terms of recovery rates? Because instead of relying on covenants, the lenders relied on something much easier and simpler: subordination. Invariably, whenever you see a cov-lite loan, you’ll find a junior loan beneath it, which needs to be wiped out before the cov-lite loan takes any losses at all. (That’s why the default rate for companies with cov-lite loans, in the first chart, is higher than the default rate on the cov-lite loans themselves.)
For both borrowers and lenders, then, cov-lite loans make perfect sense. The borrower doesn’t need to worry about an unwieldy consortium of unfriendly lenders breathing down its neck, forcing restructurings even when all the debt-service payments are being made in full and on time. And the lenders don’t need to worry about such negotiations either, protected as they are by subordination — and by the proven ability of cov-lite borrowers to navigate difficulty and emerge in one piece on the other side. Covenants, after all, are based on the idea that lenders know better than borrowers how a stressed borrower should best run its business — a proposition which, these days, is unlikely to be true.
The only conceivable losers here are the banks, which lose their dream of having a broad-based relationship with a certain borrower, knowing its finances intimately on a real-time basis, and being able to sell it all manner of overpriced financial services if and when it gets into trouble. You’ll forgive me if I don’t shed many tears for them.