There have now been several covenant-lite senior financing deals in the European market. The first of these, World Directories, has been oversubscribed in syndication, confirming that while some banks are reluctant to participate in such deals, there is strong demand from institutions and funds. Some arrangers of leveraged buyout (LBO) loans might be wary of the underwriting risk associated with such facilities, but they are all under increasing pressure from their large private equity clients to offer such financings.
Covenant-lite deals were initially expected to be confined to relatively strong leveraged credits, ie stable credits with strong cashflow and low capital expenditure requirements, operating in non-cyclical industries and at less than maximum leverage. Media assets and directories businesses were thought to be ideal candidates, but the perception now is that these deals will happen in a diverse range of sectors. While market conditions are favourable, sponsors are increasingly challenging their lenders to provide such facilities at higher-leverage multiples.
Incurrence-based negative covenants are a key feature of ‘true’ or ‘total’ covenant-lite deals and such covenants originate from the high-yield market. The drafting is standardised but nevertheless complex. Typically, incurrence covenants seek to control both borrower and ‘restricted subsidiary’ activity and therefore prevent the transfer of value out of this controlled group. These negative covenants will only bite when certain corporate actions are undertaken, such as when debt is incurred or dividends paid. They differ from the maintenance covenants found in most conventional LBO deals, which require a corporate group to maintain a certain credit position – in particular by complying with financial covenants (eg leverage, interest cover) on a periodic basis.
There are also ‘semi-lite’ or ‘hybrid covenant-lite’ deals. These hybrid deals vary, but often maintenance covenants are preserved, perhaps with only a single maintenance financial covenant in the form of a leverage ratio.
A key feature of true covenant-lite deals is the incurrence-based nature of the covenants. In a standard LBO credit agreement one would expect to see an interest cover ratio, a cashflow cover ratio and a leverage ratio (essentially the ratio of consolidated net debt to consolidated earnings before interest, taxes, depreciation and amortisation) as the triple cocktail of financial covenants, tested periodically to provide an ‘early warning’ to lenders.
The only financial ratio that appears in a true covenant-lite facility is the leverage ratio test, but it is not tested periodically. Rather, pro forma compliance must be demonstrated only when the company or a restricted subsidiary wishes to take certain specified actions, including incurring additional indebtedness, granting security, entering into affiliate transactions or making restricted payments (being essentially distributions, investments in non-controlled entities and repayments of subordinated debt).
The credit agreement contains the concepts of obligors, material companies, unrestricted subsidiaries and restricted subsidiaries. The definitions of obligors and material subsidiaries follow those in conventional LBO credit agreements. A restricted subsidiary is any subsidiary of the key holding company that is not designated by the board of directors as an unrestricted subsidiary. Unrestricted subsidiaries are ring-fenced and are not controlled by the covenants. Similarly, debt and earnings of unrestricted subsidiaries are not included in the calculation of the consolidated leverage ratio.
Covenant-lite transactions also differ from conventional LBO facilities in that they:
•have non-amortising term facilities, whereas conventional LBO facilities still typically involve a slice of amortising term debt;
•contain a super-senior revolving facility, to provide an incentive for clearing banks (which are best placed to provide revolving facilities) to participate in the revolving facility;
•provide for ‘incremental facilities’, a mechanism that allows additional debt (subject to a limit) to be spliced into the facilities such that the new lenders share the security and guarantee package; and
•generally do not contain a restriction on capital expenditure.
Covenant-lite facilities are similar to conventional LBO facilities in that:
•the interest rate will be floating and the margin will ratchet down if leverage decreases;
•the credit agreement requires a percentage of ‘excess cashflow’ to be applied in prepayment of the facilities;
•mandatory prepayment is required on change of control and from net proceeds from disposals, insurance proceeds, proceeds from receivables financing and from reports recoveries (in each case, there are exceptions including broad reinvestment rights, and there are no prepayment penalties);
•they contain broadly similar representations and warranties, information undertakings and events of default, save that there is usually no material adverse change event of default; and
•the security and guarantee package for a covenant-lite facility is typically similar to that for a conventional LBO credit agreement and is subject to the same structural constraints.
Lenders under covenant-lite deals generally have full liquidity, ie the ability to transfer without borrower consent. This was the traditional position under European LBO credit agreements, but more recently some stronger sponsors have obtained control over lender transfers. Bankers argue strongly that full liquidity is necessary to reflect the bond-like characteristics of covenant-lite deals and to accommodate the investor base for these loans.
A high-water mark?
Thus far, covenant lite deals in Europe have been confined largely to strong leveraged credits. But will this discipline continue?The stakes are high for bankers and private equity sponsors alike. Where a covenant-lite approach is agreed, lenders may see that a business is in distress but be unable to intervene until the business runs out of cash.
Some bankers argue that this luxury – if suitable for leveraged credits at all – should be afforded only to the very strongest leveraged credits. But so long as there is demand for these loan assets, competition between banks will mean that covenant-lite in hybrid or in true form will become more common.
Certainly, if covenant-lite in its true form has caught on, there may be frustrating times ahead for workout teams.
•Chris Howard and Christopher Davis are partners at Freshfields Bruckhaus Deringer