What previously seemed like a relentless decline in investor protections for new leveraged loan deals not only abated in the first quarter of 2019, but in some respects actually reversed course, according to data from sister publication Xtract Research.
A big catalyst for the change is lower demand for leveraged loans after the Federal Reserve signaled a pause in interest rate hikes, which has given buysiders more ammo to push for tighter protections.
While covenants are still historically weak, the proportion of sponsor-backed loan deals that allow uncapped EBITDA addbacks — an aggressive clause with the knock-on effect of making it easier for borrowers to raise more debt or pay dividends — dropped to 41% in 1Q19 from 69% a year prior.
Meanwhile, the proportion of sponsor-backed deals graded eight or higher on Xtract’s new covenant scoring scale — which runs from zero to 10, with zero indicating the weakest protections — increased to 31% in the first quarter, compared to 17% a year prior.
Charles Tricomi, head of leveraged loan research at Xtract, said that changing market dynamics had given buysiders more firepower to push back on terms, even as the supply of new deals has decreased.
"In the past, lower supply has typically given the borrower even more of an upper hand to push the envelope on covenants,” he said. “This time, lower issuance has resulted in improvement in covenant quality, because demand also dropped.”
The shift is due in part to record outflows from floating rate loan funds and higher funding costs for CLOs — which last year were estimated to be buying roughly 60% of new leveraged loan deals — hurting demand for new loans, as well as a decline in credit quality, he said.
Total assets at US loan funds were USD 152bn at the end of the first quarter, according to Lipper, down from a record USD 184bn last October, before a selloff rocked global markets. CLO issuance in the first quarter was USD 36bn, down from USD 44bn last year, according to sister publication CreditFlux.
Meanwhile, the proportion of loan issuers rated single-B increased to 60%, according to Xtract. “CLOs didn’t gobble up everything they came across, and investors are also demanding better covenants because recent issuers have had lower credit ratings,” said Tricomi.
Buysiders also attributed the improvement to an increased awareness of just how much covenants have degraded over recent years, in part driven by high profile examples of loose covenants being used to the detriment of creditors, such as controversial asset transfers at PetSmart, Neiman Marcus and J.Crew.
“Even my mom is asking about this covenant stuff these days,” said one investor. “And it’s not like it’s in People magazine, but it is finding its way into the more mainstream financial media. The drumbeat has gotten so strong that people have no choice but to start pushing back.”
Borrowers were forced to tighten covenants in several high-profile buyout financings during the first quarter, including deals for Dun & Bradstreet and Brookfield’s buyout of Johnson Controls’ Power Solutions business.
Meanwhile, in the high yield bond market, issuers including Surgery Partners and Kodiak Gas Services have recently been forced to tighten covenants or scrap deals entirely, as reported by Debtwire. Buysiders noted that these names have often been at the lower end of the ratings spectrum.
“We’re definitely seeing investors push back more on dicey names to get changes made, but there’s still a lot of leeway in covenants to screw over bondholders,” said a portfolio manager.
But with credit spreads continuing to ratchet tighter over recent weeks and purchase multiples remaining high — which two bankers said was leading to increasingly intense competition to finance upcoming buyouts — buysiders still need to be vigilant about overall deal quality, investors said.
Covenants "might not be getting worse, but it does feel like we could be getting back to a sponsor’s market again,” said a portfolio manager at a large leveraged loan fund. “It just feels like a lot of deals are starting to get done regardless of whether we say no or not.”