Thursday, October 23, 2008

The Luxuries of a Covenant Light Lifestyle

Blackstone president and COO Tony James wrote a piece for the Financial Times this morning touting covenant light loans as a "positive development," allowing companies "the flexibility to work through their problems and, thus, help maximise total enterprise value."

When a business hits a downturn, because of either poor management or external forces, you want the business to continue. An ongoing business has a far greater total enterprise value than one liquidating. Loans with strict covenants can destabilise an otherwise healthy company, when even a short recession over a few quarters might trigger defaults. The holders of the senior debt take action; cash flow stops to the junior debt, suppliers stop shipping, customers flee and employees lose jobs. The equity holders with little or no remaining stake in the business not only find it difficult to restore health to the business, but they have no economic incentive to do so.

Equally important is the value destruction that ensues when a company defaults. Creditors squabble and courts hold interminable hearings. In the meantime, the company drifts. The very worst time for a boat to lose its pilot is during a storm. But this is exactly what results from the traditional hair-trigger covenants that many see as the healthy formulation of leveraged capital structures.

All valid points, perhaps. But let's dig a little deeper...

Typically, the two pertinent loan covenants are incurrence and maintenance covenants. Incurrence covenants restrict the company's ability to issue debt (typically, senior to this loan - which makes sense, especially if you're the lender and wish to retain your level of seniority). Maintenance covenants describe (minimum) collateralization levels (think coverage ratios) that must be maintained to avoid the loan from being in default. When you speak of covenant light loans, you're primarily talking about loans who lack the maintenance covenant(s). The fewer the covenants, the lower the likelihood of default, and hence Mr. James' rosy article.

Now let's consider covenant light loans as a microcosm for today's environment. Everybody's long regulation. Regulation is king. The market has seen what happens without it, and decided that it prefers regulation. Let's examine the lack of restriction (as a metaphor for regulation) on covenant light loans. The covenants act as a means for the lender to involve itself (think govern or regulate) in the performance of the company if/when it fails to comply with its covenants. Among other things, the lender can extract additional spread from the failing company (as an alternative to enforcing default) or, upon default, the lender at least has a strong position at the negotiation table, as a senior secured lender, and since the only-recently-failing maintenance coverage ratio describes the company's ability to "cover" the loan, the lender often walks away whole, or at least close to whole.

In the absence of such a covenant, the lender has limited recourse until default. Granted that defaults are less likely, but once they occur, who is to say what the recovery rate may be?

In summary, if I'm borrowing, I'm long the additional flexibility (unless it costs much more); but as a lender, one has to expect that the severity of any defaults will be sharply higher than those having quality/coverage controls in place. This is the real downside that should be guarded against: lenders with large exposure to low-recourse, low-recovery loans which are or may defer interest or "pay-in-kind."

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