- Issuers using more future cost cuts to boost creditworthiness
- Lenders agreeing to terms ‘they should be fighting off’
Riskier companies are increasingly getting credit agreements that allow them to raise the amount of future cost savings to appear more creditworthy, boosting potential losses for investors.
The tweaks make it easier for borrowers to stay in compliance with their loan terms and add more debt, according to Charles Tricomi, a senior analyst at covenant research firm Xtract Research.
“There is too much money chasing too few loans,” Tricomi said. “Lenders are really at a disadvantage and have to agree to these terms significantly against their own interest, terms that they should be fighting off.”
Whittling away standards that keep a lid on leverage levels may leave investors with soured assets, according to Tricomi. This is happening just as the credit cycle is peaking, prompting warnings from S&P Global Ratings that companies in the U.S. have taken on so much debt that they’re at least as vulnerable to defaults and downgrades as they were leading up to the 2008 financial crisis.
“The market is so much leveraged on the side of the borrower at this point and they are forcing lenders to swallow a lot of things that they wouldn’t otherwise take,” Tricomi said. “In the event there is a default, there is a greater likelihood of lower recoveries.”
Issuance of leveraged loans has been declining in the last few years, with loan sales funding U.S. buyouts plunging more than 30 percent from 2015, according to data compiled by Bloomberg. This shortage is giving companies more power to negotiate better terms with investors who have little choice but to go along because yields on other assets are at rock bottom amid central-bank stimulus.
A unit of US Foods Holding Corp., a food distributor controlled by KKR & Co. and Clayton, Dubilier & Rice, got a $2.2 billion loan in June that excludes limitations on so-called add-backs that allow the company to raise earnings and decrease leverage, according to Tricomi. Aspect Software Inc., a telecommunications company, obtained a $387 million loan in May backing its exit from bankruptcy with similar terms, Tricomi said.
A representative for Aspect Software based in Chelmsford, Massachusetts, declined to comment on its loans and the terms of the debt. Representatives for US Foods didn’t respond to a call and e-mail requesting comment on the loan.
Earlier this year, Valeant Pharmaceuticals International Inc. loosened its credit pact with lenders to allow it to use more add-backs. At the time, a spokeswoman declined to comment.
The practice of abandoning the caps has also crept into some European deals, according to Jane Gray, co-head of European research at Covenant Review LLC.
“I’ve seen this in European mid-cap sponsor deals,” Gray said. “It is still off market and we would consider it egregious,” because the norm in Europe remains for future savings to be capped.
Gray noted the caps on cost savings are also increasing, with 20 percent now “very common” in the sponsor market compared to about 10 percent to 15 percent previously, she said. In the U.S., the cap is typically 20 percent to 25 percent, she said.
Investors obviously place faith that private-equity companies that back a lot of the borrowers in the leveraged-loan market will “make a reasonable judgment on the amount of savings that can be added back,” said Suhrud Mehta, a London-based partner at Milbank Tweed Hadley & McCloy, who has also seen an increase in the practice in Europe. “This is where the market is headed.”
While companies are getting better terms in the European loan market in the last 12 months due to the scarcity of large deals, lenders can live with that provided the underlying borrower is strong enough, according to Ian Brown, head of strategic debt finance at Lloyds Banking Group Plc’s commercial banking unit.
“Some deals have seen some pushback but equally a number of deals with punchy terms have been getting good traction in the market,” said Michael Curtis, co-head for European loans at Intermediate Capital Group Plc, which has 22 billion euros ($25 billion) of assets under management.
In the face of looser terms, investors should remain disciplined, he said.
But till then companies will continue to get flexible terms on leveraged loans.
“It all comes down to the fact that in this market, borrowers hold the strings,” Xtract’s Tricomi said.