Lenders Can Only Watch as Covenant-Lite Debt Strips Influenceby
Weak terms leave creditors less recourse if things go awry
Strict tests are out of fashion at Nine West, Weight Watchers
Lenders to struggling shoe chain Nine West have watched the company’s debt soar to more than 20 times earnings, and there’s little they can do about it. Unfortunately for them, that’s exactly what they signed up for.
Nine West’s debt is “covenant-lite,” meaning it carries minimal protections for lenders should the company falter and little obligation to explain if something goes wrong. There are no limits on how much debt the company can hold relative to its earnings, and the only required disclosures are annual and quarterly reports, according to S&P Global Ratings analysts. The absence of specific metrics to meet or tests to pass leaves creditors with virtually no power to force answers from their borrower or changes in its behavior.
It’s an example -- a warning, some analysts would say -- of what creditors can expect as they trade away traditional debt protections for extra yield. With past covenant-lite deals like Nine West and Weight Watchers International Inc. now causing headaches for their lenders, credit analysts and investors say they’re seeing similarly loose terms more frequently on new loans and bonds. Just 35 percent of new leveraged loans issued in 2016’s first half had traditional covenants that require regular financial check-ups, compared with 100 percent in 2010, according to Xtract Research, which analyzes debt packages.
“This is the classic issue with covenant-lite loans -- it doesn’t give the creditors very much leverage when things start heading south,” said Steve Moyer, a professor at the USC Marshall School of Business and author of “Distressed Debt Analysis,” a bible for investors in the field. “But they knew that when they bought the loan.”
Michael Freitag, an external spokesman for Nine West and its private-equity owner Sycamore Partners, declined to discuss the credit terms in detail. Nine West is saddled with about $1.7 billion of debt lingering after a $2.2 billion buyout two years ago by Sycamore. Weight Watchers didn’t respond to requests for comment.
Covenants prevent borrowers from taking actions that could hurt creditors. This might include limits on how much more debt can be issued, or curbs on selling divisions or transferring assets among subsidiaries, and changes in who’s controlling the company. A violation can give creditors the right to demand action to protect their investment, and in some cases force immediate repayment.
“The fact that there are no covenants tells you that people are substituting yield for credit judgment,” said Wilbur Ross, the billionaire distressed-debt investor, in a Bloomberg Television interview.
Lenders in the leveraged loan market have been increasingly agreeing to looser terms, with more than three-quarters of new loans this year offering weak protections, according to a Moody’s Investors Service report this month. That’s up from 46 percent in 2013. The ratings firm said in June that covenant quality for high-yield bonds has also plunged.
“In what passes for optimism on this subject, it appears possible that covenant quality has finally hit rock bottom,” Martin Fridson, chief investment officer of Lehmann Livian Fridson Advisors, wrote in a report this month.
By one measure, the discipline that covenants impose can be good for both lenders and borrowers. Companies that trip a covenant and draw extra attention from creditors are more likely to turn around and outperform than similar firms that lack such restrictions, according to a 2012 academic study published in the Review of Financial Studies.
Cuts in acquisitions, capital spending, debt levels and shareholder payouts typically follow, while operating performance and stock prices improve, the authors concluded. The study by Greg Nini, David Smith and Amir Sufi covered U.S. nonfinancial firms from 1996 through 2008 and found 10 percent to 20 percent a year disclosed covenant violations.
“Lenders can come in and see what’s going on, kick the tires and adjust things accordingly,” said Smith, a professor at the University of Virginia’s McIntire School of Commerce. Without covenants, creditors “are reduced to asking the owners, can we please agree or negotiate? And the owners can say no,” he said.
Weight Watchers creditors could find themselves in that situation, according to S&P analyst Peter Deluca. The weight-loss company was allowed to omit some typical investor safeguards in 2013 from its term loan, and from its revolver loan in 2014, by volunteering to pay higher rates while cutting the size of the revolver. Those changes could leave creditors without a say in future decisions, Deluca said.
Weight Watchers’ stock rallied last year after Oprah Winfrey joined the board and became a spokeswoman for Weight Watchers, but has since fallen back to its lowest level since before Winfrey took her ownership stake. Earnings before interest, taxes, depreciation and amortization were almost 10 times as high as interest expense in 2011, and are now less than two, according to data compiled by Bloomberg. The New York-based company, which had about $2 billion of debt as of July 2, is looking for a new CEO.
Nine West managed to weaken its covenants in the third quarter of this year, which weren’t very strong to begin with. The company made amendments to its asset-based loan agreement that included discarding a springing covenant that capped its leverage ratio, S&P analyst Suyun Qu said.
Springing covenants are protections that get tested only when a certain amount of the company’s revolver is drawn, giving “the illusion of a financial covenant without any real bite,” according to Charles Tricomi at Xtract. Those rose to 48 percent of leveraged loans issued this year from 25 percent in 2013, according to Xtract.
Another way that risky companies make themselves appear more creditworthy is by negotiating agreements that allow them to increase estimates of future cost savings. This can boost potential losses for investors if those savings don’t materialize, according to Xtract.
Nine West has enough liquidity in its revolver to fund operations for now and no debt maturities until 2019, according to S&P and Moody’s. Management has made the chain as competitive as possible to get through their key seasons, S&P’s Deluca said.
While no formal investor group has been organized, creditors among Nine West’s largest holders have been discussing restructuring alternatives among themselves for at least two quarters, people familiar with the conversations said.
The creditors have been approaching Nine West and Sycamore, its private-equity owner, with questions about the company’s latest financial data, but have been frustrated by the lack of answers, the people said. The weak covenants don’t provide them with many tools to pressure the company.
Among topics that creditors have asked Nine West about is a sharp increase in reimbursements for “out of pocket expenses” to Sycamore that reached $5.7 million last year, said people familiar with the conversations and private financial statements. That’s 19 times more than the $300,000 the struggling footwear chain paid Sycamore during the last nine months of 2014, said the people, who asked not to be identified discussing confidential data.
The funds covered fees related to Nine West that were paid to outside advisers by Sycamore, said Freitag, who represents both New York-based companies. He declined to elaborate on what kind of services the advisers performed.
Covenant-lite debt investors are “at the mercy of the document that they agreed to,” said Justin Forlenza, an analyst at Covenant Review, which analyzes debt agreements for investors. “There’s really not much that they can do unless there’s some other trigger event.”