CLO managers tweak deal language to push up cov-lite limits

Mon May 13, 2013 3:50pm EDT

NEW YORK, May 13 (IFR) - The resurgence in issuance of so-called "covenant-lite" loans -- a controversial crisis-era corporate-lending product -- and an insatiable thirst for yield among investors, has forced US collateralized loan obligation (CLO) managers to devise creative ways to get more of the loans into CLO structures.

CLO managers have a shrinking pool of overall leveraged loans to choose from to feed their booming market, and a greater proportion of those are cov-lite loans.

Cov-lite loans offer less protection to investors and lenders than loans with covenants. CLO managers say that a supply/demand imbalance has given them no choice but to fill new deals with more of the loans, even beyond the limits, or "buckets", set aside for such loans in CLO structures.

In fact, CLO arrangers and collateral managers have been watering down the definition of "covenant-lite" in deal documents in order to exceed the allowable allotments for cov-lite buckets in forthcoming deals.

With various so-called "carve-outs" built into documentation language, new deals may contain up to 90% cov-lite loans, surpassing the record of 70% attained in two recent offerings, according to three industry participants with knowledge of the coming transactions.

And investors are fully aware of the practice, as every CLO is fully negotiated and not finalized until investors sign off on the documentation.

Investors can expect to be handsomely compensated with extra yield if the offerings contain more cov-lite loans, which put fewer restrictions on borrowers and are considered more risky as they have fewer financial tests that monitor their structure and performance.

One deal currently in warehouse has a carve-out for covenant-lite leveraged loans rated Double B minus or higher, meaning that these loans will not be counted towards the official cov-lite limit on the deal, which has recently been as high as 50% to 60%.

The carve-out may push the cov-lite percentage in the deal to 80% to 90%, according to a senior CLO banker.

"In general, the cov-lite bucket for CLOs is evolving to a changing market," said Kevin Kendra, the head of structured credit ratings at Fitch.

"If this trend continues, it's not hard to envision a scenario where the asset-manager credit selection universe is going to be limited by the allowable percentage or constraints in the documentation."

CLOs -- which package leveraged loans into different slices of risk and sell them to investors as bonds with varying yields -- helped fuel the private equity leveraged buyout boom of 2006 and 2007, giving private equity firms the ability to cheaply finance loans for M&A activity via the capital markets.

CLOs make money based on the difference between the liabilities spreads that they pay to their investors and the spreads they earn on the underlying loan assets.

DEMAND MEETS SUPPLY

Loan issuers have taken advantage of excess investor demand for assets this year by issuing a sharply higher share of cov-lite loans.

As a reaction to the supply/demand imbalance - CLO players insist that the composition of the underlying loans to choose from is driving the increase in cov-lite CLOs, and not the other way around - CLOs have had to increase their cov-lite baskets at a quicker pace then expected.

According to Thomson Reuters LPC, while the level of primary cov-lite issuance fell in April from the March total, year-to-date cov-lite volume stands at US$92bn, up from US$14bn in the same period a year ago.

Cov-lite buckets in CLOs stood at about 30% in 2010 to 2011, but jumped to 40% in early 2012. Given the growing pool of cov-lite loans, the baskets jumped to 50% to 60% in the latter half of 2012, depending on how strictly collateral managers defined "cov-lite" in deal documents.

Some deals went even higher: the US$415m OHA Credit Partners VIII from Oak Hill Advisors, which priced on April 17, comprised 70% cov-lite loans, according to RBS; so did a US$722m Apollo deal that priced last October, titled Apollo VII CLO.

Ratings-based carve-outs have been discussed for a while, but have not been put into practice until now.

"I understand the logic there, and I don't disagree with the sentiment of carving out Double B credits from a 'cov-lite' definition, but it is a bit aggressive," said a senior CLO portfolio manager.

"The argument to investors is that it's a Double B loan, which is low leverage. If the issuer carves out the Double Bs, you cut your cov-lite problem in half, in terms of basket compliance."

GREY AREA

Double B credits make up roughly half of the cov-lite market, the investor said.

"It's an inherent understanding that a cov-lite borrower is better quality. These days, because of the preponderance of cov-lite loans, when anything actually has a covenant, we ask, 'What's wrong with it?'," he said.

"As an investor, it's important to look through the documentation and see what the definition of cov-lite is," said Ken Kroszner, a CLO analyst at RBS.

"There is a negotiation process between the manager and investor; typically a larger, well known manager is going to be able to command more presence in the negotiation process than a less established manager."

Besides ratings-based carve-outs and other tweaks to definitional documentation language, sources say that another grey area is whether a loan should be considered cov-lite if the revolver has a maintenance covenant, but the term loan does not.

In that case, the maintenance covenants do not kick in unless the revolver is drawn. However, the loan may still not be considered cov-lite for the purposes of a CLO.

Despite the potential risks of cov-lite loans, the jury is still out as to how their actual performance will pan out. While many experts say that they may not fare as well during the next economic downturn, there is no proof.

"There is zero empirical evidence to show that cov-lites performed any worse than cov-heavy loans during the recent recession," said RBS's Kroszner.

"Cov-lites can actually give borrowers more flexibility to manage their loan in order to pay back timely principal and interest."

Despite one of the most promising first quarters of issuance since 2007 - US$26bn in US CLO volume - longer ramp-up periods and a dearth of underlying assets may undermine the optimistic 2013 issuance levels originally envisioned for the sector.

The pace is expected to slow down as a lack of underlying leveraged loans hamstrings an otherwise rejuvenated sector.

After a robust US$56bn in 2012 US CLO issuance, some analysts predicted US$70bn or more for 2013 at the start of the year, but have tempered their predictions to US$60bn to US$70bn.

CLO issuance reached its peak at about US$103bn in 2007.

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