June 19, 2019 / 8:04 PM / in a month

Riskier borrowers face heightened scrutiny as uncertainty mounts

NEW YORK, June 19 (LPC) - Speculative grade companies looking to the leveraged loan market to fund their operations are bracing for heightened scrutiny from investors demanding greater compensation for deals being executed under a cloud of macroeconomic uncertainty.

Some US leveraged loan borrowers, particularly companies languishing in single-B rated territory such as dialysis services provider US Renal Care, midstream water firm Waterbridge Operating and supermarket chain Smart & Final, have introduced improved covenant packages to skeptical investors while banks offer steeper discounts in a sign of their mounting challenges to underwrite loans.

The US$1.2trn leveraged loan market has fallen under the spotlight of a US Congressional subcommittee wary of the potential risk such loans could bring to the economy in the event of a downturn. Near-term cuts to US interest rates this year, meanwhile, could weaken demand for floating-rate loans and 30 consecutive weeks of loan outflows have further dampened the sentiment.

“Investors are concerned about downside scenarios and demanding more protections and higher pricing based on their perception risk,” said David Mihalick, head of US high yield investments at Barings, adding there is a “general risk-off sentiment” in both the bond and loan market.

This investor pushback comes as companies rated B3 by Moody’s Investors Service made up 44% of new bond and loan issuances in 2018, against 22% in 2007, the ratings agency said in a May 29 report. Low-rated corporates have gorged on low interest rates in recent years and high investor demand while increased activity from private equity firms has led to a high proportion of speculative-grade borrowers with loan-only debt, Moody’s said.

LATE-CYCLE BEHAVIOR

While there is no shortage of investor liquidity — US$58.6bn of new collateralized loan obligations (CLO) have been arranged through June 14, roughly in line with 2018’s record numbers for the period — single-B rated companies lack the “juice” to force aggressive covenant packages on loan buyers, according to Charles Tricomi, the head of leveraged loan research at Xtract Research.

“Lenders are starting to say ‘no’ the closer you get to the bottom of the barrel,” Tricomi said of companies teetering on the edge of CCC ratings status.

B3/B-rated US Renal Care, for example, on June 13 sweetened the price of a US$1.6bn seven-year term loan to 500bp over Libor from an initial suggested range of 450bp-475bp, banking sources said.

Investors also have looked to limit borrowers from easily incurring additional debt and are pushing back on language including most-favored nation clauses, carve-outs and ways to mitigate a company’s ability to move assets away from investors should a borrower struggle to repay debt.

US Renal Care added a 25% cap on the amount of add-backs, or projected cost savings, it can include in the transaction, which serves as a means to lower leverage.

WaterBridge Operating, rated B1/B/B+, is in the market for a US$1bn seven-year loan. On June 14 the company also widened the interest rate of the loan to 575bp over Libor from prior guidance of 550bp.

Importantly for investors, WaterBridge adjusted its excess cash flow sweep, or free cash left to pay back debt, to 50% once its first-lien net leverage hits 4.0 times. Originally, the cash sweep was offered at 50% once first-lien net leverage hit 4.5 times, a source familiar with the transaction said.

“These two deals are examples of investors seeing that we are late in the credit cycle and it is high time to compel lenders to put covenants in place that will protect lenders,” Mayra Rodrigues Valladares, a banking and capital markets consultant said.

Banks have taken a hit, offering steeper discounts to get deals across the finish line. Smart & Final on Tuesday priced its B3/B-rated US$340m term loan B at 675bp over Libor and a discount of 90 cents on the dollar, sources said.

Smart & Final, which is using the leveraged loan market to back its purchase by Apollo Global Management, had initially pitched the loan at 650bp over Libor and a discount between 97-98 cents.

To be fair, better-rated deals are getting done without much trouble as CLO demand remains strong while supply has been limited.

Aircraft components provider Wencor, rated B3/B-, on June 13 finalized terms on a US$405m first-lien term loan at 425bp over Libor with a leverage-based step-down to 400bp and a discount of 99 that will refinance existing debt. Software provider Perforce on June 12 also finalized terms on a B2/B- first-lien term loan at 450bp and tightened the discount to 99.5 cents from 99.

“There is a market of ‘have and have not.’ And a lot of reasons why certain deals go through and others do not,” an investment banker said, adding that borrowers in cyclical industries would struggle to complete transactions as opposed to familiar, higher-rated companies with simple refinancing needs or borrowers in high-growth sectors such as technology.

“It’s nice to see the broader market pushing back on riskier credits,” Barings’ Mihalick added. (Reporting by Aaron Weinman. Editing by Michelle Sierra and Jon Methven)

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