LONDON (Reuters) - Looser covenants on the debt packages backing leveraged buyouts may actually reduce the risk of defaults, said William Jackson, managing partner of private equity firm Bridgepoint Capital.
Eager lenders have allowed private equity funds to extract easier terms on the debt they use to fund buyouts, with U.S.-style “covenant-lite” deals being used in recent European financings for VNU World Directories and classified ad group Trader Media.
That has raised eyebrows in the debt markets, which have long been used to strong covenant packages that allow lenders to step in when problems appear in order to protect their interests.
It has raised concerns that the looser standards could let companies get too deep into trouble before warning flags are raised, particularly when leverage levels have reached dizzying heights.
But Jackson argued that absolute leverage levels are largely irrelevant and looser covenants could allow companies to trade through trouble, reducing defaults.
“Covenants themselves are where risk lies, not the actual amount of debt,” he told the Reuters Hedge Funds and Private Equity Summit on Thursday. “Fundamentally, leverage is not the cause of problems in businesses.”
His view contrasts with that of John Sainsbury, the former CEO and life president of the eponymous supermarket chain, who said on Wednesday that he opposed a 10.1 billion pound takeover by CVC Capital Partners because the large amount of debt involved would weaken the company in the long term.
Jackson argued lending standards were more important. “What has a big impact is covenants. You can have an underleveraged deal that has very tight covenants (where) if there’s a slight downturn in trading, it’ll start to mean that there’s a cashflow problem for the business,” he said.
“What ironically has happened in this cycle is that in the last year, covenants have been lighter, which actually provides a slightly better risk environment than was the case 12 months ago,” he said.
“The real exposure arises if you get into the situation where the banks pull the credit and the asset gets sold and the banks take a write-off,” Jackson said. “To the extent that they don’t have the ability to pull the credit, then the asset will remain there and trade through.”
Covenant packages on LBO financings have typically included three major maintenance covenants that test companies’ leverage levels, interest cover and cashflow cover. They also place restrictions on capital expenditure.
Covenant-lite financings remove any combination of these checks and balances and can contain as little as one covenant.
Banking sources said in March that the funding backing the bid for British pharmacy chain Alliance Boots by Kohlberg Kravis Roberts and the company’s deputy chairman, Stefano Pessina, would be structured as a covenant-lite loan.
The loosening of standards has come at a time of historic lows in the global default rate, leading to intense debate over what will happen when the credit and business cycle turns and company failures happen at a faster pace.
“I‘m a great believer in cycles,” Jackson said. “Most cycles last six or eight years, and we’re in year six of a cycle. It’s just a matter of time and that is the biggest issue not just for private equity, but all industries.”