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Financials

Virus puts cov-lite loans to the test

LONDON, March 27 (LPC) - As the coronavirus crisis escalates, covenant-lite loans are set to be put to the test for the first time en masse as swathes of borrowers face a liquidity crunch and stress to the bottom line, leaving investors virtually powerless to react.

In the last financial crisis, covenanted loans enabled lenders to step in as soon as a business started to turn sour. While covenant-lite loans were a rarity in Europe then, they have been in steady rise since 2015 when investors started giving away their rights by putting more power in the hands of sponsors and borrowers in a bid to compete with the high-yield bond market.

Covenant-lite loans, which lack traditional covenants such as leveraged, interest, cashflow and capex ratios, dominate Europe’s syndicated leveraged loan market and in some cases have even crept down into the middle market.

Coronavirus has brought most economic activity to a halt as countries across the globe imposed lockdown to contain the spread of the virus impacting leveraged loan borrowers across a wide number of sectors including chemicals, cinemas, cruise operators, retailers, events and restaurants.

BREATHING SPACE

While debt investors will have little engagement with portfolio companies regarding any financial damage caused by the virus, many bankers consider such breathing space as necessary in the current market situation.

“The covenant-lite structure may save the market,” said a senior banker. “At the moment, management aren’t being disturbed by covenant issues and they can focus on keeping business alive.”

If the impacted credits recover well, sponsors will feel more strongly toward covenant flexibility than leverage levels or pricing going forward, analysts said.

“This crisis is a real test case for covenant-lite. If credits recover, then sponsors will emphasise the necessity of such flexibility,” said Edward Eyerman, head of leveraged finance at Fitch Ratings.

“In contrast, if recovery does not develop meaningfully then we will have fully drawn defaulting and zombie credits. In that case, banks and debt investors will drive a harder bargain on underwriting terms.”

Still, the bargaining power of investors will also be determined by market technicals.

“It’s a supply and demand exercise,” said an investor. “If you still get ample liquidity, sponsors still could win whatever terms they want.”

TRIGGER HAPPY

Any autonomy gifted to borrowers through covenant-lite loans won’t last long however once borrowers draw down revolving credit facilities at certain levels because that could trigger a maintenance covenant. Then, a borrower’s leverage ratio will get tested regularly.

“We are seeing borrowers draw down their RCF, so that the springing financial maintenance comes into effect. This gives the RCF lenders rights to get access to the firm once borrowers breach the covenant,” said Lisa Gundy, a vice president and senior covenant officer at Moody’s.

Still, only RCF lenders are entitled to such rights, not the other lenders who are holding the term loan B paper.

“It is worth monitoring how it plays out if borrowers get caught in breaching the covenant,” said Gundy. (Editing by Claire Ruckin and Christopher Mangham)

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