In the private room of an upscale cocktail bar in London’s West End last month, the head of one of Europe’s largest managers of specialist loan vehicles gave a triumphant speech.
The speaker noted that the crowd was the biggest the firm’s annual party had ever drawn, the room packed with bankers and lawyers involved in the creation of collateralised loan obligations, which bundle higher-risk corporate loans into securities.
He concluded by addressing the elephant in the room: a big sell-off in risky loans at the end of last year. But he assured the audience that a significant pick-up in defaults was not on the horizon.
“After all, how can we have defaults when we don’t have any covenants?” he quipped.
While laughter spread round the room, some of it was awkward. The joke underscores growing tensions in the European market for leveraged loans, where companies already carrying lots of debt tap the market for more. The asset class has been buoyed by a flood of new money in recent years, much of which ends up invested in “CLO” structures.
But that influx has come at the expense of protections for investors that were once considered sacred. And some fear that the historically conservative European market is now spawning issuer-friendly features unknown even on Wall Street, such as curbs on which funds investors can sell their loans on to.
“There’s definitely some key areas where terms have been stretched further in Europe,” says Luke McDougall, a London-based partner at law firm, Paul Hastings.
The speaker in the cocktail bar was alluding to the steady rise of “covenant-lite” loans, which lack once-customary investor protections requiring borrowers to maintain key financial ratios, such as keeping total debt beneath a certain multiple of operating profits.
While covenant-lite loans were a common feature of the most aggressive US leveraged buyouts signed at the peak of the last credit cycle, they were virtually absent in Europe. Even in 2007, only 7 per cent of European leveraged loan issuance lacked these protections, according to data from S&P Global’s LCD. Now it has become rare for leveraged loans to have any “maintenance” covenants at all. Last year 88 per cent of such loans across Europe were covenant-lite.
One banker says that the situation is exacerbated by the greater number of banks competing to underwrite leveraged buyout deals in Europe. That makes it easier for private equity firms, which commonly issue these riskier loans to fund their takeovers of companies, to drive a “race to the bottom” in terms.
Regulators have done little to tame banks’ appetite for underwriting the riskiest of deals. While the European Central Bank introduced guidance on leveraged lending in 2017, the average multiple on European buyouts has increased since then, according to LCD data.
The ECB’s guidance said that deals with total debt to earnings before interest, taxes, depreciation and amortisation in excess of six times should be “exceptional”, and that this threshold should also take account of any subsequent debt that can be taken on by the company. But this second part is in effect unworkable, say analysts, given how much latitude loans now give to borrowers.
“If you followed the guidance to the letter, it would effectively mean you could not do any large-cap leveraged finance transaction,” says Carol Van der Vorst, a partner at Ropes & Gray in London.
Further, while European loan documents are still governed by English law, the language underpinning many loans is now lifted from high-yield bond documents written in New York law — terms that are untested in Europe in the event of another wave of restructurings.
The Debt Machine
Lenders outside conventional banking are helping companies get further into debt. What will the consequences be as the economy tilts towards recession? This series will look at the following issues
Mapping the ecosystem
How investors are losing out
CLOs: the debt machine’s engine
The private debt flood
The legal labyrinth of leveraged loans in Europe
“A big question is how these documents will be interpreted in the next downturn,” says Richard Hodgson, a partner at Linklaters.
Covenant specialist Xtract Research notes more than half of European loan documents fell under this category in the second half of 2018, up from just 10 per cent two years earlier.
Another big risk is that the European loan market has not matched Wall Street’s standards of trading and liquidity. Jonathan Butler, head of European leveraged finance at PGIM Fixed Income, a $730bn-in-assets fund manager, notes that it commonly takes 20 days for loan trades to settle in Europe — compared with three to five days in the US.
Private equity firms in Europe also tend to place more onerous restrictions on who investors can sell their loans on to, by supplying so-called “white lists” of acceptable firms. Adversarial investors — such as litigious hedge funds — are often excluded.
Europe has even seen deals where white lists are enforced even after a company defaults, a trend one CLO manager describes as “outrageous”.
One investor said the acceptance of white lists in Europe simply reflected a clubbier nature, describing Europe as “the Annabel’s of the loan market”, in reference to London’s famous private member’s club.
In contrast, one banker describes private equity firms’ use of white lists as a “form of blackmail” that European loan investors had learnt to “rationalise”.
“It’s a stick that’s threatened against them,” he says. “If you get in a fight with a private equity sponsor, in a market that is dominated by their deals, you could be blocked off the white list. So they live in fear.”
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