Alert on leveraged loan terms; Big buyer Eaton Vance warns of growing risk of piling on debt

March 31, 2014 4:10 pm

Alert on leveraged loan terms

By Stephen Foley and Tracy Alloway in New York

One of the biggest buyers of US leveraged loans is sounding the alarm over unusual new terms being jammed into deals, increasing risk in one of the hottest investment areas of recent years.

Eaton Vance, the US fund management group, says company owners are seeking – and increasingly being granted – extra freedom to pile on more debt in the future without recourse to existing lenders.

The changes further shift the balance of power towards borrowers in the leveraged loan market. Regulators are already concerned that the majority of new issues are “covenant-lite”, meaning they do not carry many historic protections for investors.

Eaton Vance has a name for the increasing prevalence of additional borrower-friendly provisions: “cov-lite 2.0”.

“As the market stays hot, attorneys for the issuers just can’t help themselves,” said Andrew Sveen, director of bank loan trading at Eaton Vance, which has $44bn invested in leveraged loans out of $279bn under management.

“We are fighting battles every day. We really have to be the policeman, to read the fine print, because slight adjustments can drive big holes in these agreements.”

Worrying new terms cited by Eaton Vance include expanded “freebie incremental debt” provisions which allow companies to incur additional amounts of first-lien debt after securing a loan.

Investors countered by demanding “most favoured nation” terms that would reset their own interest payments to the same level as the newer debt, but borrowers have also started to withdraw this concession. Debt issues by CRC Health and Multiplan last month set a time limit after which the most favoured nation rule will not apply.

“Sidecar” provisions, which allow a company to take on extra debt for specific purposes, are also turning up more commonly, Eaton Vance says.

“This is how you start sliding down that road: something becomes a precedent, and then it gets harder to get it out of the next deal,” Mr Sveen said.

Sales of loans made to the riskiest corporate borrowers have surged in recent months as investors clamour for the higher yields on offer from lending to such companies, often private equity-owned. According to Lipper data, flows into loan funds have been positive for 93 consecutive weeks.

US leveraged loan issuance in the past 12 months is $579.5bn, according to S&P Capital IQ, up from $539.5bn the year before and up 65 per cent on two years ago. Demand is also improving in Europe, where cov-lite is becoming more widespread.

Investors appear to have successfully watered down some borrower-friendly ideas, including provisions that allow the issuer to decide who investors can sell the loan to in the secondary market.

Only 10.8 per cent of first-lien loans sold in the second half of last year had disqualified lender lists that could be amended after the deal closed, according to Xtract Research.

“There’s been a fair amount of pushback on that issue,” said Justin Smith, Xtract managing director.

“There is a tremendous amount of flexibility that the borrowers are getting that they typically haven’t gotten in the past,” Vincent Ingato, senior portfolio manager at Zais Group, said at a recent industry conference. “So you’re really not quite sure what you’re lending to from day one.”

Booming sales and looser covenants have drawn the attention of US regulators, who are urging the banks who arrange such deals to be more cautious. While the loans rarely stay on banks’ balance sheets for very long, there is a danger that banks could get stuck with a faulty loan if the market breaks down before they can sell it to investors.