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NEW YORK Companies including drywall and building materials manufacturer Continental Building Products are including exceptions in US leveraged loan credit agreements that could bypass auditors’ opinions and make it harder for banks to declare a default.
These ‘going concern’ exceptions are a sign that lender protections are continuing to erode as companies take advantage of liquid market conditions and a lack of deals to win more favorable borrowing terms.
The exceptions could prevent lenders from calling a default if auditors say that a borrower may not be able to meet its financial covenants in the next 12 months, according to regulatory filings.
Lenders are seeing this as further curbing their ability to correct problems quickly and may mean that they are unable to limit companies’ access to cash before covenants are breached.
Including going concern exceptions “removes a key lever lenders had on the ability to call an event of default,” said Enam Hoque, an analyst at Moody’s Investors Service.
Covenants are sets of tests that borrowers have to meet. They often give the first indication that companies may be in trouble and offer lenders a chance to revise credit agreements and increase pricing to compensate for higher risk.
Many US leveraged loans are now ‘covenant lite’ as the tests have been stripped out of loans in recent years, a development regulators see as a sign that prudent underwriting practices have deteriorated.
In the most recent Shared National Credit, an examination of the largest syndicated loans, regulators said credits still had “ineffective or no covenants.”
In the first nine months of the year, about 60% of institutional loan volume, US$160bn, was covenant lite, compared to 25% in 2007, according to Thomson Reuters LPC data.
The Office of the Comptroller of the Currency (OCC) “and other regulators have highlighted concerns regarding the weakness or lack of covenants in leveraged lending," said Bryan Hubbard, an OCC spokesman.
Spokespeople for the Federal Reserve (Fed) and the Federal Deposit Insurance Corp (FDIC) could not immediately comment.
Loan credit agreements require companies to deliver financial statements without any qualifications that are often called clean audit opinions, according to Jed Zobitz, a managing partner in the corporate department at law firm Cravath, Swaine & Moore.
Auditors can include a provision that says they are not completely confident a company will be able to function as a going concern in the next 12 months.
Lenders may able to call a default if auditors include a going concern qualification in their opinion, as this often violates an affirmative covenant regarding delivery of financial statements, said Jeff Ross, a partner in the finance and private equity group at law firm Debevoise & Plimpton.
“It used to be very straightforward, a [borrower] couldn’t have any going concern delivered with its annual financial statement,” said Ian Feng, an analyst at Covenant Review.
Private equity firms are taking advantage of strong market conditions to win concessions. Sponsors are asking for exceptions, first for upcoming maturities and then for potential financial covenant breaches, Feng said.
The August credit agreement for hotel operator Extended Stay’s loan includes exceptions to going concern opinions relating to an upcoming maturity date and a potential inability to satisfy any financial covenant, according to filings.
Food manufacturer AdvancePierre’s June credit agreement includes similar exceptions, the filings show. Spokespeople for the companies could not comment.
Lenders can still call a default with going concern exceptions in place, but only after companies breach covenants. This could allow troubled companies to increase their leverage by drawing down revolving credits, which are typically barred by a default.
The additional leverage “ultimately increases risk for lenders and loan investors,” Hoque said.
However, proponents of the exceptions, which include private equity owners and some investors, think lenders should not call defaults before maintenance covenants are breached as a company’s financial position could improve after an auditors opinion is released.
The Fed, the OCC and the FDIC said in updated leveraged lending guidance that leverage levels of more than six times “raises concerns.”
Total leverage for large buyouts was 6.02 times in the first nine months of the year, down from 6.18 times in 2013 when the guidance was issued, according to LPC data.
More borrowers are expected to ask for going concern exceptions going forward, to lenders’ dismay.
Going concern language “has traditionally been viewed as an opportunity to get management to the negotiating table and to the extent you don’t have that, it’s not a helpful thing,” said Jonathan Insull, a portfolio manager at Crescent Capital Group.
(Reporting by Kristen Haunss; Editing By Tessa Walsh)