NEW YORK, March 26 (LPC) - Bouts of volatility in the US$1.2trn leveraged loan market has given lenders clout to push for heightened credit protections, including quarterly discussions with borrowers, which were eliminated as demand for loans soared in recent years.
Besides the traditional quarterly financial reports with debt providers, companies previously held formal calls where investors were able to ask questions about a borrower’s finances. As demand for these floating-rate instruments grew with the expectation that loans would serve as a hedge in a rising interest-rate environment, borrowers’ influence grew in tandem. This allowed companies in the last few years to reduce the number of such calls to once annually or do away with them completely.
Hospital operator LifePoint Health, construction company Infrastructure & Energy Alternatives (IEA) and electric generation plant Carroll County Energy were among companies that since November were required to add quarterly calls to obtain financing, according to sources.
Volatility in the credit markets in December and January, as well as mounting fears of a looming slowdown in the global economy, shifted the pendulum back to investors who demanded to be better compensated for their risk. Among their requests was reopening lines of communications that had been shut.
The number of credit agreements for public companies that required an annual or quarterly call or a meeting with management increased to almost 30% in 2018, up from 21% the prior year, according to data compiled by Moody’s Investors Service. Quarterly calls were previously the norm.
With the majority of loans lacking full lender protections called covenants – 81% of loans arranged in 2018 were covenant-lite, according to LPC data – investors’ visibility on potential credit issues has been removed, thus the ability to get information directly from the company can become more valuable.
When markets do turn, a call “gives the syndicate guaranteed access (to management),” said Jessica Reiss, head of leveraged loan research at Covenant Review.
Former Federal Reserve Chair Janet Yellen, Bank of England Governor Mark Carney and Senator Elizabeth Warren have all expressed concerns about leveraged loans, with the later even likening the asset class to the subprime mortgage market that contributed to the 2008 credit crisis.
The White House warned in its 2020 fiscal-year budget that leveraged loans are a risk to the economy, noting “care must be taken that excessive leverage and risk do not reprise the mistakes of the 2000s,” according to an analytical perspectives document accompanying the proposal.
Loan defaults remain low, mainly due to covenant-lite structures – 1.75% at the end of 2018, according to Fitch Ratings. However, when defaults start to rise, lenders will want more communication with their borrowers, as the lack of lender protections may lead to lower recoveries.
First-lien loan recoveries are forecast to be about 61% in the next downturn, down from the average historical recovery of 77%, according to Moody’s. Recoveries for second-lien loans are forecast to be just 14%, down from the average historical rate of 43%.
“It is important for loan investors to maintain a working relationship with the management team or private-equity owner for their own credit monitoring,” said Enam Hoque, a vice president at Moody’s. “These covenants (requiring calls) will become even more important when the cycle turns and problems arise.”
IEA added quarterly lender calls to a financing package it sought late last year to back the acquisitions of Consolidated Construction Solutions and William Charles Construction, LPC previously reported.
Carroll County Energy added quarterly calls as a requirement for new debt it sought in February to refinance existing credit facilities and pay a distribution to its shareholders, according to a second source. LifePoint in November included quarterly calls when it reworked financing to back its buyout by private-equity firm Apollo Global Management, according to a third source.
An IEA spokesman declined to comment. Calls to the other companies seeking comment were not returned.
While some companies have been forced to add quarterly calls, it is still a small subset of the loan population that requires the more frequent communication. As the market turns back to favor borrowers, quarterly calls may go by the wayside. But for now, the additional question and answer sessions are welcomed by lenders.
“While loan investors have very little direct recourse against a borrower, at least they will have information,” said Hoque. “This is not a substitute for financial covenants, but it is a positive development.” (Reporting by Kristen Haunss and Jonathan Schwarzberg; Editing by Michelle Sierra and Jon Methven)