LONDON, April 24 (LPC) - Exceptionally aggressive documentation gained by sponsors on portfolio companies over the past few years is finally set to be put to the test as borrowers seek to bolster liquidity in the wake of the Covid-19 pandemic.
Loan documentation has got increasingly loose as banks and investors competed for deals amid a supply and demand imbalance that has dominated Europe’s leveraged loan market for the past few years. This has given private equity sponsors a great deal of flexibility to incur additional debt and gifted them a greater control over assets.
Investors are concerned sponsors will use everything in their armoury as companies face liquidity issues, caused by the lockdown.
“The problem is the loose documentation has never been tested,” a debt investor said. “Everybody should assume that sponsors will take advantage of all baskets and loose documentation points if they need to inject money or find securities to back new money.”
Under ‘freebie baskets’ in most loan agreements, borrowers are allowed to incur equally ranked additional debt, without an approval from existing lenders.
“We are seeing sponsors begin to use it. They are either looking to use it through further bank borrowings or potentially looking to provide senior debts themselves.” said David Gillmor, sector lead, European leverage finance at S&P Global Ratings.
While additional liquidity is positive for many borrowers, it could prove a negative for many lenders as leverage increases and recovery rates lower.
“The additional debt would inevitably boost the company’s leverage ratio and dilute the position of the senior lenders,” said Gillmor at S&P.
Analysts believe the loan holders would recover far less in this current economic downturn than they have historically.
S&P estimates the average first lien recovery rate in Europe’s leveraged loan market will be around 60% of face value, compared to the 70%-75% recovery rate during the last two cycles.
However, one of the situations that horrifies investors the most is a borrower’s ability to pledge or transfer valuable assets in a bid to lock in extra liquidity.
One of the alarming examples was J Crew Group at the end of 2016. Private equity firm TPG took advantage of a loophole in the US apparel retailer’s debt terms to move certain intellectual property rights into a subsidiary.
As a result of the transfer, the assets no longer served as collateral for the secured loans and instead the transferred assets were used to collateralize new debt issuance and buy back bonds.
In Europe, security packages have also eroded over the last few years. Most of them have a limited scope of assets as collateral and the documentation provides sponsors with flexibility over the control of those assets.
“There are a long list of baskets, carve-outs and provisions buried in 500-page long legal documents. Lenders probably aren’t even aware of how many loopholes there are,” said a lawyer.
However, analysts think sponsors are unlikely to strip out assets for liquidity purposes, due to reputational risk.
“It might be seen by the market as a nuclear option, as no individual private equity firm wants to be the first one to be labelled as the J Crew equivalent in Europe,” said Gillmor at S&P.
In addition, investors said the flexibility that financial sponsors have enjoyed over the years is based on trust and breaking that trust could cost sponsors severely in the future when they return to the capital markets for fund raising.
“Sponsors will need to be really careful how they act because otherwise they will break the market,” said a second investor. (Editing by Claire Ruckin and Christopher Mangham)