The writer is a former investment banker and author currently working on a book about the rise and fall of General Electric.
Once upon a time it would have been unthinkable — if not career suicide — for lenders to make risky loans without what are called “covenants”. These are contractual protections that, among other things, served as an early warning of a company’s increasing financial distress or that prevented it from borrowing additional money without an existing lender’s approval.
But these days, so-called “cov-lite” leveraged loans are all the rage among borrowers and lenders alike and comprise, by some accounts, nearly 90 per cent of all the riskiest loans issued in the US in 2019.
In our steadfastly low-interest rate environment, driven in large part by central banks the world over, lenders have traded fewer contractual protections and more risk for more reward in the form of higher interest rates. Now the price is being paid for such recklessness. Lenders are facing the inevitable unintended consequences of their foolish risk-taking and greedy behaviour.
Some of their loans are rapidly losing value because companies that issued “cov-lite” loans are struggling financially in the face of pandemic-related economic stress. A further sign of how exposed some lenders are more broadly to a general loosening of credit discipline are several fierce recent battles over fundraisings.
As companies look for additional sources of capital, some are finding that new investors are willing to lend them money by exploiting the weakness in the covenants of the old lenders.
Take, for instance, what happened in October at TriMark USA, a distributor of restaurant equipment and supplies. The private equity firm Centerbridge Partners bought TriMark in 2017 for about $1.2bn. It loaded the company up with $795m of bank debt that was then sold by the banks that underwrote it to investors.
When TriMark ran into financial trouble this year because of the Covid-19 pandemic, it obtained a new $120m loan from a group of hedge funds led by Howard Marks, the savvy founder of Oaktree Capital, and by Ares Management, another clever Los Angeles-based hedge fund.
In making the new loan to TriMark, Oaktree and Ares were able to “prime” the existing lenders, placing the new loan more senior to them in the capital structure and giving the new loan protections the old lenders had previously bargained away.
It was a brilliant tactical move by Mr Marks, who has long been critical of the US Federal Reserve’s willingness to drive down short- and long-term interest rates through its quantitative easing programme. Mr Marks was also sceptical of the Fed’s massive interventions in March and April to provide much-needed liquidity as pandemic concerns hit markets. Mr Marks wanted businesses to meet the denouement that the markets had in store for them, not to be bailed out by the Fed.
“Capitalism without bankruptcy is like Catholicism without hell,” he wrote in an April blog post. “Markets work best when participants have a healthy fear of loss.”
But rather than try to fight the Fed, it’s clear in the TriMark case at least, that Marks decided to teach “cov-lite” lenders a lesson. As news of the new $120m TriMark loan hit the market, the value of TriMark’s existing debt plummeted; one of the existing loans was reportedly trading at around 20 cents on the dollar, a loss of 80 per cent in a matter of days. That hurts.
TriMark is not the only example where the value of “cov-lite” loans has been decimated as a result of getting primed by new lenders. A similar dynamic occurred with a recent $200m loan for mattress maker Serta Simmons, owned by Advent, another buyout firm.
The mutual funds Eaton Vance and Invesco provided the new financing and agreed to restructure their existing debt to Serta Simmons, effectively priming others of the holders of the same “cov-lite” loans. The hedge funds sued to stop the priming but lost in court, since Serta Simmons “cov-lite” terms permitted such a possibility.
The same thing happened with Boardriders, a surf clothing company owned in part by Oaktree. Boardriders recently negotiated a new $135m financing, a piece of which had priority over other of the company’s lenders which did not participate in the new loan.
Some have described these battles as a “civil war” between lenders. But what is actually happening is a correction in the loan market after years of perverting the well-established rules of credit analysis. It’s a long overdue puncturing of yet another credit-related euphoria. What remains unfathomable is why the lessons never seem to be learned until it’s too late.
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