Cov-Lite is Catching on in Europe's Leveraged Loan Market

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A combination of loosened covenants, minimal call protections and aggressive, U.S.-style “dry powder” leveraging strategies have produced the most sponsor-friendly market for European leveraged loans since the financial crisis, according to a new report from U.S.-based Covenant Review.

The growing advantages for borrowers is most keen through institutional term loan Bs, which increasingly benefited last year from fewer maintenance restrictions and cheaper pricing to overtake high yield bonds as “the leveraged finance instrument of choice” for sponsors, the report stated.

“The move towards cov-lite loans with bond-style restrictive covenants containing far broader incurrence-based flexibility has continued unabated,” even as draft leveraged lending guidelines from the European Central Bank were placed on the table, stated analysts Jane Gray and Manisha Gayaparsad, in the report issued this week. 

This move favoring TLBs over bonds is exemplified in a wave of bond-to-loan refinancing trends, a “natural consequence” of lightened covenants that have encouraged borrowers to shift to more flexible loan structures, including those credit profiles with no history of producing bond yields or minimal annual earnings.

Among the primary concerns raised by Covenant Review's report is the fewer limits European companies face in adding leverage with lender or investor consent.

“[T]oday’s cov-lite deals not only include a flat leverage test for the benefit of the revolving facility lenders only, but numerous credits in Q2 2016 have also allowed for well over a turn of extra leverage under capped permitted debt carveouts,” the report stated.

The addition of "U.S. style" cash reserves (or “dry powder”) from voluntary prepayments and debt buybacks under facilities are allowing European firms to add debt beyond ratio test limitations under cov-lite conditions, creating baskets for such purposes as funding dividends without a "look-forward" covenant compliance test, and "have been permitted to be drawn at any level in the capital structure” as alternative debt in a sidecar financing or under a ratio-based debt carveout.

“Sponsors can now incur material future debt outside the purview of the financing documents, and the debt can take any form, including bonds and unitranches,” the report stated. Such debt can be placed in a favorable capital structure position over unencumbered assets, as well – in ways that can even exceed traditional U.S. sidecar finance allowances that are limited to debt of obligors and secured by collateralized assets.

“Perhaps unsurprising in large cap deals, these provisions have now also become common in deals with an opening EBITDA of €100 million and below,” reminiscent of 2007 financings, the report stated.

Soft call protection remains “minimal” in Europe, usually standardized at six months at 101 of par. This protection has been “fundamentally weakened” with repricings that allow borrowers to pay down premiums that reduce investor payouts. In addition, call protection provisions are now excluding change-of-control or other “transformative” transactions that leave lenders with an “eviscerated” position.  

Covenant Review also noted the proliferation of higher covenant-release provisions that allow the suspension of maintenance requirements upon a certain net leverage level. That level has increased to a 3.5x level in most European credits, and as high as 4.25x in one “outlier” deal – allowing now only the “standard covenants” to fall away “but also the security and additional guarantees related covenants.”

This covenant suspension trend includes speculative-grade firms, the report notedl.

Covenant Review believes these and other loosened covenant trends for European senior loans will continue into 2017. Absent adjustments in macro-economic technicals or a "wholesale investor pushback,” there is “no reason for a reversal for this trend in the short to mid-term.”

The ECB draft guidelines for high-leveraged transactions were introduced in November. Public hearings are scheduled this month.

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