The mid-March launch of a 975 million ($1.32 billion) refinancing for VNU World Directories set the ball rolling for what European loan market players expect to be a growing trend in Europe: That of the covenant-lite loan.
The feature has been part of the U.S. loan space for a while, and now it is starting to gain ground in Europe as well. On April 10, Citigroup and BNP Paribas launched a $840 million, cross-border covenant-lite recap for Culligan Finance Corp., and last Wednesday, BNP Paribas and JPMorgan launched the first new-money covenant-lite loan in Europe for Trader Media Group, consisting of a an 800 million sterling institutional loan and a 35 million sterling revolver.
Ahead of the deal's debut, there was significant interest from investors, said Charlotte Conlan, head of leveraged syndications at BNP Paribas in London.
"The fund market in Europe is very robust, and so long as investors are comfortable with the underlying business and consider the structure appropriate, they will do covenant-lite deals," Conlan said. "There will definitely be more such transactions to come."
The emergence of covenant-lite loans in Europe is a direct consequence of the continuing appetite of investors such as institutional funds, hedge funds and CLOs to invest in leveraged loans. Leveraged buyout activity remains strong and, encouraged by current investor demand, many sponsors are looking to improve the terms of their bank loan deals so that they more closely resemble what sponsors are currently able to achieve on their capital markets deals, said Alan Rockwell, a partner at law firm White & Case in London.
"Many investors these days are active in both the high yield bond market and the bank loan market. So they are more familiar with the typical covenant packages that you see in the high yield bond market and are therefore more comfortable in accepting the more limited protection that these covenant packages offer," Rockwell said.
Yet while the European covenant-lite deals currently in the works are no doubt likely to succeed given the energy in the market, there are some who feel the phenomenon may be short-lived and will disappear when the credit cycle turns.
"Currently there is no indication that investor appetite in leveraged loans is decreasing, and there is no indication that the market is about to cool off," Rockwell said. "However, whilst covenant-lite deals will remain a feature of the European market in the short term, in the longer term the ability of sponsors to agree to these types of covenant packages in bank loan deals will be linked to investor demand and available liquidity in the market."
Indeed, the covenant-lite wave is largely the result of the exponential rise in the number of non-traditional investors in the European loan space, said David Bassett, global head of loan markets at Royal Bank of Scotland in London - investors who, unlike the loan investors of yore, are "willing to do whatever is hot at the moment."
With a covenant-lite loan, investors lose their early warning signals in the form of maintenance financial covenants and thus their ability to bring an issuer to the table and set right any potential problems. Similarly, looser covenants reduce the effectiveness of those early warning signals, said Michelle De Angelis, senior director of leveraged finance at Fitch Ratings in London. In covenant-lite deals with only incurrence financial covenants, so long as a company doesn't draw down any new debt, it can perform poorly without breaching its lending agreements.
However, the deals that have come to the European market thus far have not been at the lowest end of the credit spectrum, so the weaker documentary protection is perhaps balanced in investors' eyes by, relatively-speaking, less financial and operational risk, De Angelis said, at least for the time being.
Covenant-lite deals like the VNU transaction and an 850 million Swiss franc refinancing for airline catering company Gate Gourmet are indeed either higher quality or less levered, BNP's Conlan said, reflecting the fact that although the loan market is still skewed toward issuers, investors in covenant-lite transactions do want to be compensated for the concession in some way.
The covenant-lite structure is also likely to figure more in larger deals such as the VNU World Directories transaction, said Pablo Mazzini, director of leveraged finance at Fitch Ratings, deals where secondary trading is assumed more active. As such, the control will most likely be shifted to the market in those deals, meaning that CLOs and other investors will get their early warning signals from the quotes in the secondary market and not from the company's monthly or quarterly financial reporting, Mazzini said.
Whatever be the case, there is no denying that the covenant-lite structure has made its debut in Europe, and according to market rumor, an 11.1 billion sterling deal for private equity consortium KKR and Pessina's buyout of Britain's top drugstore chain, Alliance Boots, is to be in part financed by a covenant-lite loan.
Although the going seems good for now, the real test for these deals will come when defaults start to affect European leveraged transactions that feature covenant-lite structures, Rockwell said.
"The covenant-lite loan, like the second-lien loan, has not yet been tested in default and restructuring scenarios," he said. "While nobody yet knows exactly how this will affect deals featuring covenant-lite packages, it's evident that the options for restructuring on these deals are likely to be much more limited, because lenders on these deals will only be able to force a borrower to renegotiate the terms of its bank loans at a much later stage in the process, when payment defaults have occurred. Accordingly, borrowers may have no alternative at that stage but to file for formal insolvency."
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