Leveraged loan investors have a new risk to worry about: They could end up lending money to an entirely different company.
Broadly syndicated loans to below-investment-grade U.S. companies typically have what’s known as a change of control provision. In the event the company is acquired by another company, it must refinance or pay the debt. Recently, however, several new issues have come with "portability" provisions that subvert this assumption, according to Covenant Review, an independent credit research firm. This could result in investors suddenly holding the paper of a company with a different owner and/or management team, and, potentially, a different credit profile.
Referred to alternatively as portability (because the capital structure can be carried from owner to owner) or "precap" (because the new owner buys the company already capitalized), the concept “boils down to carveout in the change of control provision,” Covenant Review warned in a report published last week.
Though still fairly unusual, such provisions were included in five U.S. leveraged loan offerings in the fourth quarter of 2017: ABILITY Network, Mitchell International, PSSI, Varsity Brands, and Wheelabrator Technologies, Covenant Review said, citing reporting by LevFin Insights.
“Unfortunately, due to the overall rarity of precaps, many investors continue to lack the basic understanding of what to look for in change of control provisions,” Covenant Review's report stated.
There are two reasons a change of control normally results in prepayment of loans. The first is that a change of control is normally considered to be an event of default under a traditional New York law-government credit agreement. (That’s in contrast to an indenture for a typical high-yield bond, in which a change of control is considered an offer to prepay.)
The second is that leveraged loans are commonly repaid at par, or face value, at least after an initial “non-callable” period of six months or a year has passed. And leveraged loans are in such hot demand that most trade above par. So it’s less costly to take out secured debt upon an acquisition that it might otherwise be.
For now, at least, precaps are not a free for all. They come with terms and conditions are generally intended to protect investors by ensuring that a sale carved out from change of control does not reduce the overall credit quality of the company and that the new owner is substantially comparable. The conditions include a sunset, which allows a permitted change of control within a limited time period; a leverage compliance test, which limits the amount of debt a company can have on its balance sheet; and provisions that the buyer meet certain conditions, among other requirements.
In addition to evaluating the terms and conditions of precaps, Covenant Review recommends that investors consider how a precap may affect other kinds of covenants deal documents may contain that are designed to protect them. There are two types of covenants, those that require the borrower to fulfill certain conditions (a specific ratio of cash flow to debt or total debt) and those that forbid the borrower from undertaking certain actions (diverting cash or selling certain assets). Over that past couple of years, strong demand for leveraged loans has allowed issuers to remove covenants or significantly erode them.
Precaps can further erode these investor protections, Covenant Review warned. In some cases, for example, precaps will alter the conditions required for an allowed exception to covenants known as a "basket" in a way that is favorable to the borrower.
While precaps are still a relative oddity in the U.S. loan market, Covenant Review believes that the practice bears watching. "Unlike many of the more esoteric provisions negotiated by issuers where flexibility is theoretical or academic, borrowers and [their private equity] sponsors have actually exercised the precap in a number of cases," the report stated.