The Treasurer July-August 2007
True impact of covenant lite
Every treasurer knows it is essential to read the small print on any deal. And one set of small print that seems to be causing a lot of angst is that relating to so-called ‘covenant-lite’ provisions. This new development, perhaps predictably, emanated from the highly leveraged markets in the US, but has been seen increasingly in the UK – for example, in the successful KKR bid for Alliance Boots (see The Treasurer, June 2007, page 08).
It may be tempting to worry about the emergence of covenant lite at a time when highly leveraged deals are so prevalent both in terms of numbers and size. But it is reasonable to ask how much the phenomenon is being talked about as opposed to how much lenders and investors are actually allowing issuers to remove traditional financial safeguards.
Following the Treasury Select Committee’s public hearings into private equity, the ACT pointed out in June in a letter to the Chairman of the committee that although covenant-lite loan agreements may be more relaxed than previous practice for highly leveraged loans, significant covenants and restrictions continued to apply. These deals are in some ways more like those associated with (high yield) bonds rather than with bank loans. Many of the non-banks now making such loans are longstanding bond investors and accustomed to that level of provision. The agreements are competitively negotiated.
On the other hand caution would be sensible. So far, 2007 has been a peak year for corporate mergers and acquisitions by private equity. The appetite for deals seems undiminished and as KKR/Alliance Boots is Britain’s biggest private equity deal to date it can hardly be dismissed as an irrelevance.
In a recent speech, Paul Tucker, the Bank of England’s Executive Director for Markets and a member of the Monetary Policy Committee, pointed to the Bank’s financial stability reports, which have drawn a distinction between a ‘fast fuse’ risk, in which credit is abruptly repriced, and a ‘slow fuse’ risk, in which cheap credit leads over time to overleveraged borrowers and so to vulnerability to a deterioration in the global economy.
He noted: “As time passes, attention has perhaps been shifting to the longer-fuse risk, given signs of a pick-up in aggregate corporate sector leverage and gradual dilution of covenants in loan terms and conditions, most obviously recently in so-called ‘covenant-lite’ transactions in the leveraged loan market.”
Treasurers might perhaps agree with Tucker’s analysis. For a long time treasurers have benefited from a benign debt market, with banks aggressively offering debt which historically is cheap and on high multiples. It doesn’t necessarily follow that these credit conditions will lead to disruption in the overall markets but everyone involved in leveraged deals needs to be aware of the potential impact of adding covenant lite to the mix.