When a handful of big Wall Street banks reluctantly funded part of a $26 billion takeover of First Data, a transaction-processing firm, in early autumn, there was jubilation among those eager for any sign that the chaos in financial markets was abating. It did not mean debt would flow freely again, though. Indeed, it marked the first, feeble sign that creditors were regaining the upper hand after years of bowing and scraping to borrowers.
At the end of weeks of wrangling over the terms of the loan, the banks finally managed to squeeze from Kohlberg Kravis Roberts (KKR), a private-equity group buying First Data, a concession helping them make sure that the debt would be repaid. Such “covenants” vary, but the important ones are those that either prevent a company from borrowing too much (known as leverage covenants), or force it to earn enough to pay interest (coverage covenants). These girdles were fairly common until a few years ago. Companies that broke them had to pay a penalty to their creditors or were forced into bankruptcy.
In recent years as liquidity expanded, banks held on to fewer of the loans that they originated, syndicating them instead to money managers such as hedge funds. Borrowers found that such creditors, in their hunger for higher yields at a time of low interest rates, were quite willing to drop safeguards altogether, leading to a surge of “covenant-lite” loans. Because banks held on to fewer loans, they relaxed their guard. According to Standard & Poor’s LCD, a research unit which tracks leveraged lending, the share of non-investment grade loans held by banks in America fell by over 30 percentage points to around a fifth between 2000 and the first six months of this year. In Europe that share fell from over 90% to well under half.
But as the credit markets have slowed and institutional investment has clammed up, banks have returned, keeping more loans on their books. And they have also brought back covenants. It may be too late in some cases — Moody’s, a rating agency, expects the proportion of lowly rated companies that default to rise from 1.3% to 3.5% globally in the next 12 months. But it is welcome nonetheless.
If credit conditions deteriorate, banks and other creditors will be far less patient with erring companies than they were. During the boom, borrowers could often get covenants waived. Not any more. Whereas covenants exist mainly to keep companies on the straight and narrow, they also earn banks a handsome fee each time they are breached. That is an incentive to be tough.
Banks have also sought to stop large borrowers, such as private-equity funds, from funnelling money to companies they own that are in danger of violating covenants. This practice, known as an “equity cure,” was used to give companies a quick bill of health even if the finances were unsound. It is likely to stop. As William May of Fitch Ratings, another rating agency, points out, companies hoping for a prepayment option on any new borrowing in order to refinance their loans at a cheaper rate, will almost certainly have to pay their lenders a premium for doing so. Finally, more exotic forms of borrowing such as payment-in-kind notes, which allowed companies to pay interest in bonds rather than cash, have faded—for now, at least.
The new conditions that the banks finally imposed on First Data after long negotiations with KKR are considered to have been quite lenient. “What we are seeing even now is a mix of the older, more aggressive form of lending coexisting with newer, more conservative types of loans,” says Kristi Colburn, of GE Capital Markets. The liberal regime may not have been toppled, but it is tottering.