In part three of our four-part blog series on cov-lite lending and beyond, we explore loan default risk and recoveries in the era of cov-lite lending.
The European loan market continues to be underpinned by solid market fundamentals: corporate performance is strong, the outlook for M&A-related issuance remains very supportive, and loan defaults are very low.
The average default rate (by value) for the European loan market was 3.8% in the period from 2008 to 2018, based on historical data on default rates for the S&P European Leveraged Loan Index (S&P ELLI).
Loan default rates in Europe
Source: S&P Capital IQ, as at 30 June 2018
As covenant light, or ‘cov-lite’, lending becomes more prevalent in the market, there are concerns that investors will be more exposed to losses, through lower recoveries, when the credit cycle turns.
This is sub-investment grade lending to leveraged companies, so over time, some credit deterioration, leading to downgrades and even defaults, is likely to occur. Defaults could increase due to several factors; for example, weaker credits or non-viable companies that have been artificially propped up by cheap and abundant capital could be vulnerable to a less-accommodative refinancing environment. Similarly, sectors with higher idiosyncratic risk, such as the oil and gas sector, may be vulnerable to extreme cyclicality creating a lack of liquidity and default.
Determinants of recovery rates
To determine what cov-lite means for ultimate recovery in a default scenario, we turned to historical default and recovery experience of the US loan market – being well-established for several decades – which could help us to make useful assumptions about Europe.
We think it is important that lenders remain eternally vigilant but worrying about whether a loan is cov-lite or not may be a false anxiety, assuming that it is made to a strong, large, high-quality company and that the lender has an unassailable priority position in the capital structure, according to the documentation. In our experience, taking a nuanced view of the determinants of recoveries on defaulted loans can help to support this assertion:
Not all loans are created equal – It is important to understand that cov-lite and fully covenanted loans are not alike in terms of quality or size. Until 2017-2018, there has been greater incidence of cov-lite structures for larger, more liquid deals and higher-rated borrowers. Only now is there evidence of increased pressure for investors to consider cov-lite for smaller companies. Not all loan managers will be tempted to invest in small, cov-lite loans.
Equally, not all cov-lite loans will behave the same way in a downturn and certain cov-lite loans – in the right businesses with the right loan managers – should shake out better than average in a default scenario.
Quality of the business and management focus – The sheer size of the companies in today’s borrowing population is higher than that of five years ago and can consist of major industry players or best-in-class companies. The quality of the businesses may be more important than covenants in determining the value of the business in distress and thus the recovery. This encourages investors to dig deeper into a company’s fundamentals and management strategy – for example, to ascertain whether it is a cash-generative business with a ‘reason to exist’. There is an argument to be made that, when management is focused on running a company to meet covenants, its focus on growth is lacking, with excessive energy being expended on lurching from one covenant test-date to another without the ability to run the company for the longer term.
Recoveries are complex especially in Europe – Restructurings are usually privately negotiated in Europe, unlike the well-trodden Chapter 11 route in the US, and can often be complicated and lengthy albeit with similar ultimate outcomes in recovery rate terms. This feature of European restructurings may become particularly important in the era of cov-lite defaults. As the variability of restructuring outcomes widens, we believe that the dedication of specialist restructuring resources is ever more crucial to the management of distressed situations and performance.
The quality of the business, followed by the secured status of the first lien lender is more important, in our view, than covenants in determining the ultimate value of the business and thus the ability to protect capital in a default. However, covenants influence the timing of when a lender can take action and it is acknowledged that ‘the sooner the better’ is typically the maxim for best outcome. Furthermore, in Europe, cov-lite loans may be more likely to stay in the hands of original or ‘par’ lenders until a company has a liquidity crisis. The ability to provide funding at such a time is a critical part of controlling and protecting future value too.
We will conclude this short blog series exploring current conditions in the leveraged loan market, by looking at how to approach cov-lite lending in Europe.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested.