Investors look to rating agencies to sanction aggressive loan documents
LONDON (LPC) – Investors are calling on rating agencies to downgrade leveraged loans with overly aggressive documentation as low lender protection continues to cause concern.
Moody’s European Convention quality indicator hit a record high in the fourth quarter of 3.83, the lowest figure since the rating agency created the monitor in 2012. The statistic focuses on high yield bonds, but analysts say the loans are in a similar condition.
Covenant-Lite loans, which offer little protection to lenders, have become the market standard. Several services, including Fitch-owned Moody’s, Covenant Review and Debt Explained, have been set up to analyze documentation and educate investors on individual transactions.
Some investors would like to see rating agencies go deeper into assessing the risks that flexible documentation presents to lenders and demote loans with offensive documents, especially loose restricted payment tests and the ability to collect dividends as soon as possible. first day.
“I think the agencies have talked a bit about the impact of [covenant-lite] and what, according to them, are the recovery rates. Our frustration is that they are talking about a good game, but that is not reflected in the actual ratings, ”said a senior investor.
The flexible document sets raise several unknowns about individual companies and the actions their private equity owners might take in a range of scenarios, and therefore are not heavily weighted in the final rating.
“Our credit ratings are based on analysis of issuer fundamentals, while covenant scores focus only on the documentation details of a specific bond,” said Lisa Gundy, Chief Covenant Officer at Moody’s.
“Covenants, allowing the ability to distribute cash, remove security protection or increase debt, may reflect aggressive financial policy.”
LOST IN TRANSLATION
Financial data firm Refinitiv, LPC’s parent company, scored 4.77 on the Moody’s indicator. It was the lowest ranked alliance package in the European market in 2018 and one of the biggest deals of the year.
The score was related to liquidity leakage, investment flexibility, leverage and structural subordination. The company obtained a B2 / B / BB from rating agencies and tranches of loans in dollars and euros valued respectively at 375 bps and 450 bps above the Libor / Euribor.
Private equity firms place great importance on flexibility in credit documentation. The freedom gives them options to meet high return goals and manage credits in a downturn.
Many have adopted active buy and build strategies with acquisitions that see sponsors regularly tapping into the loan market and investors and lenders are ready to give sponsors flexibility on good loans.
For banks, repeated top-up funding provides a reliable income stream. But the frustration remains that more flexible restrictions are not factored into the ratings.
“If loans with weak documents are issued, they should be rated significantly below what a normal loan would be rated and I hope to see more price distinction on this,” the lead investor said.
The lack of protection of the lenders in the light conventional loans is expected to reach the recovery rates. Recoveries in the leveraged market have been on average less than 60% since 2015, according to Fitch, around the same time that senior debt relative to EBITDA levels rose to 4.5 times-5. times, reflecting the risk of weakening covenants in recent years.
“Based on their own covenants, it is seldom enough to change the default ratings of issuers, which capture the relative credit default risk based on the business model, execution risk and cash flow metrics and leverage, ”said Ed Eyerman, CEO of Fitch.
“Restrictive covenants can also impact collection assumptions, especially if the value of the collateral can be diluted or removed.”
While some would like restrictive clauses to be more integrated into individual ratings, the role of rating agencies in the market makes it difficult to control risk.
“Rating agencies are paid by issuers, so they might be hesitant about that because they are not paid by investors. They are not independent, ”said one analyst.
A second investor said: “I don’t think rating agencies are very helpful when it comes to risk analysis. A rating is a probability of default, and in my opinion, small documents reduce the risk of default. “
An influx of cash into segregated managed accounts on top of the record CLO fund issuance in 2018 – $ 128 billion in the United States and $ 27.29 billion in Europe – means investors have very little margin for cash. maneuver to be more selective on credits.
“Investors have lacked bargaining power over the past few years and they are turning to ratings because they can impact the distribution strategies of arrangers,” Eyerman said.
Few see the trend towards the reversal of loans allocated to restrictive covenants. While the summer saw a number of deals falter on the documentation, hope for a larger shift in market sentiment was short-lived.
But unless there is a blast over an individual deal, many believe market conditions continue to favor sponsors for now, with investors penalized for holding cash and having little opportunity to invest due to a thin pipeline in early 2019.
“Liquidity hunts very few assets. But the most marginal credits will be discovered and the banks will lose money. This will temper the behavior of the banks, ”said one banker.
Additional reports by Yoruk Bahceli; Edited by Christopher Mangham