Covenant-lite: The default crisis that never happened. Will it now?

Commentary about business and finance.
Feb. 22 2011 5:35 PM

Corporate Subprime

The default crisis that never happened.

(Continued from Page 1)

Some cov-lite boosters like Tony James, the president of private equity giant Blackstone, argue that that covenant-lite loans have proven to be less risky than regular loans. In a Feb. 3 call with investors, James said that the cov-lite structure "helps preserve enterprise value. It helps preserve jobs. It's good for the economy. It is good for the sponsors, but it's also good for the creditors, and it is also good for the employees of these companies." The argument is that without covenants, trigger-happy lenders can't step in and dismantle a company at the first sign of problems. Instead, they have to work with management, often extending the terms of the debt, for the benefit of all. In effect, James's argument is that borrowers are smarter, better managers than lenders are. 

The Fed's stunning largesse means that the jury is still out on James's argument. It also means that in some key ways, we're right back where we were in 2006 and 2007.  Interest rates are very low, meaning that yield-hungry investors are reaching for risk. According to an index of high yield bonds tracked by Credit Suisse, the yield on risky debt is a record low 6.86 percent, down from more than 20 percent at the height of the panic in March of 2009. Retail investors are pouring money into high yield bond funds—$6.7 billion so far this year, according to the Wall Street Journal. That's half the inflow for all of 2010.

There are other similarities between the credit bubble and the current credit market. Banks still want to please their biggest clients, the private equity firms. And CLOs are once again a brisk market for whatever higher-yielding debt that can be found. That's because CLO managers aren't paid to have cash on hand, and all that refinancing of risky debt has resulted in an inflow of cash. They have to invest the money somewhere—and in order to justify the existence of the CLO in the first place, it has to be somewhere that offers a decent yield.

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So is it surprising that, according to S&P, more than 25 percent of first-lien loans (those that have the first call on a company's assets) issued in 2011 have cov-lite structures? The $8.8 billion in such issuance so far this year already tops the total for all of last year, and it isn't even March. Among the private equity deals that used cov-lite loans are the buyouts of Del Monte and J. Crew, according to market participants. "Investors want yield any way they can get it and are willing to take less and less protection to get it," says one hedge-fund manager.

There's some reason to be sanguine about this. If, indeed, we're having an economic recovery, then it's in the early stages, meaning that debt issued now has a better chance of being paid off than debt issued later in the cycle. The prices on private equity deals aren't crazy, so the debt levels might be manageable. And the Fed is showing no signs of raising interest rates, meaning that risky assets should continue to perform well.

Then again, if you're a pessimist—or a rationalist—this might give you some pause. As Pesikoff, a fellow Williams College math major, reminds me, and as any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky. The fact that the Fed rode to the rescue doesn't necessarily mean that cov-lite loans were a good risk to begin with. You also might see in the desperate hunt for yield some uncomfortable parallels to the bubble years. Weren't we all supposed to have learned that too much debt is bad for us? Whether the cov-lite deals getting done right now will face a day of reckoning is anyone's guess. But at the very least, these deals strike me as a sign that some kind of reckoning is in store. I hope I'm wrong about that.

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