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Leveraged loans: the unbearable liteness of covenants



Lenders to US companies have made their beds. Now they are proving uncomfortable to lie on. So-called covenant-lite loans place heavy potential burdens on asset managers who flocked to buy the debt during ten years of loose central bank money. Rates are still low. But defaults and bankruptcies are predicted to soar.

Issuers of leveraged loans — largely businesses backed by private equity — have borrowed cheaply. They have faced few restrictions on aggressive asset shuffling or fat dividends.

A new study from Standard & Poor’s Leveraged Commentary & Data reveals the cost. Analysts studied 67 companies that exited bankruptcy between 2014 and 2020. For cov-lite loans, the average recovery was just 65 cents on the dollar. Investors in senior loans with normal covenants recovered 99 cents at the median.

Charts showing Leveraged loans and Covenant-lite share of outstanding US loans

The question now is whether buyers can collectively learn their lesson and become more disciplined, even as interest rates stay glued to the floor.

Covenants — specifically financial maintenance covenants dictating a minimum level of profitability — can benefit lenders in this troubled era. The borrower has to negotiate an amendment with lenders if a violation has happened, or is likely. They can extract fees or other protections to give their principal more protection. In the worse-case scenario, they can foreclose on the company.

Charts showing recovery rate of of outstanding US new-issue US loans

Issuers and buyout firms argue that minimal covenants give them the freedom to engineer a turnround after things go south. But as we have seen in recent years at companies such as Neiman Marcus, loose covenants have allowed owners to extract value for themselves ahead of creditors. More innocuously, by preventing creditors from calling a default, out-of-the-money equity owners can hang on too long. By the time a company finally succumbs to bankruptcy, it is a shrivelled carcass. 

Chart showing New-issue US loan volume

The S&P study only examined companies that filed for bankruptcy and the sample size was limited. On a risk-adjusted basis, investors perhaps fared more favourably. The period in the study was benign, however. In an economy where many traditional businesses are struggling, investors are set to rue their “anything goes” approach — and toughen their stance.

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Rock-bottom rates drive soaring Asian issuance of dollar bonds




Companies and governments in Asia have tapped dollar bond markets at a blistering pace in the opening weeks of 2021, as they take advantage of ultra-low rates to raise funds for acquisitions and cover costs owing to Covid-19.

Issuance of dollar bonds in the region climbed to more than $45bn in the first two weeks of the year, according to Dealogic. That is almost three-quarters of the total amount raised across the whole of January 2020.

“What’s driving the volume is that rates are creating a very opportunistic market for issuers locking in very good long-term funding,” said Ed Tsui, head of Asia-Pacific debt syndicate at Deutsche Bank, referring to rock-bottom US interest rates.

The bumper crop of dollar bonds is set to continue in the coming weeks. Chinese ecommerce group Alibaba is expected to tap debt markets for as much as $8bn this month, according to people directly familiar with the matter.

The surge in issuance comes in spite of predictions that corporate fundraising would slow in 2021 following last year’s record levels.

Among the blockbuster issuance this month was a $2.5bn debt sale from South Korean chipmaker SK Hynix. The dollar bond, the biggest ever sold by a non-financial company in the country, attracted orders worth almost five times the issuance’s size. It will be used in part to finance the group’s $9bn acquisition of Intel’s Nand memory business.

Mr Tsui said low rates had prompted many issuers to refinance their existing debts at longer maturities. “Investors are absolutely opportunistic” and had strong appetite for longer-dated debt, he added.

That demand helped the Indonesian government to sell the 10-year tranche of a $3bn dollar bond this month at a record-low interest rate of 1.9 per cent. The issuance, sold alongside a €1bn bond, will be used in part to fund a Covid-19 vaccination drive in the country of more than 270m people.

In Japan, where bankers have described all recent dollar debt issuance by local companies as heavily oversubscribed, Nippon Life Insurance last week completed a $1.6bn offering of 30-year subordinated notes at an all-time low of 2.75 per cent.

The pandemic, which has had a disastrous effect on the travel industry, has also driven bond issuance from the likes of Singapore Airlines. The carrier, which has been forced to operate at a sliver of its normal capacity, raised $500m from its first dollar debt sale.

Bankers in Tokyo said that dollar bond issuance by Japanese businesses had begun the year at a “very high pace”.

Companies were encouraged, said one banker involved in recent deals, by demand from hedge funds, money managers and private banks — the typical market for dollar issuance in Asia. Big Japanese asset managers, he added, tended to prefer buying such bonds in the secondary market.

In addition to Nippon Life, a combined $7bn of bonds have been sold in January by Toyota Motor Credit, Sumitomo Mitsui Financial Group and the Japan Bank for International Cooperation. All of those offers were heavily oversubscribed.

“From the Asian corporate perspective, the market has continued to be hot and these good supply-demand technicals will continue,” said a senior debt capital markets banker at Morgan Stanley in Tokyo. “Companies will be incentivised to continue issuing in this quarter.”


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ECB threatens banks with capital ‘add-ons’ over leveraged loan risks




The European Central Bank is threatening to impose additional capital requirements on banks that continue to ignore requests to rein in risk in the booming leveraged loan market.

Policymakers are increasingly frustrated by the lack of action to tighten risk controls in the market at some European lenders, which they fear could lead to repayment problems if interest rates rise.

If industry practices do not change, the EU regulator “won’t hesitate to impose capital add-ons” through its annual Supervisory Review and Evaluation Process process, said a person familiar with internal discussions. 

Leveraged loans are junk-rated debt usually used to back or refinance private equity takeovers of companies. Banks keep little of the risk on their own balance sheets and sell almost all of the loans on to other investors.

Fierce competition has led to ultra-low pricing, a softening of underwriting standards and increasing leverage in private equity buyout loans. The use of “covenant-lite” structures — which strip out many of the usual protections for investors — has surged.

In response, the ECB is planning more frequent “on-site” visits — performed virtually during the pandemic — to evaluate banks’ risk management procedures on recent and current deals and adjust their capital requirements accordingly, said the person.

“Where banks incur risks in leveraged lending that are not adequately addressed by appropriate risk management practices, ECB banking supervision is considering supervisory actions and measures, including qualitative or quantitative requirements as well as capital add-ons,” the ECB said in a statement.

Last summer, Deutsche Bank received a request to suspend part of its leveraged finance business because of shortcomings in its risk controls but it refused, the Financial Times has reported.

A senior eurozone central banker said the issue would be raised as a key concern in the ECB’s next financial stability review in May.

Banks have become more aggressive in investment banking as income from traditional retail and commercial lending activities has plunged because of negative interest rates. More recently, they have also had to contend with a surge in coronavirus-related loan-loss reserves.

Supervisors’ concerns have been prompted by changing market dynamics, one of the people said. Indicators suggest that inflation is picking up and once interest rates around the world start to rise, repayments on some of the most aggressive deals could become difficult. Many banks have been pricing loans on the assumption that negative rates will persist for a decade or more, the person said.

In 2017, the ECB introduced guidance that defines “high levels” of leverage as deals where total debt — including undrawn credit lines — exceeds six times earnings before interest, tax, depreciation and amortisation. 

The regulator said that such transactions and covenant-lite structures “should remain exceptional and [ . . . ] should be duly justified” because very high leverage for most industries “raises concerns”. 

Despite these instructions, the ECB found that by 2018 more than half of new leveraged loans by major eurozone banks were already above this threshold.

Deutsche Bank is among banks the ECB has contacted. Despite receiving a letter from the regulator calling its risk management framework for highly leveraged transactions “incomplete,” Germany’s largest lender refused to suspend parts of the business and said it was “impractical” to follow the request. It was not required to do so because the guidance was non-binding.

Deutsche Bank declined to comment.

As it is for many other big lenders, such as BNP Paribas, leveraged finance is a buoyant and lucrative business for Deutsche’s investment bank. It generated €1.2bn of revenues in the first nine months of 2020, an increase of 43 per cent from 2019.

Recent transactions on the riskier end of the scale include a €4.4bn leveraged loan and high-yield bond package for Swedish alarms company Verisure this month. The deal is more than seven times levered, even when using the company’s own heavily adjusted earnings number, and includes a €1.6bn dividend paid out to its private equity owners.

Deutsche is a joint global co-ordinator of the Verisure debt, with BNP Paribas, CaixaBank, Crédit Agricole and Santander also involved.

Another highly leveraged buyout this year is BC Partners’ takeover of US gynaecology company Women’s Care Enterprises. The deal’s overall leverage is more than nine times its ebitda, according to S&P Global Ratings. Deutsche is again a joint bookrunner.

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Wall Street’s new sheriff is on a mission




Financial markets may soon have a new regulatory sheriff. President-elect Joe Biden, who will be inaugurated on Wednesday, is expected to pick the former head of the US Commodity Futures Trading Commission, Gary Gensler, to run the Securities and Exchange Commission. Given that US capital markets are the broadest and deepest in the world, the chair of the SEC is not only the most important market regulator for America but also, arguably, for the wider world. The good news is that Mr Gensler is exactly the right man for the job. 

As a former Goldman Sachs partner who also served in the Treasury department during the Clinton administration, he is a powerful choice in part because he’s a “born-again” regulator.

After 18 years at the US bank, including time in the risk arbitrage unit, Mr Gensler began his regulatory career working with his former boss Robert Rubin, who had been appointed US Treasury secretary. He then became an under-secretary to Mr Rubin’s successor, Larry Summers, who passed the Commodity Futures Modernisation Act. This was the law that exempted credit default swaps, which exploded the global economy during the financial crisis of 2008, from regulation.

But later, as chair of the CFTC under President Obama, Mr Gensler spent a large portion of his time cleaning up the mess that such lack of oversight created. He passed dozens of new rules to increase transparency and reduce risk in the swaps and futures markets — moving faster and further on financial regulation than any of his peers.

Indeed, Mr Gensler almost seemed to see it as his own personal mission of penance. As he told me in a 2012 interview, “Knowing what we know now, those of us who served in the 1990s should have done more [to protect] the derivatives market.”

Democrats usually decry the revolving door between Goldman Sachs and Washington. But Mr Gensler is both beloved of financial reform types and feared on the Street in large part because of his status as a former insider.

“Gary can’t be intimidated, and he’s usually smarter than you are,” says Dennis Kelleher, president and CEO of Better Markets, a non-profit financial reform organisation. “He’d call baloney on arguments that didn’t withstand scrutiny,” Mr Kelleher adds — recalling Mr Gensler’s tenure at the CFTC, when financial executives would lobby for or against various rules.

Since stepping down from the CFTC, maths-whizz Mr Gensler has been at MIT, studying and teaching on the next big things in finance: blockchain and cryptocurrency. That background will make him even more useful as a regulator at a time when the largest tech platform companies — from Google and Facebook to Amazon and Apple — are moving into the financial industry.

Mr Gensler has so far lauded the convenience and low cost of retail financial services apps while cautioning against the use of decentralised technologies for financial speculation. In a November 2020 MIT paper, he and co-author Lily Bailey discussed the “significant opportunities for efficiency, financial inclusion, and risk mitigation from AI and big data in the financial sector, but also the possibility of ‘regulatory gaps’ that might lead to ‘financial system fragility and economy-wide risks’.” Translation? In a Gensler-led SEC, fintech will be under greater scrutiny.

But he will also have to address past failings. For some years, the SEC has been criticised for not being tough enough on corporate America and not adequately protecting investors. Indeed, scams and fraud have been on the rise during the Trump administration, according to the SEC’s Office of Investor Education and Advocacy.

As head of the SEC, Mr Gensler would therefore have to balance two jobs. First and foremost would be restoring trust in the agency’s ability to accomplish its core mission of protection, financial stability and penalising violations. In addition, though, as a longtime Democratic politico, he would want to help facilitate the Biden administration’s priorities, such as addressing income inequality, racial injustice and climate change.

On the former, progressives will look to the next SEC chair to acknowledge that it is not banks that break laws, but individual bankers. By appointing a tough director of the enforcement division — perhaps a former prosecutor or a consumer advocate — the chair could send a message: there will be no more sweetheart deals for individual executives while organisations write-off their regulatory fines as a cost of doing business. The chair could also revisit Trump-era deregulation, and toughen rules around whistleblower protections, pay clawbacks for illegal gains, and limits on executive pay for high-risk activities.

On the broader Biden agenda, the SEC could meanwhile play a big role in increasing transparency and disclosure around hidden fees, predatory lending and unseen risks from factors such as climate. Imagine, for example, if companies had to disclose their potential litigation risk around lending to the fossil fuel industry or developing waterfront property. This, combined with opening up the black box of algorithmic finance, could go a long way towards mitigating risk at a delicate time for the global economy. 

With a new administration and a new “born again” SEC director, markets may soon get regulatory religion too.

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