Navigating the perfect storm of COVID-19 plus covenant loosening in European leveraged loans
Over the past couple of months, as the pandemic-induced economic crisis has worsened, we’ve seen a marked increase in activity on the Eigen platform. Our clients in the corporate credit market are using the platform to dig into their documents to understand the potential downside risks within their portfolios. So last month, with the markets and the world continuing to reel from the effects of COVID-19, we decided to take our own deep dive into publicly available Loan Market Association (LMA) credit agreements. Using our platform, we were able to gather insights into covenants and other key provisions, surfacing the risks and opportunities that lenders must now address to minimize potential losses.
This analysis gives a first-of-its-kind deep-dive into the covenant provisions in place within European leveraged loan agreements and how these have changed since the last financial crisis. The data pinpoints areas where actions need to be taken to mitigate the risk of default. We've shared the findings with our clients and contacts within the market in the hope that it will help them with their decision-making and action planning during this time of dislocation.
How we analyzed data on European leveraged loans
Using the Eigen NLP platform, we extracted and analyzed data from 60 LMA documents (as these were easier to obtain. than LSTA US agreements). Within three hours (1.), we were able to train the Eigen platform to recognize language in the documents that pertained to covenants, default events, margins and equity cure rights and automatically answer questions related to them. It took another three hours to successfully upload and process all the LMA documents through the platform. Within this time frame, we also performed a manual review of the ~20% of answers that the system flagged as low confidence to ensure the data was accurate.
After exporting the results, it took approximately six hours to analyze the data and compare it to publicly available external data from sources such as Bloomberg, Moody’s, S&P and Simmons & Simmons to give it market context. In total, starting from scratch, it took less than 12 hours to extract and analyze ~2,000 data points from 60 LMA documents.
What we learnt from analyzing European leveraged loans
Our analysis reinforces the fact that in the battle for new business and the search for higher yield, corporate loans have become increasingly covenant-lite or covenant-loose. However, by extracting additional language and data points from LMAs, we were also able to see the emergence and prevalence of some agreement terms that offset, to some extent, the lack of covenants. These terms provide lenders with downside protection and flexibility in the event of default while also being more favorable for borrowers, especially during a downturn such as this.
The findings from our analysis include:
1. Margins have steadily compressed with BB loan margins now less than BBB margins were ten years ago
Lenders have been in a race to the bottom for more than a decade, resulting in margin compression. Fierce competition for deals has put non-investment grade margins under the most pressure, with initial margin on BB loans decreasing by 320bps, down from 4.5% in 2009 to just 1.3% in 2019.
For BBB+ deals, margins have declined by 170bps over the last ten years, down from 2% in 2009 to just 0.3% in 2019. With margins eroding over time, lenders have become more inclined to finance riskier deals with higher levels of leverage to sustain their returns, as is well known in the market.
2. Covenant requirements for non-investment grade loans have loosened since the 2008 financial crisis
It’s been well-documented and well-reported that leveraged loans in Europe and the US have become less covenant heavy. Over the last 12 years, cov-lite loans have become increasingly popular. More than 80% of European leveraged loans issued since 2016 are cov-lite (2.). In contrast, less than 20% of European loans issued between 2008-11 were cov-lite.
By drilling further into the documents, we found that 25% of loans issued since 2016 include interest coverage ratio and leverage ratio covenants. The same is true for investment (IG) and non-investment grade (non-IG) loans illustrating the convergence of terms between IG and non-IG loan documentation. These financial covenants were previously much more common in non-IG loans, and 60% of documents signed prior to 2012 included them.
We were also able to see that the leverage ratio, typically calculated as Net Debt/EBITDA, has increased from 4x to 6x for non-IG loans since 2008 while the leverage ratio for IG loans has fluctuated between 2x and 3x since 2008. Yet again suggesting the need to chase riskier deals in the search for yield.
This data confirms that loans have become more covenant-loose over the years, but what’s interesting is seeing how this is reflected directly in the terms within these documents by using Eigen’s NLP platform to surface these specific details.
- Events of default made more likely due to the pandemic are more prevalent in the higher-margin and more recent deals
Financial covenant breach, material adverse change (MAC) and cessation of business as events of default are clauses that have attracted much market attention due to their relationship to businesses operations that have been affected by COVID-19. These terms have become the norm in deals with an initial margin of 1% and higher. At least two of these three terms were present in 100% of the LMAs we analyzed.
We also found that 75% of all LMAs issued since 2016 irrespective of initial margin include at least two of these three events of default terms with financial covenant breach being the slightly less popular choice. It’s evident that lenders are exercising caution when entering into high margin deals and set out terms to minimize the downside.
However, questions remain over the validity of MAC and cessation of business event triggers in the context of COVID-19. For example, how do these default events apply to businesses forced to suspend or reduce operations due to social-distancing measures enacted by Government? How do you define and measure materiality within this context? What is the reputational and financial cost to lenders who invoke these clauses when businesses are struggling to stay afloat because of coronavirus?
- Equity cures are included in all higher-margin European loans issued since 2017
Consistent with Simmons & Simmons research published in 2015, we found that all leverage loans with a current margin of >4% issued since 2017 had equity cure rights included in the documentation. Typically, two to three equity cures were permitted over the life of the loan, enabling shareholders to inject money into a business to prevent a breach of covenant and an event of default being triggered.
We then analysed the default interest rate adjustments by initial margin for the LMAs issued since 2010. We saw that these conformed to a market standard of 1 – 2% with a bias for the higher-margin loans having a default interest rate adjustment set at 2%.
Again, there is clear evidence that as the loan becomes riskier, as evident by the increased initial margin, so do the agreement terms set out to protect the lender and keep the borrower in business with a slightly higher default interest rate.
- More than 50% of European loans include variable margins which allow for higher yield potential in the short-term
By analyzing the extracted data, we were able to see that over 50% of all the LMAs included a variable margin with adjustments based on either credit rating or leverage ratio. For investment-grade loans, the variable margin was predominately based on credit rating, although this has become less common for agreements issued post-2016 with only 20% of new loans including this margin. For non-investment grade loans, we’ve seen a shift towards leverage ratio with 50% of new loans arranged since 2012 including a variable margin.
These provisions give lenders the ability to ratchet up margins in the event of an adverse change to a borrower’s credit rating or a reduction in the borrower’s earnings. The results of which can be a higher yield for lenders in the short-term. An interest margin increase of 0.2x typically corresponds to a rating downgrade of one notch. For leverage ratio, the average interest margin increase was 30-45 bps per 1x increase in Net Debt/EBITDA.
What does this mean for lenders in the current market?
With the end of Q2 upon us and defaults and downgrades inevitable due to coronavirus lockdown, lenders must take action now to mitigate expected losses and take control of their non-performing loans. The detailed data extracted from the LMAs pinpoints areas where actions should be taken to mitigate the increasing downside potential in the current market. In particular, the ability to flex adjustable margins and renegotiate and tighten terms at the point of a covenant breach.
During last month’s webinar, we explored cov-lite trends in CLOs and asked attendees from across the industry to anonymously tell us what actions they thought lenders should take on defaults. Three-quarters (76%) of respondents answered ‘Renegotiate on current terms’ with one-fifth (21%) voting for ‘Restructure on capital stack’ and a small number of 3% voting for ‘Acceleration’. The responses show a clear bias for action and a need for lenders to get to grips with the covenants, clauses and contents of their loan documents.
Using data extracted from Eigen we were able to model out four scenarios for an example loan of £153m to see the impact on loss adjusted margin of different actions taken at the point the ND/EBITDA covenant was triggered. The PD*LGD component is based on EBITDA decline scenarios with the PD coming from a study by UBS (3.).
In the graph below, you can see that by renegotiating current terms at the point of a covenant breach, it would be possible to increase the loss-adjusted margin by up to 3%. The terms of the loan set out a default interest rate of +1% when ND/EBITDA exceeds 4x. And as EBITDA decreases the leverage ratio increases ratcheting up the adjustable margin each time ND/EBITDA increases. Without tracking ND/EBITDA and adjusting margins accordingly or without renegotiation, loss-adjusted margins can quickly enter negative territory.
The key is to fully understand the options the terms in your loans offer you and take action to mitigate the downside risks.
Where to find more information on the analysis
We walked our clients and market contacts through these findings during a webinar on cov-lite trends in European CLOs last month. Attendees included banks, asset managers, insurers, pension funds, hedge funds and ratings agencies. If you missed the webinar, the event recording is available on-demand to watch and download on our website.
We’ve also performed some additional analysis on US CLOs that we recently presented at the IMN CLOs & Leveraged Loans Virtual Conference. To watch the video walkthrough of our analysis findings, please click here.
- Please note that this analysis was carried out by an Eigen team member who is an advanced user of the platform and is familiar with the documents being analysed. To achieve this same level of speed, clients will need to undergo training provided by Eigen. It is also worth noting that these questions were relatively straight forward to extract and more complex questions may require significantly more training and support.
- Source: LCD by S&P Global
- Source: UBS Study
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