Lpc covenants fall away on european leveraged loans

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The erosion of financial protections has spread throughout Europe's leveraged loan market, affecting lower to mid-market deals as well as larger 1 billion euro-plus ($1.12 billion) transactions, as sponsors seek greater flexibility to grow companies and protect their equity in more difficult times. The European loan market has largely accepted covenant-lite loans, having initially shunned the structures made popular in the US. European lenders were increasingly exposed to them with the emergence of a greater number of cross-border transactions in 2013, before an 818 million euro loan backing the buyout of French veterinary pharmaceutical firm Ceva Sante Animale became Europe's first pure covenant-lite loan in 2014. A European covenant-lite loan sees the removal of maintenance covenants but usually has a springing leveraged covenant in the revolving credit facility. Even if a loan is not covenant-lite, it is increasingly rare to have a European loan with all four traditional maintenance covenants. As such, covenant-loose loans have grown in popularity and contain just one maintenance covenant, sometimes two - most typically a leveraged ratio test. Only 33 percent of loans year-to-date had a full maintenance covenant package, compared with 88 percent in 2013. In its place, covenant-lite and covenant-loose loans account for 35 percent and 28 percent of 2015 deals, compared with 11 percent and 3 percent in 2013, respectively, according to data from leveraged finance data firm DebtXplained."Covenant-lite has been somewhat more prevalent in Europe recently. That is an evolution of the market: not every deal is automatically covenant-lite," a senior sponsor said.

Investors have become increasingly comfortable with covenant-lite structures on large, liquid jumbo loans, especially as most of them also invest in high-yield bonds which have similar incurrence-based covenants as opposed to maintenance covenants. Around 63 percent of loans larger than 1 billion euros have been covenant-lite in 2015, compared with 50 percent in 2014, the data shows. This has opened the gateway for sponsors to demand looser structures on smaller deals, with 77 percent of sub-250 million euro loans covenant-loose in 2015, compared with 47 percent in 2014.

FLEXIBLE FRIENDS The erosion of maintenance covenants has been particularly useful for sponsors with a buy-and-build strategy, gifting them more flexibility to make bolt-on acquisitions and raise incremental debt."Covenant-lite can reduce admin around deals, which is beneficial. The structures are probably more suitable in a buy-and-build scenario using the flexibility for bolt-on acquisitions, financed with incremental facilities," the sponsor said. "The real benefit of a covenant-lite loan is where it is akin to the benefits of a bond deal. A sponsor still has to be comfortable that investors will continue to support a growing business."

The erosion of covenants has also helped sponsors to protect their equity in a deal as companies are no longer subject to a series of regular financial tests. This is particularly useful to cyclical businesses. Covenant-lite is having an effect on the buying pattern of distressed investors. Distressed investors would previously start buying into a deal when a company got close to breaching covenants and credit funds and CLO investors sold risk. Without any covenants to breach, investors are less likely to pull the trigger and sell at such an early stage. In some cases, distressed investors will only be able to buy into a business once it runs out of cash."A business may not be bad but going through a bad market time. A sponsor can obviously improve their protection in that scenario by having incurrence tests rather than a financial test related to underlying performance," the sponsor said. Distressed trading desks are noticing a recent decline in the amount of distressed LBO paper, with some desks stating the majority of activity comes from more traditional corporate and special situations, such as Spanish renewable energy, shipping loans, busted corporates or liquidations. Distressed investors have been far more active in buying loans quoted at low levels on Europe's secondary loan market, in the hope of an upswing in the business and the value of the paper, as opposed to buying with a loan-to-own strategy, a distressed trader said."It is a different game for distressed investors when there are no covenants as they might only be able to get in once a company runs out of money, due to a lack of clear warnings like covenant breaches," an investor said. ($1 = 0.8959 euros)