Thursday, August 10, 2006

This I promise you...

In yesterday's Market Beat Serena Ng commented about the decline of covenants in bank loan deals. These are certain restrictions placed on the borrower for protection of the lender. Common covenants include maintenance of certain minimum debt or interest coverage ratios, restrictions on new issuance of debt, requirements to pay down debt early or pay a higher coupon if certain adverse events occur, etc.

Here are the dirty little secrets about covenants.

1. Ratings agencies don't assign higher ratings to pieces of debt with covenants. I'm sure if I write "Rating agencies don't care about covenants," someone will e-mail me and claim otherwise. But in my experience dealing with public finance covenants, it is quite rare that the covenants are a major factor in a rating. A rating is all about financial strength of the operation, not about whatever promises management makes.
2. Banks commonly allow borrowers to break the covenant. They just charge a fee for renegotiating terms of the loan. So the bank is more interested in getting a fee than enforcing the covenant.
3. Hedge funds and banks and CLOs (not mentioned in the WSJ article, but a big part of the issue) are obviously more interested in getting the loan done than negotiating a bunch of covenants. Otherwise they'd still be asking for the covenants.

So why should we be so worried about the decline of covenants? It seems like very few market participants care.

I think we are right to be worried, but not because of the lack covenants per se. A covenant is just a promise by management to remain relatively conservative in their capital allocation. But covenants didn't stop Enron from fiddling with their accounting. I'm sure they passed all their covenants with flying colors in 2000. The real problem is what the decline of covenants signals.

Most recessions are caused by a misallocation of capital. Capital takes time to be reallocated, and during that time economic growth suffers. When credit conditions are too loose, there is a good chance that capital is being allocated poorly. So it isn't the covenants themselves that are the problem. The fact that borrowers have the negotiating power in this market, as evidenced by the decline of covenants, suggests credit conditions are very loose indeed.

Recession anyone?


dimitri said...

Covenants are not promises by management. They are escape hatches for lenders. Breaking of covenants constitutes (generally) Events of Default, and can land a company in Ch. 11. If you are unsure about that, this is exactly what volture funds do - they buy up debt of companies and then use violations of covenants and the threat to put the company into chapter to extract goodies for themselves - priority liens on various assets, equity payoffs, etc.

Accrued Interest said...

First of all, give me an example of a covenant that ISN'T a promise by management.

Second, I grant that you are right when you say that covenants are used by some vulture funds. But this isn't why the covenants were originally put into place by lenders.

dimitri said...

Actually, as someone who has dealt with this a lot, I can tell you the covenants are anything BUT apromise. They are exactly what I said: escape hatches for lenders.

When a covenant says I will maintain X cash flow ratio, and if I violate it I have 90 days to cure it, you can bet your ass that as those 90 days tick down, the lender will be there saying either (a) cure it or I declare an Event of Default, or (b) securitize my loan with this or that asset.

Or for Negative Pledge covenants, these are definetely not "promises". If a borrower promises not to give a lien on an asset, if one day he chooses to break that promise - you better believe it that an Event of Default will be filed the following day.

Remember, a lender has no interest in future viability of the company - he has no "upside" like the equity holder. The only thing the lender cares about is getting paid. So yes, to a lender the covenants are not promises, to be lived up to or not at the whim of the management. They are vehicles to get out fast and get paid if things start going sour.

But you did make a good point, which is why I found your post interesting - if the lenders are not insisting on as tight a covenant package as they used to, that means they are being lazy or complacent about getting repaid. Bad for Corporate Bond Funds, good for equities.

Accrued Interest said...

Maybe we are arguing semantics, but if the covenant is to maintain cash flow ratio of X, then management is promising to maintain cash flow ratio of X. That's all I'm saying.

Now, I don't traffic in bank loans, so you may know about that area better than me. Within bond covenants, its common that bond holders will not try to force a ch. 11 filing because they figure the recovery is better if they renegotiate the covenant and/or allow for a cure.

The people I know in banking tell me that the bank often figures that they will make more money by charging a fee to renegotiate the covenant as opposed to forcing a ch. 11. I'm sure it depends on the type of loan. Like a real estate-backed loan, the recovery doesn't get worse and worse as the company's operations deteriorate. So the bank can try the renegotiation route knowing they can later force bankruptcy and get the same recovery.

Also, in the case of a bank loan you have a single lender, whereas a bond has many lenders who may not be as organized.