US loan investors are fighting back against terms which they believe are effectively turning supposedly senior secured loans into unsecured agreements. Some are outright rejecting loans which feature excessively borrower-friendly language, while others are lobbying rating agencies to assign lower assumed recovery rates to certain deals.
According to Creditflux’s sister publication Xtract Research, 44% of large US sponsored credit agreements in Q1 2018 had provisions allowing issuers to make unlimited investments in non-guarantor restricted subsidiaries.
“We are seeing an increasing number of such provisions as bond and loan terms continue to converge,” says Charles Tricomi, head of leveraged loan research at Xtract Research.
The fact that the subsidiary is restricted, however, means that it is bound to the terms of the original credit facility – including negative covenants such as the ability to take on additional debt. But “trapdoor” provisions appear in 13% of large sponsor credit agreements and these allow borrowers to move collateral over to unrestricted subsidiaries, although this is usually capped.
The most worrying provision has been dubbed a “black hole”, which refers to deals where there is an unrestricted subsidiary accompanied by a trapdoor that does not put a limit on the collateral that can be moved, resulting in potentially 100% of the collateral pool being moved to entities that do not guarantee the loan. 5% of large issuers in Q1 had such provisions, according to data from Xtract.
“If this is truly 5% of the market today, that is concerning because we, and many like us, would consider those effectively unsecured bonds,” says one US CLO equity investor. “They should not be in CLOs under current rules because they are being given the same assumed recovery rate as a senior secured loan, not the unsecured recovery rate of an unsecured bond. If it is 5% of the market today, it will be 50% of the market tomorrow.”
Currently, rating agencies do not explicitly change recovery assumptions on loans that have trapdoor provisions. “Senior lenders are not being properly compensated for the risk that they are taking. If the recovery rate is less as a result of such provisions, they should be paid more,” states Tricomi.
Responding to questions over its assumed recovery rates, the deputy head of leveraged finance for EMEA at Standard & Poor’s, Brad Gustafson, says S&P’s ratings capture the risks posed by covenant flexibility. “What you’re calling ‘trapdoor’ provisions are customary permitted investment terms that are standard in loan documents. Every incurrence covenant is subject to exceptions, some of which give borrowers more flexibility than others,” he says.
For example, S&P assumes that certain undrawn facilities will be drawn if a loan defaults when assigning recovery ratings.
Gustafson says that if loan documents are unusually prejudicial to lenders, S&P will reflect this – either explicitly via loan recovery ratings or flagging it in rating reports. “However lender-friendly your documents are, it comes down to creditors’ willingness and ability to enforce them; lenders always have the option of waiving protections and have a track record of being passive.”
US retailer J Crew came under scrutiny last year when it used a trapdoor provision in its credit facility to transfer intellectual property to an unrestricted subsidiary. And it seems that some lenders are homing in on these provisions in a bid to avoid the same fate. Earlier this year, loan investors rejected a $7 billion debt deal for New York beauty specialist Coty due to such provision in initial documents.
Steve Vaccaro, CIFC Asset Management’s chief executive officer, says that loan managers retain the ability to opt out of a deal if they’re not happy with the final documentation. “Trapdoors may not be included on term sheets, but loan commitments are always subject to a review of the final agreement.”
Vaccaro adds: “Although weaker covenants don’t affect default rates and may not influence a decision to buy, they will influence how tolerant you are of underperformance. Strong risk management systems are needed to ensure you are aware of exactly what’s being written into loan documents.”
Loan documentations are undoubtedly the most borrow-friendly they have been since the financial crisis, so if one lender rejects a deal with trapdoor provisions, it is likely that another lender will accept it.
In any case, as Mark Pelletier, senior managing director and head of Ryan Labs Asset Management’s leveraged finance group says, his firm takes number of factors into account when investing in loans. “We generally wouldn’t exclude solely based on a trapdoor provision.”
By Michelle D’Souza