Broken Leveraged Loans: The Coming Feast For Asset-Based Lenders

Hugh Larratt-Smith Managing Director, Trimingham — Hugh Larratt-Smith Managing Director Trimingham

Samuel Du Pont spent his childhood at his father’s home, Louviers, across the Brandywine Creek from his uncle’s estate and gunpowder factory, Eleutherian Mills. In 1811, when he was nine, he was enrolled at Mount Airy Academy. Because of a failing wool mill, his father was unable to fund his education, so at 12 years old, Dupont enlisted in the U.S. Navy. His family’s close connections with Thomas Jefferson helped him join as a midshipman.

The war was not going well for the Union in late 1862 and early 1863. Although the Confederate Army of Northern Virginia was repulsed at Antietam, it escaped intact and had inflicted a major defeat on the Federal Army of the Potomac at Fredricksburg, VA. In the west, the campaign for control of the Mississippi River was bogged down at Vicksburg, MS. In Texas, the confederates had retaken Galveston. A mood of war weariness was evident throughout the north, and the fall elections — regarded as a referendum on the war — showed a swing away from the Republican Party. The Lincoln administration applied great pressure on its field commanders to achieve success and lift the national spirit. The Navy began to urge an attack on Charleston.

Towards the end of 1862, Du Pont was the first U.S. naval officer assigned to command the newest technology — armored, “ironclad” ships. Though he commanded these new ships ably in engagements, the ironclads performed poorly in an attack on Fort McAllister due to their small number of guns and slow rate of fire. Du Pont did not share the enthusiasm of the Navy for the armored vessels. Although they could withstand the punishment of the coastal artillery, their offensive capabilities were severely restricted.

The Navy blamed Du Pont for the highly publicized failure at Charleston. Du Pont attempted to garner the support of President Lincoln who ignored him. He returned to Delaware in disgrace in 1863. As an officer, he could not publicly blame the Navy for its poor planning and underestimation of risks or the Lincoln administration for its pressure for newsworthy success.

Investors Under Pressure

Many observers of the leveraged loan market think the proliferation of covenant-lite loans is a significant underestimation of risk. To say nothing of poor planning at the late stages of the bull credit cycle. Credit risk was mostly a nonfactor for banking investors in 2019, which was all about interest rates. The new year may be different. Indeed, some industry observers think leveraged loans and the auto finance market may trigger the next recession as the bull economic cycle ends.

Prior to 1999, covenant-lite leveraged loans were far from the norm as banks only offered these structures to the strongest borrowers. However, with the dramatic expansion of players moving into the direct lending space in recent years and the search for yield by institutional investors, flexibility on documentation has become a routine point of differentiation among lenders trying to put money to work. In many cases, investors and lenders like the credit story, so they are willing to tolerate “swiss cheese” loan agreements. They are willing to accept the thesis that pro-forma EBITDA — brimming with add-backs — is achievable.

According to UBS data, average total debt on new deals is about 5.4x EBITDA, but 6.7x EBITDA once the add-backs are stripped out. About 30% of outstanding leveraged deals done since 2017 have add-backs worth about 25% of EBITDA. If EBITDA softens (as it sometimes does, regrettably), leverage can spike quickly… or if the sponsor has done a dividend recap days after the original loan was signed, hitting their coveted IRR of 100%.

The market for cov-lite loans has suffered sharp declines in recent months, a sign of growing aversion to EBITDA shortfalls or other strains at highly leveraged companies.

But investors are quick to dump cov-lite loans at any sign of trouble which is sparking steep falls in the prices of loans — particularly when they fail to hit EBITDA targets. In some cases, the first default is a payment default (no tire skid marks as the vehicle plunges over the edge of the cliff). In the absence of meaningful covenants, leveraged loans trade down quicker — especially in Europe where loan markets are smaller, less transparent and less liquid than in the U.S. — prices drop very rapidly once they go below 80 cents. The debt of Holland & Barrett, a UK retailer of vitamins and health supplements, went into a free fall plunge to less than 50% of face value early in December 2019 after a ratings downgrade from Moody’s.

CLOs, which have become the dominant investor type in leveraged loans for the past few years, have very strict limits on the amount of CCC loans that they can hold. Many CLOs try to sell loans before downgrades are announced, so they don’t become forced sellers.

While cov-lite loans have become increasingly prevalent in the broadly syndicated lending market, this pattern has not yet been reflected across the middle-market ABL environment. The ABL world has seen some impact in the hunt for outstandings and yield. We are all hearing more and more about enterprise value. Some ABL shops have taken a dramatic shift in underwriting to include enterprise value. Some players call it a stretch piece of the deal. Like many industries, ABL has become intensely competitive with significant margin compression. To stay in the game, many ABL players have to partner with leveraged lenders — or finance a sponsor-driven deal on a highly desirable borrower with swiss cheese documents that are more like equity than debt.

Nagging questions for many credit committees are: How will the sponsor behave in a workout?

Despite the proliferation of new ABL players, the ABL marketplace will benefit from an increase in loan demand as leveraged loans are replaced with conforming ABL structures in the next downturn. With banks holding 40% of leveraged loans, cashflow lenders within those banks will turn to their ABL teams to augment the capital stack of borrowers.

The questions on many lenders’ minds are: When will the next downturn start? How long is this bull economic and credit cycle going to last?

When China coughs, supply chains fall ill. The impact of the new coronavirus on factories in China could affect the global supply chain for years. The robustness of global supply chains is being tested. Even products with a small quantity of Chinese content will be affected as production is halted in the affected areas in China — items such as complex machine and vehicle parts, hard drives and certain electrical items that are vulnerable to supply shocks. For example, General Motors closed U.S. and European plants after the Japanese earthquake in 2011 and 2016 because critical parts could not be readily sourced elsewhere. Already, some Ohio manufacturers are substituting local suppliers in place of Chinese suppliers to ensure continuity of supply.

For middle-market borrowers, drastic change in supply chains can force sudden swings in profitability. Take the dance and cheerleading clothing industry — think everything from ballet tutus to tween cheer clothing. Many of the major players in this industry are currently in a crisis because their Chinese shipments have been canceled just as the dance performance season is coming to its climax in March. When their dance and cheer costumes arrive in Long Beach — if they arrive — customers will have already cancelled their orders.

Leveraged lenders and sponsors should be ready to see what the party really looks like when the lights are turned on. The party will just be starting for ABL players who will be feasting on broken cashflow deals.

A bronze sculpture of Du Pont was dedicated on December 20, 1884 with President Chester A. Arthur in attendance, and the traffic circle was renamed Dupont Circle.