Leveraged loan investors worry good times will soon haunt them

From Lisa Lee and Bloomberg:

One of the safest ways to invest in junk-rated companies is starting to look pretty risky.

Money managers have grown increasingly concerned about loans to high-yield corporations over the last month as early signs of slowing global growth have emerged. Investors are starting to realize that a key safeguard that protects them, namely the collateral they can seize if a company goes under, gives them less cover than they thought.

In December these worries helped push down prices in the $1.3 trillion leveraged loan market, hitting the debt that financed some of the biggest buyouts of 2018. In the go-go credit markets of the last two years, companies won unprecedented power to sell businesses, move operations to different units, and use other tactics to move assets out of the reach of lenders before defaulting.

“Collateral is a big long-term risk,” said Chris Mawn, head of the corporate loan business at investment manager CarVal Investors. “You think you’re secured by a Cadillac, but three years from now, it turns out you’ve got a Chevy.”

The loose contract provisions that money managers have agreed to over the last two years mean that when borrowers actually do start going under en masse, creditors are likely to end up with fewer assets to liquidate, and ultimately bigger losses. Private equity-backed firms have generally been the most aggressive borrowers when it comes to pushing for the right to move around collateral.

When Blackstone Group bought out a majority stake of Thomson Reuters Corp.’s financial terminal business last year, its $6.5 billion loan offered it wide latitude to sell assets and pull cash from the company. Soon after that Bloomberg reported that the business, dubbed Refinitiv, was looking at offloading its currency trading unit, among others. These concerns along with broader market volatility helped push the bid on these loans as low as 93.375 cents on the dollar in December, from their initial sale price of 99.75 cents.

Loans sold to help finance another leveraged buyout in September for Envision Healthcare have similarly fallen, to 93.75 cents from their original 99.5 cents. Investors have grown more worried that private equity owner KKR can easily sell off a more profitable portion of the company’s business and leave lenders with the less attractive part, according to people with knowledge of the matter.

Sometimes loan investors don’t realize the extent of the rights they’ve given to a corporation and its private equity owners until assets are taken away. The contractual provisions that allow greater flexibility, known as covenants, may be spread through a lengthy lending agreement. Only careful consideration of how different lending terms interact with each other reveals what a company can do.

“There are covenants that put together can make a loan like an equity,” said Jerry Cudzil, head of credit trading at money manager TCW Group Inc., which oversaw $198 billion of assets as of Sept. 30. Equity usually has the last claim on assets when a company is liquidated, making it the riskiest kind of investment in a company.

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