PE firms are all over this, but investors are still chasing yield.
Since the Federal Reserve started warning about the risks of “leveraged loans” in 2014, the amount of US leveraged loans outstanding has surged with delicious irony from $700 billion to $1.3 trillion. These things are hot. And now the Fed is even more worried.
The latest warning came from Todd Vermilyea, who leads the Risk, Surveillance, and Data sections at the Fed Board of Governors’ Division of Banking Supervision and Regulation. His responsibilities include, as he says, the Shared National Credit program, “a key interagency program that reviews and assesses risk in the largest and most complex credits shared by multiple financial institutions.”
Leveraged loans are issued by highly leveraged companies with below-investment grade credit ratings (“junk”) to fund primarily:
- Leveraged buyouts (LBOs) where a private-equity firm buys a company that then has to borrow the money to fund its own acquisition.
- Special dividends by the acquired company back to its PE firm owners. The euphemism for this form of asset stripping is “recapitalization.”
- Refinancing existing debt to give the company a leg up with creditors.
Regulators consider leveraged loans too risky for banks to keep on their balance sheet, so banks rearrange them, structure them, collect hefty fees, and sell them to loan mutual funds, pension funds, and other institutional investors, domestic or foreign.
Investors have the hots for leveraged loans because they pay a higher yield, and because the yield is based on a floating rate that rises as interest rates rise. But this is also one of the reasons these loans are even riskier in a rising-interest-rate environment.
In his remarks at the Loan Syndications and Trading Association Conference in New York, Vermilyea warned that “there may be material loosening of terms and weaknesses in risk management of the leveraged loan market,” and that “some institutions could be taking on risk without the appropriate mitigating controls.”
Then he went into the specifics of the surge in risks and abuses that bank supervisors are finding:
“Cov-lite” leveraged loans
“Covenant-lite” refers to loans that do not contain financial performance safeguards for the lender, such as specific commitments to maintain financial ratios related to debt service. These types of loans used to be reserved for the highest quality borrowers. Today, “cov-lite” structures are widespread.
How cov-lite loans would perform in a downturn is not well understood because data are not available.
The chart below shows how cov-lite loans have taken over leveraged lending in recent years. Their share surged from an already high 55% of outstanding leveraged loans in 2014 to 78.6% at the end of August.
In terms of dollars, cov-lite leveraged loans outstanding ballooned from $385 billion in 2014 (55% of $700 billion) to $1.02 trillion (78.6% of $1.3 trillion). So, suddenly, there are over $1 trillion in “cov-lite” leveraged loans, and no one knows how they will perform during a downturn.
This is the ability of borrowers to add further debt onto an existing loan to the disadvantage of existing creditors, and without their consent. Vermilyea:
Similarly, incremental facilities (IFs), which allow additional borrowing that is pari passu, or of equal seniority, with their existing bank loan, often without the consent of the lender, have grown in the marketplace and are now both more widespread and with looser restrictions than in the past. While IFs can provide an economic benefit to borrowers, IFs rarely limit the use of IF-provided proceeds and can be used for non-earnings purposes.
In other words, PE-firm owned companies can use “incremental facilities” to borrow even more, at equal seniority in the capital structure to the existing loan, and use these funds not to invest in something productive that can help pay off the loan, but for “non-earnings purposes,” such as a special dividend back to the PE firm, which adds risk for existing lenders.
“EBITDA (earnings before interest, tax, depreciation and amortization) is a well-defined measure of cash flow that is used to show how well a company is able to deal with its debts. “EBITDA add-backs” inflate that measure by adding back expenses and cost savings. And this “could inflate the projected capacity of the borrowers to repay their loans.”
This is a special strategy that PE firms use to strip assets away from the first-lien creditors who thought they had rights to those assets as collateral. This operation has been successfully implemented by the PE firms behind J. Crew, PetSmart, and Neiman Marcus. When these companies go into default, first-lien holders end up holding the bag because their collateral has been stripped out. Vermilyea:
Supervisors have noted transactions where borrowers were able to transfer secured collateral beyond the reach of their senior creditor banks that issued the original leveraged loans, a practice known as “collateral stripping.”
And Vermilyea concludes ever so gently that “the presence of these practices, especially without the appropriate controls, may lead to safety and soundness concerns.”
But in these crazy times, after 10 years of interest-rate repression by the Fed, investors don’t really care, and they keep buying these leveraged-loan products despite years of warnings from the Fed.