Thursday, 23 October 2008

Cov-lite deals, a gentle attack

Notes about covenant light (or cov-lite) deals, following the entry below, and in response to the article by Tony James, head of private equity company Blackstone. Firstly, these loans barely exist in Europe, the vast majority of them were in the US. So Tony James's argument that the leveraged world is unaffected by covenant tests, those nasty, horrible hair-triggers, doesn't apply in Europe. However PIK loans, which he does also address, did become relatively common in Europe.

Secondly, there is a counter argument in favour of covenants, which James must know and does not even address. Covenant tests allow lenders both to know that a company is in trouble and begin a process where lenders and borrow can work together to resolve a borrower's problems, forcing companies to make difficult decisions which they might not do otherwise. They do not just suddenly go bust as he suggests.

Thirdly, there was an interesting note from Moody's yesterday about PIK loans. These loans allow borrower to opt not pay interest at maturity but extend the debt's maturity. The rating agency distinguished between different times when PIK loans are 'toggled' in this way. It might be that the company is in serious difficulty or is just using its cash wisely, and these different uses tells us different things about the company doing the toggling.

Edited to add: Jon Moulton seems to agree that covenant-lite deals aren't a sign of strength with the following delightfully brief reposte.

Sir, I read with interest the Insight column "In praise of covenant light loans, your flexible friend" (October 23) by Tony James, president of Blackstone.

He is right - covenant light loans do extend the life of businesses with over-adventurous capital structures. A respirator maintains life in a seriously ill person too.

I cannot but observe that avoiding disease is generally better than providing for surviving it. Certainly "commending" survivable over-leverage as a capital structure for real businesses is a remarkable view.

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