CORPORATES SECTOR IN-DEPTH 8 March 2016 TABLE OF CONTENTS Covenant protections remain weak 2 We expect a modest improvement in covenant quality in 2016 3 Analyzing weak characteristics identified by regulators in connection with leveraged loans 4 Moody's Related Research 10 Contacts Enam Hoque 212-553-3939 VP-Senior Covenant Officer [email protected]Derek A Gluckman 212-553-8925 VP-Senior Covenant Officer [email protected]Evan M Friedman 212-553-1338 VP-Senior Covenant Officer [email protected]Christina Padgett 212-553-4164 Senior Vice President [email protected]Glenn B. Eckert 212-553-1618 Associate Managing Director [email protected]Tom Marshella 212-553-4668 Managing Director – US and Americas Corporate Finance [email protected]North American Leveraged Loan Covenants Stubbornly Weak Loan Covenant Protection Will Only Modestly Improve in 2016 » Leveraged loan covenant protections remain weak. Our loan covenant quality scores, which assess the degree of protection that a leveraged loan covenant package provides to investors, have remained in the “weak” category since 2013. This suggests that investors in today's volatile market are being exposed to rising risk as they forfeit key levers traditionally available to them when a borrower is in financial distress. » Our data suggests that in order for covenant quality to significantly improve, investors must push back and demand better protections. We anticipate only modest covenant improvement in 2016, absent a major disruption in the leveraged loan market, or heightened and sustained regulatory criticism of weak covenants. » Since publishing leveraged lending guidance in 2013, regulators identified general credit agreement covenant protections that they deemed to be weak. Each of these protections factor into our loan covenant quality scores, including: sales of assets without lender approval; broad EBITDA add-backs; weak financial maintenance covenants; use of net debt in leverage covenants; excessive headroom or “cushion” with respect to leverage ratios; “springing” maintenance covenants; and various accordion features, including uncapped or ratio-based incremental facilities. » Covenant cushions, and our general financial covenant scores, are slightly improving and offering more protection for investors, but not enough to move the scores from the “weakest” level. Our data also shows that the use of broad EBITDA add-backs, net debt, “springing” maintenance covenants and incremental facilities increased from 2013. Our asset sale and mandatory prepayment scores remain “moderate,” with protections unchanged.
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CORPORATES
SECTOR IN-DEPTH8 March 2016
TABLE OF CONTENTSCovenant protections remain weak 2We expect a modest improvement incovenant quality in 2016 3Analyzing weak characteristicsidentified by regulators in connectionwith leveraged loans 4Moody's Related Research 10
Tom Marshella 212-553-4668Managing Director– US and AmericasCorporate [email protected]
North American Leveraged Loan Covenants
Stubbornly Weak Loan Covenant ProtectionWill Only Modestly Improve in 2016» Leveraged loan covenant protections remain weak. Our loan covenant quality
scores, which assess the degree of protection that a leveraged loan covenant packageprovides to investors, have remained in the “weak” category since 2013. This suggeststhat investors in today's volatile market are being exposed to rising risk as they forfeit keylevers traditionally available to them when a borrower is in financial distress.
» Our data suggests that in order for covenant quality to significantly improve,investors must push back and demand better protections. We anticipate onlymodest covenant improvement in 2016, absent a major disruption in the leveraged loanmarket, or heightened and sustained regulatory criticism of weak covenants.
» Since publishing leveraged lending guidance in 2013, regulators identified generalcredit agreement covenant protections that they deemed to be weak. Eachof these protections factor into our loan covenant quality scores, including: sales ofassets without lender approval; broad EBITDA add-backs; weak financial maintenancecovenants; use of net debt in leverage covenants; excessive headroom or “cushion” withrespect to leverage ratios; “springing” maintenance covenants; and various accordionfeatures, including uncapped or ratio-based incremental facilities.
» Covenant cushions, and our general financial covenant scores, are slightlyimproving and offering more protection for investors, but not enough to movethe scores from the “weakest” level. Our data also shows that the use of broadEBITDA add-backs, net debt, “springing” maintenance covenants and incrementalfacilities increased from 2013. Our asset sale and mandatory prepayment scores remain“moderate,” with protections unchanged.
This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.
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Covenant protections remain weakOur loan covenant quality (LCQ) scores, which assess the degree of protection that a leveraged loan covenant package provides toinvestors, indicate that covenant protections remain stubbornly weak. (For more information on how we score leveraged loans, see theshaded box on page 4). This suggests that investors – especially in volatile market conditions – are being exposed to rising risk as theyforfeit key levers they have traditionally been able to pull when a borrower is starting to experience financial distress.
Average LCQ scores for loans meeting our scoring criteria1 from 2013 through the first half of 2015 have remained persistently in the“weak” category (3.5 to 4.4 constitute “weak” scores in our analysis; see Exhibit 1 below). We note that there has been no remarkablechange in our scores since regulators published their leveraged lending guidance in the first half of 2013. (See shaded box, below, formore on leveraged lending guidance).
Exhibit 1
Moody's Average Loan Covenant Quality (LCQ) Scores
The first half of 2015 is the latest period for which complete LCQ scores are available, although extremely low leveraged loan volume during the second half of 2015, plus our preliminaryanalysis, suggest that covenant quality remained in the “weak” category for the remainder of 2015.Source: Moody's Investors Service
Leveraged Lending Guidance: The Basics
In March 2013, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency and the Federal DepositInsurance Corp. issued Interagency Guidance on Leveraged Lending to discourage the origination and distribution of poorly underwritten and low-quality leveraged loans. Designed to improve and stabilize the overall banking and broader financial system in the wake of the financial crisis, theguidance applies to certain regulated financial institutions. Regulators have since supplemented the guidance with a series of public announcementsand confidential supervisory criticism.
One focal point of the guidance was on overall leverage levels, with regulators noting that “leverage level[s] after planned asset sales… in excessof 6x Total Debt/EBITDA raises concerns for most industries.” But the guidance also identified general credit agreement covenant protections thatregulators deemed to be weak. Initially, regulators focused on asset sale and financial maintenance covenants, but have since elaborated on otherspecific covenant characteristics that they believe should be strengthened (See Analyzing weak characteristics identified by regulators in connectionwith leveraged loans).
Overlapping with the publication of the leveraged lending guidance, leveraged loan outstandings in 2013 and 2014 rose to theirhighest levels since 2007, according to Thomson Reuters LPC, sustained by a low default, low-interest rate environment dominated byinvestors hungry for yield. During this same period, regulators noted increased competition among lenders to originate deals, which
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further diminished underwriting standards and covenant protections. Deal structures loosened as sponsors and borrowers were able tonegotiate additional flexibility in the form of weaker covenants.
While regulators raised the red flag for initial leverage exceeding 6x EBITDA, we note that average multiple levels did briefly jumpabove 6x EBITDA (see Exhibit 2 below), with leverage levels rising shortly after the guidance was published in Q4 2013 and again at thebeginning of Q3 2014. Separately, although regulators have hinted that total debt should be calculated to include both incremental (oraccordion) facilities and available but untapped debt baskets, our initial leverage levels are based solely on outstanding debt as of theloan closing date.
Exhibit 2
Initial Leverage Multiples (by quarter)
Source: Moody's Investors Service
We expect a modest improvement in covenant quality in 2016While LCQ scores remain persistently weak, we forecast a modest improvement in 2016, driven by a combination of market factors.These include (1) low leveraged loan volume, allowing investors to be more selective in the loans they purchase and to receiveprotections that were not available in the red-hot market of 2013 and 2014; (2) a declining number of leveraged buyouts; (3)regulators' continuing focus on covenants; (4) a rising speculative-grade default rate (see our report, Default Rate to Reach Six-YearHigh in 2016. 29 January, 2016); and (5) market uncertainty in the face of central bank actions globally and in the US. The scope andscale of improvements in LCQ scores would also be significantly amplified by a major disruption in the leveraged loan market or byincreased supervisory criticism by regulators in 2016, citing specific covenant components.
While we expect a modest improvement in 2016, consistently weak loan covenant quality - despite regulatory guidance over the lasttwo years – suggests that it is up to investors to demand better covenant protections. The leveraged lending guidance is by no meansa substitute for thorough credit and documentation analysis. Indeed, our LCQ analysis shows that certain risk categories have actuallyweakened since 2013, including ranking and security/structural subordination; cash leakage/value transfers (i.e., ability for borrowers tomake dividends generally); leveraging (debt incurrence); and investments in risky assets (see Exhibit 3 below).
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Exhibit 3
Breakdown of LCQ Scoring Components Since 2013
Source: Moody's Investors Service
How Moody's Scores Loan Covenant Quality
We compute overall loan covenant quality (LCQ) scores for loans meeting our scoring criteria based on a variety of factors. We measure covenantquality across seven risk categories, each scored on a 1 to 5 scale, with 1 representing strong covenant quality and 5, the weakest covenant quality.Each risk category is individually scored using a weighted average of scores assigned to provisions or covenant features relevant to the given riskcategory. Each risk category score is then further adjusted to take into account certain features or the absence of standard protections that affectcovenant quality. The risk category scores are weighted to determine the overall LCQ score, which follows the same 1 to 5 scale. We determined therelative risk category weights based on our view of the relative importance of the various risk categories to investors.
Analyzing weak characteristics identified by regulators in connection with leveraged loansRegulators have specifically noted the following covenant deficiencies: (1) material dilution, sale or exchange of collateral withoutlender approval; (2) enhancements to EBITDA without reasonable support; (3) reduced number of financial maintenance covenants; (4)excessive headroom in the calculation of financial maintenance covenants; (5) presence of “springing” maintenance covenants, whichare triggered only when a certain amount of the revolving facility is in use; (6) the use of net debt in calculating leverage ratios; and (7)various accordion features, including incremental facilities that allow increased debt above starting leverage and material dilution ofsenior creditor claims.
We generally agree with the list of covenant deficiencies regulators have identified. However we believe investors should also focuson other components that drive our LCQ scores. These include (1) the ability of non-guarantor entities to incur debt under the generaldebt basket and other ratio-based debt baskets (a large component of our ranking and security/structural subordination score); (2) theaggregate quantifiable baskets (or carve-outs) for permitted indebtedness, permitted restricted payments and permitted investmentsavailable as of the initial closing date (a large component of our leveraging score, cash leakage/value transfer score and investment inrisky assets score); and (3) the use of “growth” baskets based on total assets in the case of general carve-outs for debt and restrictedpayments (components that affect multiple risk categories for purposes of our LCQ scoring criteria).
Our LCQ scoring process identifies and tracks several sub-components within each general risk category, including component scoresfor each of the covenant deficiencies identified by regulators above.
Asset Sales and Mandatory Prepayment ScoresMoody’s asset sale and mandatory prepayment scores measure, among other things, the asset sale basket structure and the strength orweakness of mandatory prepayment and reinvestment provisions with respect to collateral and other asset sales.
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Exhibit 4
Asset Sales and Mandatory Prepayment Scores
Source: Moody's Investors Service
Scores in the asset sales and mandatory prepayment risk category have been stable since 2013 (see Exhibit 4 above), offering moderateprotection to investors. Asset sale scores will likely remain flat through 2016, continuing to provide investors with a moderate degree ofprotection.
Aggressive EBITDA add-backs contribute to the weakest level Financial Covenant scoresEBITDA add-backs factor into the overall financial covenants risk category score.
The EBITDA definition flows through credit agreements in meaningful ways, because the definition feeds into the calculation offinancial maintenance covenants and ratio-based incurrence baskets (see our report, EBITDA: Used and Abused, November 2014).
Very aggressive add-backs inflate EBITDA calculations (such as uncapped restructuring charges and uncapped cost savings) and scorehighest/weakest in our system; minimal or no add-backs (i.e., pristine EBITDA) score lowest/strongest.
Exhibit 5
Aggressive EBITDA Add-backs Score
Source: Moody's Investors Service
The base score component for EBITDA add-backs has weakened alongside the publication of the guidance and has remained “weak”since 2013 (see Exhibit 5). Although we have not noted any trends supporting an improvement in this score, continued focus byregulators, coupled with increasing attention from investors (especially in terms of caps on cost savings), may improve these scores in2016.
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Financial Covenants Overall ScoresThe financial covenants risk category score is based on the following three subcomponents: (1) tightest maintenance covenant cushionat issuance (also known as the financial covenant “cushion” score); (2) presence of one or more maintenance covenants, and (3)EBITDA add-backs (as discussed above), with other point adjustments and scoring overrides.
Exhibit 6
Financial Covenants Overall Score
Source: Moody's Investors Service
Although financial covenant risk category scores improved slightly in the first half of 2015, the average score is above 4.40, indicatingthe weakest level of protection (see Exhibit 6). Overall financial covenant component scores will continue to improve modestly andincrementally in 2016, driven by strengthening financial covenant cushion scores as discussed below.
Financial Covenant Cushion ScoresMoody’s financial covenant cushion scores are calculated based on the amount of cushion between the maximum (in the case of aleverage ratio) or minimum (in the case of a coverage ratio) permitted covenant level and the actual ratio as of the loan closing date.The cushion, which we measure as a percentage of adjusted EBITDA, shows how much adjusted EBITDA would have to decrease orincrease before a borrower would no longer be in compliance with the maintenance covenant.
Exhibit 7
Financial Covenants Cushion Scores
Source: Moody's Investors Service
Financial covenant cushion scores are noticeably improving (see Exhibit 7), albeit at the weakest levels.
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Although cushion scores have improved since 2013, the continued dominance of covenant-lite loans in the market continues to dragthe average score down (in deals with springing maintenance covenants, the financial covenant cushion score component receives anautomatic worst possible score of 5).
The rise of springing maintenance covenants since 2013 and other covenant-lite structures significantly undercuts covenant protectionsfor most term loan investors. (See Exhibit 8, below. Also see our report, The Cov-Lite Label Can Mischaracterize Credit Risk, November2015).
Exhibit 8
Percentage of Deals with “Springing” Maintenance Covenants
Source: Moody's Investors Service
Nonetheless, strengthening covenant cushion scores, as demonstrated by the trend line in Exhibit 7, will likely be the primary driver ofimprovements in the overall financial covenant risk category scores in 2016, but will continue to remain in the “weak” category as aresult of the prevalence of covenant-lite structures in the market (as shown in Exhibit 8). If investors begin to seriously push back oncovenant-lite structures in 2016, financial covenant overall and cushion scores would improve dramatically.
Use of Cash NettingThe use of cash netting is a subcomponent of our overall financial covenants risk category score. Cash netting gives borrowers theability to reduce the debt figure used in the calculation of leverage ratios by subtracting the amount of cash and cash equivalents ontheir balance sheets.
Our scoring criteria penalizes uncapped cash netting - the rationale being that cash on hand may not necessarily be used to reducedebt in the future. Regulators have similarly criticized cash netting for this reason.
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Exhibit 9
Percentage of Deals Broken Down by Type of Cash Netting
Source: Moody’s Investors Service
Since 2013, we have noted an increase in the use of uncapped cash netting (see Exhibit 9). While uncapped cash netting has decreasedin 2015 from its 2014 high, it is still higher than in 2013. Without significant investor push-back in 2016, the percentage of dealspermitting uncapped cash netting will likely remain the same as in 2015, with the majority of deals permitting uncapped cash netting.
Incremental FacilitiesThe structure of an incremental facility provision factors into our miscellaneous scoring criteria (along with lender voting rights,assignment provisions, etc.)
An incremental facility provision provides flexibility for a borrower to add additional debt under the credit agreement, generally at thesame priority level as the original loan, with the same collateral priority as existing lenders. Similar to our scoring criteria, regulatorshave criticized incremental (or accordion) features that permit increased debt levels under the credit agreement above starting leverageand the concurrent dilution of senior secured facilities.
We assign incremental scores based on the structure of the incremental provisions. No incremental capacity scores a 1 (the strongestscore), while uncapped incremental capacity, subject only to there being no default, scores a 5 (the weakest score).
As shown in Exhibit 10, incremental facility scores have significantly worsened since 2013, with the majority of deals having anincremental structure permitting both (1) a fixed-dollar starting basket and (2) an additional amount so long as the borrower is incompliance with a leverage ratio.
Exhibit 10
Incremental Facilities Score
Source: Moody's Investors Service
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Regulators have noted that “[i]ncremental facilities have been included in loan agreements for a number of years, but are drawingattention because of their increased usage in conjunction with relaxation of other structural elements such as covenants andrestricted payments.” In other words, regulators likely wish to see additional or concurrent tests for incremental use (such as covenantcompliance, in addition to a simple “no default” requirement ) and a prohibition on using incremental proceeds for dividends (versusother value-added transactions such as investments or acquisitions).
Incremental facility scores will remain relatively flat in 2016, with no significant changes forecasted. Dramatic improvement inincremental facility scores will likely only be achieved by heavy investor attention to these mechanics or sustained criticism of thesestructures by regulators.
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Moody's Related Research
» US Corporate Default Monitor - Fourth Quarter 2015, January 2016
» The Cov-Lite Label Can Mischaracterize Credit Risk, November 2015
To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of thisreport and that more recent reports may be available. All research may not be available to all clients.
11 8 March 2016 North American Leveraged Loan Covenants: Stubbornly Weak Loan Covenant Protection Will Only Modestly Improve in 2016
Endnotes1 Moody’s covenant team analyzes syndicated speculative-grade leveraged loan issuance over $500 million originated in the US and Canada with publicly
and timely available credit and financial documentation. The covenants team identifies whether a loan is leveraged by whether the loan is rated non-investment grade by Moody’s, followed by other characteristics such as spread, use of proceeds, presence of equity sponsor, etc.
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