S&P Sounds Alarm on Cov-Lite Loans in CLOs

One of the most talked-about events at Information Managment Network’s Second Annual CLO Conference took place before participants arrived.

On April 5, Standard & Poor’s sounded the alarm about loans with weak or non-existent maintenance covenants, which are playing an increasing role in collateralized loan obligations. The ratings agency warned that it would take this into account in rating deals.

S&P noted that the “demand pull” from CLOs themselves may be fueling the increased issuance of so-called covenant-lite loans. “We view the resulting lower recovery prospects as a critical factor we address when we rate CLOs,” it said.

Throughout most of 2012, new CLOs had maximum covenant-lite buckets of 30% to 40%, according to S&P. In the first quarter of 2013, the percentages trended toward, and even surpassed 50%, the agency said.

To take a recent example, the $500 million Apidos CLO XII, which closed in April, has a covenant-lite bucket of up to 60%, according to a presale report published by S&P.

Speakers on an IMN panel of investors in the mezzanine tranches of CLOs said it was worth paying attention to the size of covenant-lite buckets. Niraj Patel, a managing director at Genworth, pointed out that mezzanine CLO notes are “long-dated investments with no put option... you have to be very comfortable with the manager.”

Aaron Meyer, a principal at Silvermine Capital, said that, even in a low-default environment, “credit discovery matters,” and “the market should value it.”

The problem isn’t just weak covenants, according to S&P; it’s the fact that even the riskiest companies are able to issue covenant-lite loans. “Unlike pre-crisis covenant-lite loans that were generally limited to stronger borrowers, in our view, the recent wave of covenant-lite loans includes borrowers with weaker profiles.”

S&P also thinks that the credit cycle is entering into a period of deteriorating credit quality and, with the speculative-grade cycle becoming negative, recoveries can also become challenging for buyers.

The rating agency addresses this elevated credit risk through the recovery rate assumptions it employs in its cash flow analysis of CLOs.

Although many CLOs issued pre-crisis, including those with heavy concentrations of covenant-lite loans, performed well, S&P is holding new CLOs to a higher standard: In order to obtain a ‘AAA’ rating, a CLO tranche must demonstrate the ability to pay under economic stresses that S&P views as equivalent to the Great Depression.

Taking this stance could cost the rating agency market share in of one of the busiest sectors of the securitization market. CLO issuance reached $50 billion in 2012, and forecasts for this year range as high as $75 billion.

What’s more, not everyone shares the rating agency’s sense of alarm.  Richard Farley, a partner at the law firm Paul Hastings, told ASR sister publication, Leveraged Finance News, that the “drivers for the healthy covenant-lite issuance are simply supply and demand. The robust nature and liquidity of the leveraged finance market are to the borrowers’ advantage.”

Farley said that, “outside of the middle market, it’s unusual to see something that’s not covenant-lite or carries with it a springing covenant on the revolver.”

However, not all covenant-lite loans are created equal. David Keisman, a senior vice president at Moody’s, said in a telephone interview with LFN that from a recovery basis, covenant-lite loans did “well overwhelmingly when they were well-structured loans. This means the loans had subordinated debt or had an underlying debt cushion beneath the first-lien. In our analysis, a 40% of balance sheet support below the debt is sufficient cushion.”  —By Karen Sibayan


CLO M&A: Unmotivated Buyers, Unmotivated Sellers

Consolidation among managers of collateralized loan obligations has slowed considerably, and not just because so many smaller players have already teamed up with larger ones.

Instead, many smaller CLO managers are finding they don’t need the deep pockets and wide reputations of bigger players to bring new deals to market.

“A few years ago, there was a question if [some smaller managers] had the ability to build deals,” Christopher Allen, senior managing director at CVC Credit Partners, told attendees at the IMN’ conference. 

CVC Credit Partners was formed last year when European private equity group CVC Capital Partners Group purchased Apidos Capital Management from Resource America.

But recently, Allen said, CVC was in talks to acquire another CLO manager that ended when the other CLO manger was able to issue a deal on its own.