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Cost-Cutting Plans Erode Middle Market Loan Safeguards

Cost-Cutting Plans Erode Middle Market Loan Safeguards

(Bloomberg) -- Investors are demanding strong protections on middle market corporate loans, but ambitious cost-cutting projections that make earnings look rosier than they are could still expose them to losses in a downturn.

Almost a third of middle market loans for private-equity owned firms arranged over the past year were covenant-lite, according to a recent report from research firm Covenant Review, which surveyed loans of $50 million to $250 million. Taken at face value, that implies they’re safer than loans to companies owned by mid-sized and large sponsors over the same period where covenant-lite was more prevalent at 81% and 94% respectively.

Yet that may not be the case thanks to add-backs to Ebitda, which help inflate earnings before interest, taxes, depreciation and amortization -- a measure of earnings -- while also making a company’s leverage appear lower.

So-called maintenance covenants -- financial tests typically carried out every quarter -- help alert investors to signs of stress and often give them more power in potential restructurings. But loose terms on add-backs may make those covenants less meaningful, Covenant Review warns.

“Lenders in the middle market are still not comfortable with covenant-lite structures, but they’re giving away the shop with aggressive Ebitda add-backs,” said Covenant Review analyst Ian Walker. “If you have sufficient Ebitda add-backs, and you can juice your Ebitda numbers, it means that financial covenants are not going to be as effective.”

Growing Concern

Such add-backs might include cost cutting projections that haven’t yet materialized. Without specific controls, including deadlines for when those cuts have to be met, companies may avoid breaching a covenant even when they miss targets.

Such adjustments have become an increasing concern in other places of the credit market such as institutional loans. In a report last year, S&P Global Ratings found that companies that borrowed to finance takeovers or leveraged buyouts in 2015 inflated projected earnings by an average of 45% because they relied on overly optimistic projections.

“When taken with the cushion on the sponsor’s model in setting covenants, the scope or looseness of Ebitda add-backs can drive much wider cushions in the final numbers,” Randy Schwimmer, head of capital markets and originations at Churchill Asset Management said in a June report about covenants easing in sponsor-backed deals.

Nearly all middle market loans arranged over the past year - some 93% - included expected synergies in their Ebitda adjustments, Covenant Review said. Synergies were capped at 22.4% on average, but around 15% of the loans had uncapped synergies where add-backs were unlimited.

Arrangers are agreeing to covenants to make investors comfortable, while still leaving borrowers with leeway, said Walker.

“Transactional flexibility is key for borrowers,” Schwimmer wrote. “These provisions reflect that sponsors are often successful in negotiating for this elbow-room.”

To contact the reporter on this story: Kelsey Butler in New York at kbutler55@bloomberg.net

To contact the editors responsible for this story: Natalie Harrison at nharrison73@bloomberg.net, Sally Bakewell

©2019 Bloomberg L.P.