Leveraged Loan Investors Worry Good Times Will Soon Haunt Them
(Bloomberg) -- One of the safest ways to invest in junk-rated companies is starting to look pretty risky.
Money managers have grown increasingly concerned about loans to high-yield corporations over the last month as early signs of slowing global growth have emerged. Investors are starting to realize that a key safeguard that protects them, namely the collateral they can seize if a company goes under, gives them less cover than they thought.
In December these worries helped push down prices in the $1.3 trillion leveraged loan market, hitting the debt that financed some of the biggest buyouts of 2018. In the go-go credit markets of the last two years, companies won unprecedented power to sell businesses, move operations to different units, and use other tactics to move assets out of the reach of lenders before defaulting.
“Collateral is a big long-term risk,” said Chris Mawn, head of the corporate loan business at investment manager CarVal Investors. “You think you’re secured by a Cadillac, but three years from now, it turns out you’ve got a Chevy.”
The loose contract provisions that money managers have agreed to over the last two years mean that when borrowers actually do start going under en masse, creditors are likely to end up with fewer assets to liquidate, and ultimately bigger losses. Private equity-backed firms have generally been the most aggressive borrowers when it comes to pushing for the right to move around collateral.
When Blackstone Group bought out a majority stake of Thomson Reuters Corp.’s financial terminal business last year, its $6.5 billion loan offered it wide latitude to sell assets and pull cash from the company. Soon after that Bloomberg reported that the business, dubbed Refinitiv, was looking at offloading its currency trading unit, among others. These concerns along with broader market volatility helped push the bid on these loans as low as 93.375 cents on the dollar in December, from their initial sale price of 99.75 cents.
Loans sold to help finance another leveraged buyout in September for Envision Healthcare have similarly fallen, to 93.75 cents from their original 99.5 cents. Investors have grown more worried that private equity owner KKR can easily sell off a more profitable portion of the company’s business and leave lenders with the less attractive part, according to people with knowledge of the matter.
Sometimes loan investors don’t realize the extent of the rights they’ve given to a corporation and its private equity owners until assets are taken away. The contractual provisions that allow greater flexibility, known as covenants, may be spread through a lengthy lending agreement. Only careful consideration of how different lending terms interact with each other reveals what a company can do.
“There are covenants that put together can make a loan like an equity,” said Jerry Cudzil, head of credit trading at money manager TCW Group Inc., which oversaw $198 billion of assets as of Sept. 30. Equity usually has the last claim on assets when a company is liquidated, making it the riskiest kind of investment in a company.
Weaker collateral protection is just one factor that makes loans to junk-rated companies much riskier in this cycle than they’ve been in previous downturns, and one factor spurring investors to pull money from leveraged loan funds. Companies have more debt relative to their assets than they had in the past, which means that if a failed corporation liquidates, the proceeds have to cover more liabilities.
On top of that, a higher percentage of loan collateral is intangible assets -- about two thirds, up from about 60 percent in 2009, according to UBS Group AG. Those kinds of assets, like brand names, are harder to value and liquidate than tangible assets. And more borrowers have just loans and no other form of debt this time around, meaning if the company fails, there are fewer other creditors to absorb losses.
Add it all up, and Moody’s Investors Service reckons that investors will recover just 61 cents on the dollar when first-lien term loans go bad whenever the market turns, well below the historical average of 77 cents.
Credit Brief: Fear and Loathing in Leveraged Loans
A key to loosening investors’ hold over collateral has been tweaking the tests that determine if a company is earning enough relative to its debt obligations, known as leverage. As long as corporations are generating enough income, managers often have the freedom to move assets around and pull money from the company, among other things. Companies have been easing the requirements for these tests, making it easier for them to clear the hurdles and keep their flexibility.
“These leverage tests are like a master key that unlocks all these flexibilities,” said Derek Gluckman, analyst at Moody’s, “and the master key is working better and easier.”
One of the first signs of the potential trouble ahead for loan investors came from J. Crew Group. In 2016, the preppy clothing retailer told lenders it was moving intellectual property including its brand name into a new unit that was out of the reach of creditors as part of a restructuring, a process it completed in July 2018. Litigation ensued, as angry lenders said that collateral was being taken away from them. But the company has showed signs of recovering, and its term loan now trades at 92 cents on the dollar, up from around 55 cents in November 2017.
J. Crew’s efforts seem to have inspired other private-equity owned retailers as well. PetSmart Inc. and Neiman Marcus Group Inc., for example, have shuffled online businesses into different units where lenders can’t reach them.
“If new terms get through, all the private equity firms and their counsels start to claim that the new term is becoming standard in the market and they point to the precedent,” said Justin Smith, an analyst who looks at high-yield lending agreements at Xtract Research. “There are too many lenders who don’t care enough about covenant packages or don’t pay attention.”
©2019 Bloomberg L.P.