By Tom Stock, Senior Vice President, GoldenSource.
Lenders across the globe are bracing themselves for a plethora of defaults by business borrowers. One could say this is the calm before the real COVID-19 induced economic storm. While many businesses have been granted temporary reprieves via government loan support, this next wave has the potential to swiftly wipe out a number of lenders from the scene as liquidity becomes dried up.
In a desperate attempt to keep the economy moving, many government-backed loans have already reached debt laden companies. However, governments are hesitant to lend to PE portfolio companies due to the fact that PE firms, due to the nature of their business, already hold highly leveraged positions. The trouble is that the knock-on effect of these measures has not yet been felt by the wider industry.
Firstly, there are the arrangers, the banks initiating the debt to the PE portfolio firm to support the leveraged buyout, before then selling some of the debt off (syndicating) to investors who buy up variable rate leveraged loans. With less appetite from spooked investors, and as defaults mount, banks will be less willing to arrange these loans and will have a smaller market to syndicate them. Carrying a larger proportion of the risk at this time is also unlikely to align with the risk profile of many arrangers.
Then, there are the numerous asset managers that are running specialist leveraged loan funds, heavily invested in this leveraged debt. The assets in these funds are inherently riskier during a downturn. The tradability and valuation of the underlying debt will be impacted by the liquidity of the portfolio firm and the market overall, maturity dates, and the extent to which the debt is senior and secured by strong covenants.
In the period prior to the COVID-19 pandemic such leveraged loan investments were in high demand and the covenants around them became more lax, because firms invested whether or not the covenants adequately reduced the potential loss associated with default. Typically, there would be covenants around the assets of the company and to protect the seniority of the debt from future issuance of debt. Portfolio firms had to maintain certain financial ratios. Weaker covenants expose lenders and also investors in PE funds. PE partners might have shifted primary assets, such as buildings or intellectual property, to new firms or obtained additional debt with higher seniority. Only when defaults occur, and loan documentation is tested in the courts will the true extent and cost of the loopholes be exposed.
All this means that there has never been a more pressing need for bank loan data in order to really understand what an investor’s or arranger’s position or risk actually is. This means understanding what specific covenants an asset manager may have, related to such debt. If the covenants are weak, an asset manager then has to assess the probability of failure during the pandemic and the extent to which are protected. This involves having a granular understanding of what sort of business a portfolio company is in and the covenants that are protecting their assets. For example, is it a loan that is exposed to a restaurant chain on the brink of bankruptcy, and did their properties get transferred to a different entity in the meantime?
A lot of PE groups often leave their portfolio companies with a thin financial cushion, which presents a problem when trying to navigate through times of economic stress. However, given the scale of the current crisis, one cannot help but think that there are more firms at risk right now then during previous downturns. Businesses have issued highly leveraged, covenant-lite loans out into the marketplace and, as a result, are at a higher risk of causing widespread impact if they fail. All of the leveraged loan funds, individual holdings of asset managers and pension funds that hold a lot of these syndicated bank loans are, as an unintended consequence, at significant risk. Unless steps are taken to get a better handle on their exposure to all this, then this health driven economic crisis will soon turn into the next financial crisis where lack of transparency about exposures reduces the ability to respond and mitigate.
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