LONDON (Reuters) – Flimsy loan agreements drawn up in haste during the credit boom are coming back to haunt lenders as private-equity owned companies blow up without advance warning, forcing banks to rein in lending and tighten standards.
Italy’s Ferretti shocked lenders when its value plummeted to little more than 100 million euros ($126.9 million) last month — roughly the same value as just two of the luxury shipbuilder’s most expensive yachts.
There had been little warning the group was in difficulty before its private equity owners walked away.
Unlike listed firms, which are forced to regularly release information to the public, companies owned by private equity do not have the same restraints. And during the boom years of 2006 and 2007, already low levels of disclosure slipped even further.
“Some of the documents around were put together in a very different market — we have seen some deals where lenders have a right to information about a company’s performance only every six months,” said Kevin Hewitt at FTI Consulting.
“Whatever form the lending market takes when it returns, there will be much higher standards for the information companies have to provide their stakeholders, as well as much tighter corporate governance,” said Hewitt.
In another example, Swedish auto parts supplier Plastal Holding filed for bankruptcy on March 5, barely two months after private equity owner Nordic Capital made a “substantial” cash injection into the company, in January.
The loose terms offered to borrowers during the boom years of 2006 and 2007 help explain the low number of defaults seen so far in Europe, because lenders have few levers to take control of a company if it is getting into difficulty.
Such “covenant lite” and “covenant loose” loans, however, will only provide a short-lived stay of execution, and credits from this era will now experience the sharpest increase in defaults, Commerzbank analysts said in a note.
“Investors have been looking for higher defaults for some time, but the speed of the acceleration will surprise them,” the bank said.
During the boom era, many borrowers were able to dictate terms to lenders because debt was cheap and the market was flooded with new and less discerning entrants.
“There was so much cash in the market people were fighting to get onto the deals (and lend) rather than fighting about the terms of the deals,” said Carolyn Conner, a restructuring partner at law firm Allen & Overy.
Covenants — which give lenders the right to take control of a company if it fails to meet pre-stated performance goals — became increasingly loose through 2006 and the first half of 2007 (For more on covenants, see).
Lenders, however, are now seeking greater protection, as their business is hurt by the global downturn.
During the fourth quarter of 2008, 64 percent of Europe’s banks reported tightening credit standards, according to a European Central Bank survey published February 13.
The cost of insuring risky debt has risen sharply since the start of the year, with the iTraxx Crossover index, made up of 50 mostly “junk”-rated credits, hitting a record high on Monday, at 1170 basis points.
Leveraged lending in Europe has also shrivelled, amounting to just $2.0 billion in the first two months of 2009, compared to $11.1 billion in the same period of 2008 and $30.6 billion in 2007, according to Thomson Reuters LPC data.
The largest leveraged loan likely to be syndicated shortly is a $1.275 billion credit backing the buyout of set-top box technology maker NDS Group.
Syndication of the loan has been repeatedly delayed since banks were initially appointed in September, however, in a sign of how difficult even such a small deal, by boom-era standards, is to complete.
Inevitably, more companies will fail as banks clamp down on lending. And this will affect heavily indebted listed companies, as well as those owned by private equity.
For example, shares in Taylor Wimpey have slid 90 percent in the last year as the UK housebuilder has struggled to seal a deal with lenders over its 1.6 billion pound debt load.
Rating agency Moody’s forecasts its speculative grade default rate — which measures the number of defaults of the companies with the lowest credit ratings — will hit 22.5 percent end-2009, up from 2.7 percent in February.
The euro zone’s 1.5 percent economic contraction in the fourth quarter of 2008 is another sign of an imminent sharp acceleration in defaults, Commerzbank said.
Banks will bring in the lawyers and will scour the often hastily-written loan agreements for any mistakes or ambiguities which might give them an advantage over rival claimants.
“If the documents are unclear you will exploit whatever weaknesses you can to ensure your client’s position is protected,” Allen & Overy’s Conner said.
By Tom Freke
(Additional reporting by Zaida Espana; editing by Simon Jessop)