Cov-lite financing complicates life for distressed investors

The reason that the next credit crunch will be harder to play is the profusion of covenant-light loans, which will limit the ability of debt-holders to precipitate action based on the borrower’s technical violation of those covenants, market players say.

“It’s going to lengthen investment cycles,” said David Groban , head of research at MatlinPatterson Global Advisers, a credit-focused private equity firm in New York. “What it comes down to is finding the right entry point, because there are no accelerating events.”

Even today, MatlinPatterson is focusing on “specific situations where there is an immediate liquidity issue driving the event,” Groban said.

So-called cov-lite lending has exploded as credit investors compete more aggressively in an environment of historically low interest rates. Total cov-lite volume reached $381 billion in 2013, easily surpassing 2007’s prior record of $108 billion, according to sister service Thomson Reuters Loan Pricing Corp, which tracks the commercial lending market. Practically one out of every two institutional deals was structured with the cov-lite feature in 2013 and lenders do not see the trend abating soon.

But the day of reckoning also seems distant. The speculative-grade default rate on U.S. borrowers fell to 2.2 percent in the fourth quarter, down from 2.7 percent in the prior quarter, Moody’s Investors Service Inc reported in January. At the end of 2012, the U.S. rate stood at 3.4 percent, and the credit rating agency predicted that the rate will be 2.3 percent in the U.S. by the end of this year.

In the meantime, commercial borrowers have taken advantage of low rates in recent years to extend the maturities on their debt, and with rates expected to remain low until at least 2015 and with the economy showing signs of stronger growth, the next wave of macro-driven loan defaults probably is several years away in the future.

“As we’ve seen these credit metrics become more aggressive, we’ve throttled back,” said William Landis, managing partner at Raith Capital Management, a New York-based private equity firm that invests in commercial real estate debt. “We literally go loan by loan, asset by asset, and we are finding deals to do.”

Groban and Landis were among the speakers at a “distressed debt investing summit” in New York, staged by iGlobal Forum, an event-planning firm serving the financial industry. Participants at the conference said they were concentrating on specific situations, such as the economic pressures facing publicly traded retailers such as J. C. Penney Co, Sears Holdings Corp and Radio Shack Corp, as well as the difficulties facing buyout-backed businesses such as the broadcaster Clear Channel Communications Inc, backed by Bain Capital Partners and Thomas H. Lee Partners, the specialty retailer Guitar Center Holdings Inc, also backed by Bain Capital, and U.S. casino operator Caesars Entertainment Corp, which is backed by Apollo Global Management and TPG Capital.

One credit receiving special attention at the conference was the Texas electric utility Energy Future Holdings, the October 2007 buyout by Kohlberg Kravis Roberts & Co, TPG and Goldman Sachs Group Inc’s private equity arm GS Capital Partners. The $45 billion deal was history’s largest buyout. EFH skirted bankruptcy last fall when it made an interest payment of about $270 million to subordinated bondholders that many market watchers had expected it to miss. Plans for a pre-packaged Chapter 11 have been snarled for the past year as sponsors tried to negotiate with creditors, including Oaktree Capital Management and Apollo Global Management. EFH’s next test comes in the spring, when investors again question whether the company will make its next semi-annual debt payment.

Some investors continue to look for industry themes rather than special situations. The credit investor Archview Investment Group has been following the shipping industry for several years, looking for an opportunity to buy loans from banks at less than net asset value, but the right buying point has not yet appeared, largely because growth in the U.S. shale industry has dampened demand for shipping products such as petroleum, said Aaron Rosen, a principal at Archview and its director of research, but the firm continues to look for an “opportunity to buy below NAV and take advantage of a cyclical upturn.”

Benign economic conditions increase the challenges of investing in distress, acknowledged Groban of MatlinPatterson. “You can still win big. You’ve just got to dig a little harder.”