NEW YORK (Reuters) – Private equity firms, battered by the financial meltdown, are now thankful for deals that were cushioned with looser loan covenants and debt restructuring terms as they steer acquired companies through stormy seas.
But while the new wriggle room allows temporary relief to PE-owned companies it isn’t clear whether the softer covenants introduced during the recent boom will resolve underlying problems in the investments or just delay them.
“The jury is still out as its a relatively recent phenomenon,” said Russell Solomon, senior vice president of corporate finance at credit rating firm Moody’s Investors Service. He said so-called covenant-light deals extend the life of a company because the normal default triggers are not there.
Lenders could be worse off since it takes them longer to get a seat at the bargaining table because there are less trigger points to a default and they could also have less muscle to renegotiate terms.
Covenant-light deals lack the traditional restrictions on borrowers, while pay-in-kind deals, also called PIK-Toggle, allow firms to defer interest payments in favor of issuing more debt.
“Our fundamental concern is the extent it prolongs the ability for more senior creditors to take action,” said Solomon, referring to covenant-light loans. He said that could result in lower recovery prospects for creditors.
Issuance of covenant-light loans peaked in the second quarter of 2007 with $32.96 billion sold, nearly five times more than the same period the previous year, according to data from Reuters LPC (RLPC).
Deals signed included the $17.6 billion buyout of Freescale Semiconductor and the $26 billion takeover of payment processor First Data Corp, according to RLPC.
Looser covenants typically mean investors put a discount on the debt, reflecting the higher risk.
Recent bid levels on First Data’s LBO loan, which was structured and sold during the private equity bubble, were in the range of 71 cents to 73 cents on the dollar, according to RLPC.
But Getty Images, a buyout deal with a tighter covenant package reached after the frothy market collapsed, had recent bid levels on its LBO debt in the range of 87 cents to 88 cents, said RLPC.
Similarly, electing to use a PIK-Toggle option can been viewed as sign of stress. Moody’s said in a recent report it expects the number of companies using a PIK option to increase over the next year as operating cash flow shrinks and tight credit markets make it difficult to refinance long-term debt.
“It’s a calculation — whether its worth say 13 percent a year to have more cash now and guarantee getting through the next two years,” said Stephen Moseley, president of private equity advisory business StepStone Group LLC. “I think most companies today would rather have the cash in the bank.”
Moody’s said in an October report that during the last two quarters at least 11 high-yield issuers, including casino operator Harrah’s and retailer Claire’s Stores, elected to use the PIK option or said they intended to do so.
If the economy goes into a protracted downturn, debt-loaded portfolio companies could face serious problems. There is an argument that in such times, flexible debt terms are a big bonus.
“These flexible bonds, far from being an abuse of unsuspecting lenders by private equity, have enabled many borrowers to stay in business despite strong economic headwinds,” Blackstone Group LP (BX.N) Chief Operating Officer Tony James wrote in an Oct. 23 column in the Financial Times.
“Loans with strict covenants can destabilize an otherwise healthy company, when even a short recession over a few quarters might trigger defaults,” James wrote.
Gar Bason, head of the mergers and acquisitions group at law firm Davis Polk & Wardwell, said lenders will likely give companies a bit of wriggle room.
“Lenders will almost always conclude that giving you a little bit of room, and a little bit of rope, is more value enhancing to them than pushing you into Chapter 11,” Bason said. “In most instances, abiding with a company and giving it room will be better than not.”
One benefit right now is that the massive amounts of debt issued and refinanced in boom years of 2005 through the first half of 2007 isn’t coming due for some time, according to Chris Taggert, a senior loan strategist at research firm CreditSights.
“If those debt maturities were today, in this environment, it would be Armageddon,” he said. “But it’s a couple of years away, and ideally we’re not in a credit crisis or an economic downturn.”
Taggert said the private equity firms with struggling deals are “not going to just wait for them to fall off the cliff before they refinance the debt.” He foresees some “heavy-duty bargaining sessions” ahead, and said private equity groups may very well have to give up some of their interest or put in more cash.
By Megan Davies