Debt is back.
High-yield debt interest rates are low and companies are rushing to borrow. But the revival of the debt market raises questions about whether Wall Street is repeating the same mistakes as before the financial crisis and whether regulators will be effective this time around.
Since Jan. 1, companies have issued $38 billion worth of high-yield debt, a 60 percent increase over last year, according to Dealogic. Interest rates have declined sharply and high-yield debt now yields about 8.5 percent, compared with 10.6 percent in 2009, according to Thomson Reuters.
Private equity, which lives on high-yield debt by borrowing to buy companies, is one of the biggest beneficiaries of investors’ hunger for yield. According to Standard & Poor’s, leverage ratios on private equity acquisitions are going up — from four times earnings before interest, taxes, depreciation and amortization, or Ebitda, in 2009, to 5.2 times Ebitda in the last quarter of 2010. This is still below the high of 6.4 times Ebitda in 2007, however.
More worrying to some critics has not been the rising leverage, but the return of “cov-lite” bank debt. Bank debt issued in private equity transactions historically contained “maintenance” covenants. These require the borrower to meet certain standards, like an earnings ratio. If the borrower violates these covenants, the bank can call the debt.
When these covenants are violated, banks typically do not foreclose. The banks instead charge the borrower a fee to waive the default. These covenants thus allow banks to monitor companies if their business is deteriorating, and to receive extra fees, but defaulting on them does not typically result in much more.
Cov-lite transactions do away with maintenance covenants. This type of debt first appeared in the years before the financial crisis. In 2007, according to S.&P., $96 billion worth of cov-lite debt was issued, mostly to finance private equity buyouts. But only $5 billion of cov-lite debt was issued in 2010. Already this year, $17 billion worth of cov-lite debt has been issued, constituting 25 percent of this market.
Cov-lite borrowing raised alarms in 2007 and is again being criticized on similar grounds. By forgoing maintenance covenants, the banks forfeit future leverage over the company and allow borrowers to take riskier actions. Cov-lite, it is claimed, is an easy way for companies to take advantage of lenders.
There are defenders of cov-lite, however. Private equity firms pay a higher interest rate in cov-lite deals, so the risk may be priced in. Hamilton E. James, president of the Blackstone Group, recently argued that cov-lite allowed private equity firms to do what they do best, manage the company through any crisis and avoid a bank takeover, which would destroy value. There is some evidence that he is correct.
Moody’s Investors Service recently released a report noting that the default rate for cov-lite deals during the financial crisis was lower than for similar debt with maintenance covenants. Moody’s attributes it to the short duration of the crisis.
Who is right? Cov-lite has resulted in banks’ missing out on refinancing fees later down the line. Cov-lite debt has also permitted companies to restructure their debt more aggressively, as Apollo Management did with its debt restructuring of Realogy in 2009. But otherwise, a chain reaction of cov-lite blow-ups — the fear in 2007 — has not happened.
It may be that banks have become careful in selecting cov-lite recipients. Of the 18 cov-lite deals struck so far in 2011, S.&P. reports that 11 of those are refinancing, meaning the market has had time to assess how the companies have performed.
Cov-lite therefore may be a problem, but we don’t know yet.
So have the banks learned anything from the crisis?
In some ways, yes. During the financial crisis, banks became stuck with hundreds of billions in debt that was unsellable in part because it contained cov-lite terms. It appears that banks are now demanding “flex terms” that permit them to add back in maintenance covenants if the debt cannot be sold.
Banks may have greater incentives to be careful about the companies that receive this debt. Before the financial crisis, banks could securitize this debt into collateralized loan obligations, or C.L.O.’s, and sell it to third parties. The banks therefore bore little or no risk of a default, meaning they more easily negotiated debt terms.
But the C.L.O. market remains moribund. According to Thomson Reuters, there were 316 C.L.O. deals worth $152 billion in 2007. Last year, there were just six deals. Despite the return of high yield, only three C.L.O. deals have been announced this year.
Debt risk remains with the banks; hopefully they will more carefully scrutinize borrowers. Certainly they are keeping the deals to a smaller size. In the last year, the largest private equity buyout was the $3.7 billion deal for Del Monte Foods, a far cry from the numerous $10 billion-plus deals of 2007.
These numbers show that Wall Street has learned, but Wall Street also has a famously short memory.
This is the real problem with the return of cov-lite and the rise in leverage. It shows memory lapses can take effect quickly. These events may not be bad today, but they show how fawning banks become when interest rates are low. The headlong rush for yield can quickly bring back old practices and subvert prudence.
And this is why regulation will be so important to prevent a repeat of the crisis. The Basel III accords, when they take effect, will require banks to hold more capital, meaning more conservative lending. But banks can still securitize and sell this debt once the C.L.O. market inevitably revives.
The Dodd-Frank Act seeks to deal with this problem by requiring that banks keep at least 5 percent of any asset securitized. The idea is to ensure that banks do not again water down standards, by keeping their skin in the game.
The banks have protested, saying that this will slow down the “animal spirits” and constrain lending. Recent developments show that when the market heats up, the banks have little leverage. Money pours in and the private equity firms and other borrowers do only what comes naturally — borrow more on easier terms. The result can be overleverage during the bad times.
If anything, the return to precrisis leverage levels and the strength borrowers are already exerting in negotiations shows that last year’s financial overhaul may not be enough. Even though banks are acting more carefully, one wonders what will happen five years from now. It may be time to give regulators stronger tools to cap leverage and place even higher capital and asset retention requirements.