99 Cents Only Stores operates a chain of over 300 “extreme value retail stores” in California, Texas, Arizona and Nevada.The company was founded in 1982, and in January 2012 it was taken private by Los Angeles private equity firm Ares Management and the Canada Pension Plan Investment Board. The new capital structure was typical of LBOs done at that time:
|
Size (millions) |
% of Capitalization |
EBITDA Multiple(b) |
|
| Revolver(a) |
$10 |
|
|
| Term Loan |
$525 |
|
|
|
Total 1st lien debt |
$535 |
38% |
3.4x |
| Senior Notes |
$250 |
18% |
1.6x |
|
Total Debt |
$785 |
55% |
5.0x |
| New Equity |
$536 |
|
|
| Rollover Equity |
$100 |
|
|
|
Total Equity |
$636 |
45% |
4.0x |
|
Total Capitalization |
$1,421 |
100% |
9.0x |
(a) The Revolver commitment was $175 million, of which only $10 was borrowed at the time of the transaction
(b) Using fiscal year 2012 pro-forma adjusted EBITDA, a reported by the company
The company’s choice of loan products shows that one of its objectives was to maintain as much operating and financial flexibility as possible:
- The revolver is an Asset Based Lending (“ABL”) facility. Compared to most secured “cash flow” revolvers, ABL facilities typically have fewer and less restrictive covenants. In fact, it is common for ABL facilities to have no financial covenants, or to have financial covenants that are only measured if the company borrows most of what is available under the borrowing base. This additional flexibility is a key advantage for ABL borrowers.
- The term facility is a Term Loan B (“TLB”). This provides the company with significant cash flow flexibility. It has amortization of only $5.25 million per year (i.e. 1% of the original principal) and a final maturity of 7 years (with a balloon payment of about $490 million). Had the company chosen a Term Loan A, the final maturity would have been shorter (i.e. only 5 years) and there would have been significant quarterly principal payments so that the loan would have been repaid in full by the maturity (without a balloon payment at the end). The TLB gives the company a longer maturity and requires only token amortization.
- The TLB is “covenant lite.” As described by the company, the TLB “includes restrictions on the Company’s ability … to incur or guarantee additional indebtedness…”
Some Definitions:
- Most loan agreements include “maintenance covenants.” For example, the company must maintain at all times leverage of no more than 5x total debt to EBITDA. If the company’s leverage goes above 5x, it is a default and the lenders can exercise their rights.
- Most bond agreements include “incurrence covenants.” For example, if the company’s leverage goes above 5x total debt to EBITDA, the company cannot take a certain action (e.g. issue more debt, pay a dividend, make an acquisition, etc.). In this case, if leverage goes above 5x, the bond is not in default unless the company also takes the prohibited action. From the borrower’s perspective, incurrence covenants are preferable to maintenance covenants – it gives them much more flexibility.
Covenant Lite Loans
During the debt market boom of the mid-2000’s, we saw the emergence of covenant lite loans. These are, typically, TLBs with incurrence covenants. The low amortization, long maturity and lax covenants give borrowers significant operational and financial flexibility, especially when compared with the typical Term Loan A. This is especially true when a covenant lite loan is paired with an ABL revolver, which also has lax covenants. This is the strategy used by 99 Cents Only Stores.
The market for covenant lite loans peaked in 2007, when almost $100 billion were issued, accounting for over 40% of all syndicated loans for non-investment grade issuers. During the credit bust of 2008-2010 very few new covenant lite loans were issued. However, starting in 2011 when the credit cycle began moving to a borrower’s market, covenant lite loans have returned. It is likely that issuance in 2013 will exceed the record set in 2007.
And the credit cycle continues …
The best thing about a true ABL–borrowing base, lock box for cash collections, field exams–is that the lender is able to cash out very quickly. A banker doesn’t need very many covenants in this kind of situation.
Ratio covenants are relatively weak if not linked to an absolute $$ minimum measure. For example, a minimum current ratio of 2.0x works much better if combined with a minimum net working capital requirement, say $1,000,000. A debt/worth maximum of 3.0x is enhanced by the use of a minimum net worth requirement of, say, $500,000. The absolutes tie the ratios to the balance sheet . One serious shortcoming of Covenant Lite is that there are rarely any absolute $$ requirements.
Yet another issue is the FDIC’s higher risk borrower (HRB) premium. Effective April 1, 2013, the FDIC began charging higher premiums on HRB’s, generally M&A type lending on transactions of $5MM or more. There are several criteria, and two of them that trip the HRB eligibility requirement are senior debt/EBITDA and total debt/EBITDA ratios of 3.0 and 4.0, respectively. Banks are required to identify eligible HRB’s, report them to the FDIC, and pay the premium, of course.
Even more interesting is the issusance of an interagency guidance in late March, 2013, that called for more scrutiny of leveraged lending. The FDIC signed on to this guidance, but the interagency quidance is broader in scope. The reporting and monitoring requirements are so substantial that the ABA has requested that the current May 21, 2013 implementation date be extended for a year to allow banks time to figure out how to design and implement the systems needed to comply.
My point is that bankers and their regulators are going to be paying much more attention to leveraged lending, and some banks may find that the reporting and monitoring is more costly than the profit from leveraged lending.
The answer really depends on the borrower, its current financial structure and the related business sector and market cycles. “Lite covenant loans” have the advantage of being somewhat more standardized than bespoke financings, and are easier to administer and therefore easier to securitize and sell. However, they tend to be more expensive for the borrower because of the increased risks perceived to be embedded in the conditions of the loan agreement. The term emerged in the process of securitization and was assigned to loan agreements that simplified the monitoring and control of loans that were destined to be securitized. One component in that process was the consideration by the lending entity that the lifetime risk of loan default would be transferred to the investor of the securities backed by these loans. The credit risk was no longer critical for the lending organization, and a tight list of covenants ultimately would only increase the difficulty to sell the securities and the subsequent administrative cost. Many of the loans to AAA rated corporations in the 70s would have qualified as “Lite Covenant” loans. However, today, these borrowers are rare and able to refinance themselves much cheaper than any of the lending organizations can and therefore are no longer a viable target for such securitized loans (except for some complex structured loans). So the targets of these lite covenant loans today are a corporate group and projects that clearly carry a higher credit risk, which should make the approval process much more extensive. Much more stringent analytical tools should be used then were applied in the past 10 years. The point to remember here is the effect the reputational risk component can – and has – had over the last few years on these securities: Even though “legally”, they were issued by a non-recourse entity, the originators of the initial loans were ultimately forced to accept the default risk for the securities due to political and reputational aspects. Today, the securities could very well be issued in a form that would justify a determination of gross negligence, a determination that is easier to make today since the notion of claiming ignorance of the potential default is much more difficult to prove today then 10 years ago. The mere fact that these are “Lite Covenants” loans may be enough to indicate a strong possibility of “negligence”.
Hi Ron…Good synopsis of cov-lite loans….Thank you for the post….
As a lender, to me it’s definitely not a good trend…Competition for loan assets lately only makes this issue that much more acute as higher risk leverage loan assets inch ever closer to being mispriced…again…Some too, may have already passed their required minimum benchmark spread…
Even the flexibility of a so called “liquid” secondary market as an exit strategy for institutional B Loans in anticipation of event risk does not mitigate the absence of hard covenants given the asymmetrical nature of information flow between borrower and lender..
Notwithstanding the research surrounding recovery rates between cov-lite and cov-heavy loans, not every borrower that comes to market is or should be considered a candidate for the former because it forces the lender to accept credit spreads and increased exposure under revolving facilities that reflect the realities of a previous credit cycle that in all likelihood will have no similarity or bearing on the next…
Leveraged credit by sector must and should be priced to reflect its relative risk at both “point in time” and “through the cycle” if we are to minimize the impact of potentially much higher future default rates and lower recovery rates that could yet lie hidden beneath the veil of cov-lite loans…
Credit discipline for banks is at a major crossroads once again and we must carefully consider the lessons of the recent past before we choose the next road we will ultimately take, i.e., if we have not already chosen a path to begin with……
Agree with Hanns that liquidity/securitization drove the covenant lite trend however would also point to the practical reality of having (very) broad distribution of B loans: maintenance tests become an enterprise risk for issuers. There is no way a company/admin. agent can keep a handle on investors where, for a marginal price depending on industry/company cyclicality, they can avoid being held over a barrel.
We have seen cove-lite type agreements fail before the cerdit crunch and during the Michael Milkin era. In addition, under the Basel 3 framework, the capital required to support this will be great as the risk would be great (especially in the tails),
In general, its a bad trend. It may lead to companies piling on more debt they can’t handle when the next downturn comes. Without the controls covenants provide, companies get debt they can’t handle and when some go bad. have to either restructure or default.
Looks like a train wreck looking for a place to happen.
The return of covenant lite transactions reflects the excess supply of loanable funds held by both banks and non-banks, the liquidity that many borrowers possess, the low growth plans of borrowers, and the lack of disciplined underwriting in many lending organizations. The only improvement I’d make on Art’s train wreck analogy is that the train is still rolling down the side of the mountain from the last recession.
Bonds can do away with covenants while loan cannot.
I often share the wisdom of my first banking mentor who said, “The single best covenant is a maturity date.” So we don’t need dozens of covenants to ensure repayment, but without collateral or guarantees, a few covenants can give the lender the opportunity to intervene before the borrower deterioates to the point of no return.
I guess, it is a good trend for the borrowers and a bad trend for the investors. However, it looks like the investors are increasingly happy to buy into cov-lite loans if the fundamentals are good (as opposed to a regular loan with somewhat worse fundamentals).