Time for lenders to insist on extra safety in finance offers | USAEMALL.com

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The promise by borrowers to repay debt at maturity at par is a fundamental cornerstone of robust and sustainable lending market. Yet this has been eroded one clause at a time in leveraged finance deals in recent years with borrowers using their market clout to gain an easier ride on meeting their obligations.

But a window of opportunity might be opening for lenders and investors to seek greater protection in the deals they strike. Recent turmoil across capital markets should result in a shift in the balance of power between lenders and borrowers. That should be seized on by lenders. Instances of lender pushback even before the current market convulsions gives me hope they can.

Why do lenders lend? Traditionally it is to collect interest payments — to “clip the coupon” in industry jargon — and receive the money lent on maturity at par. It’s a tale as old as money itself. But recently, it is proving more and more evident that the promise of payback at maturity, the most important covenant in any finance deal, can no longer be taken for granted.

The list of borrowers who have leveraged this flexibility — leaving chagrined lenders in the wake of so-called “liability management transactions” to restructure debts — is getting longer and longer. In recent years, such borrowers include J Crew, PetSmart, Neiman Marcus, Serta Simmons, At Home, Altice and Ardagh. Despite this record, terms have getting more flexible and appear more disconnected from the financial reality of borrowers.

Borrowers have always been able to negotiate flexibility to borrow more under debt agreements, but these carve-outs, or “baskets”, are getting bigger and more complex. Take, for example, so-called “super-grower baskets”. With an ordinary “basket”, a borrower can borrow more funds from their original lender or elsewhere, with limits based on earnings before interest, tax, depreciation and amortisation. The twist with “super-grower baskets” is that the agreed amount that can be borrowed never decreases, even if ebitda falls.

That calls into question what the point of the thresholds is. But according to data from Octus, the number of European high-yield bond deals with Ebitda-based “super-grower” baskets increased to nearly a quarter of deals in 2024 from less than 10 per cent in the previous year.

Ignoring losses is also a trend. Traditionally if a borrower made a loss, the debt agreement would lower how much the company could pay out in dividends. But 18 per cent of 2024 European high-yield deals contained a provision that does not deduct any borrower losses from certain calculations of dividend paying capacity. This disconnect from reality appears in other key areas as well — according to Octus, the number of European high-yield deals that permit the borrower to exclude working capital debt from leverage ratio calculations increased to more than 30 per cent in 2024, up from just under 25 per cent in 2023.

However, some borrowers are fighting back. To counter covenant erosion, lenders have crafted elegant ways to protect against the worst excesses of private equity-backed borrower contractual flexibility.

For example, according to Octus data, nearly 40 per cent of 2024 high-yield deals contain a provision that restricts borrowers from moving material intellectual property assets out of lenders’ reach. They have been dubbed so-called “J Crew Blockers”, after the retailer carried out such a manoeuvre in 2016. This is up from 30 per cent in 2023 and just 10 per cent in 2022.

And there other signs of hope on the horizon. A high-yield deal recently brought to my attention contained a provision that would provide significant protection. According to a report by LSEG, it first appeared in last year’s high-yield bond deal from a marketing and printing company RR Donnelley. The language of the provision is convoluted, but in essence it means that neither the borrower, nor its subsidiaries, may screw a subset of their lenders over by using contractual flexibility for the purpose of forgoing their promise to repay par at maturity.

It has since been marketed in other deals, including a recent bond issue from Getty Images. In my view, this provision should be in every single leveraged finance deal. There is no excuse for any lender not to insist that it is included, nor for any borrower to accept it. If you want a lender’s money, then offer up a contract that forces you to make good on your promise to pay it back. Full stop.