January 24, 2019 - While primary and secondary pricing shifted dramatically last quarter, there was another – perhaps more critical – change: Improving loan documents. Below we talk about covenants past (what happened last quarter?) and future (if you can measure covenants, will they change?).
Looking back to fourth quarter, both Xtract and Covenant Review saw loan documents tightening. Xtract noted that the sponsor market (where most of the action was) saw generally lender friendlier documentation trends. Day One Capacity (baskets available to borrower on closing date) generally tightened. Asset sale prepayment language became more lender friendly. EBITDA addback language for cost savings saw a cap of 35% for the first time, while the look forward period for implementing cost savings shortened. Additionally, loans with a free and clear incremental basket calculated in reference to EBITDA also saw language become more conservative. However, trends around MFN protection were mixed. And, paradoxically, while the number of loans with an unlimited restricted payment basket was steady, the number of loans that made the unlimited basket available at closing shrank.
Covenant Review also saw lenders getting their document groove back (slightly) in Q4. M&A transactions with leverage ratios over 6x fell from 36% in third quarter to 32.6% in fourth quarter. EBITDA adjustments were marginally lower (25% vs. 26%); thus debt multiples based on reported EBTIDA trended lower (but remained 1.5 turns higher than those on adjusted EBITDA). As Free & Clear incremental tranches trended toward 0.75x EBITDA (from 1x earlier in the year) and EBITDA adjustments declined, adjusted leverage through the Free & Clear fell significantly. In fact, it’s down nearly 1.25 turns since late last year. (Which is not to say its low.)
But let’s not merely look back. Covenant Review also introduced Documentation Scores and Sub-Scores for loans, which measure a document’s efficacy in i) limiting collateral leakage, ii) limiting the borrower’s ability to put further stress on the balance sheet and iii) allowing lenders to extract additional value if the borrower’s financial condition deteriorates. The scores range from 1 (best) to 5 (not so great). So what has been going on? Illustrated by the report’s charts, it should surprise no one that i) documentation trends trended looser in recent years and ii) snapped back (a bit) in fourth quarter. What drove the better late-year stats? Covenant Review lists 10 factors. The top three factors for the 4Q improvement were i) Builder Basket Terms (-0.5), ii) MFN Sunsets (-0.4) and iii) Mandatory Prepayment Percentage (-0.4). And, if that weren’t sexy enough, names were named. The report illustrates how Concrete Pumping Holdings went from a 4 to a 3, how Dealer Tire improved from a 5+ to a 3- and how LifePoint Health edged up a notch from a 4 to a 3-.