March 12, 2020 - Covid-19 is focusing attention on economic pressures and, potentially, defaults and recoveries. Recently, we received some additional interesting perspective into loan recovery given default (RGD). For years, prognosticators have said that RGD will be down, pointing to several factors. First, there are more all-senior capital structures and/or less subordination under loans in capital structures. Second, there is more flexibility in documentation, allowing borrowers to take on more debt and/or move collateral out of the collateral pool. Recent analysis from Covenant Review (CR) suggests that these trends do not necessarily work in tandem.
The argument around all-senior-loan capital structures and/or less subordination is intuitive. The more debt under a loan in a capital structure, the further up the capital structure losses can go without eating into the loan recovery. The more flexible documentation argument is more theoretical: Companies have more ability to take on debt and more ability to transfer collateral in today’s loan documents. If companies take these actions, then there may be more debt and less collateral at default, leading to higher losses on senior secured loans. But the company has to i) default and ii) have taken on debt and moved collateral for these losses to emerge or be heightened. If the company doesn’t take these actions, RGD isn’t impacted. If the company takes these actions and avoids default, then there are no losses. We are not arguing that position, but simply noting that the outcome is not clear cut. Regardless of the game theorizing, lenders appear to be making rational tradeoffs between structure and subordination, according to CR. Specifically, CR demonstrates that loans in “all senior” capital structures typically have less leverage and better documentation scores than loans that benefit from debt subordination beneath them. For instance, the early 2020 senior stretch deals had a (better) average documentation score of 3.63 vs 4.03 for non-stretch deals. Likewise, in the 2019 deals, documents for senior stretch deals were tighter in nearly all categories and total leverage for senior stretch deals was 4.4x vs 5.9x for non-stretch deals. While senior stretch deals are, admittedly, smaller than non-stretch ones, CR concludes that managers likely are weighing subordination against documentation and require tighter docs on stretchier deals.