One of the hallmarks of late-stage bubbles is a shift of power from lenders to borrowers. As asset prices soar and interest rates plunge it becomes harder to generate a decent yield on bonds and other fixed income securities, so people with money to lend (like pension funds and bond mutual funds) are forced to accept ever-less-favorable and therefore far-more-risky terms.
Recall the liar loans that were popular towards the end of the 2000s housing bubble and you get the idea. Lenders were so desperate for paper to feed the securitization machine that they literally stopped asking mortgage borrowers to prove that they could cover the interest.
Here we go again, but this time in the market for leveraged buyout loans:
The U.S. private-equity firm offered a yield of about 3%, but few of the protections once considered routine.
Still, the investors bought.
Rampant demand for leveraged loans is allowing private-equity firms to water down legal safeguards for investors. Many lawyers and bankers increasingly worry that such changes could result in higher losses for investors during the next downturn, as creditors find themselves with less protection.
Terms on loans from Hellman & Friedman’s takeover of Denmark’s Nets A/S allowed greater flexibility for the borrower to take on more debt, extract cash from the company and even restrict who owns the loans. That, though, is no longer unusual in the loan market.
In the financing of a previous takeover of Nets in 2014, a separate group of private equity borrowers had to prove that debt at the Danish payments company wasn’t rising too quickly. Such a requirement wasn’t present this time.
The move to more borrower-friendly terms has come in both the U.S. and Europe. But the most dramatic shift has been in Europe, where the imbalance between loan supply and demand is most acute.
Investors are clamoring for leveraged loans as years of low interest rates and central banks’ bond buying have pushed down returns elsewhere. Trillions of dollars of sovereign debt, primarily in Europe, continue to sport negative yields, meaning investors pay to lend governments money.
With “far too much cash trying to find too few homes,” private-equity firms “can be more aggressive and lenders will take it,” said Adam Freeman, a partner at Linklaters LLP.
Some of the year’s largest leveraged buyouts in Europe have either removed covenants and legal protections, or allowed the borrower to control who buys its debt.
That included Bain Capital and Cinven’s takeover of German drugmaker Stada Arzneimittel AG, Lone Star LP’s acquisition of German building materials maker Xella Group, as well as the takeover of Nets A/S.
Analysts say that along with low borrowing costs, the weakening of deal terms has helped boost the appeal of loans to private-equity firms. In Europe, around 88% of the debt funding for leveraged buyouts came from loans this year, according to S&P Global Market Intelligence’s LCD unit, up from 73% in 2015. Meanwhile, 81% of loans in Europe this year have been “covenant-lite,” meaning they lack many standard investor protections, up from 21% in 2013, according to LCD.
Among the first changes was the stripping out of so-called financial-maintenance covenants, which are investors’ main defense against borrowers taking on too much debt. They require quarterly tests of a company’s leverage level, allowing lenders to force the firm into default if it rises too high.
Other borrower-friendly terms include stringent loan-to-own clauses, which limit investors’ ability to sell to distressed debt funds. Recent loans have placed restrictions against such firms as Elliot Capital Management, Apollo Global Management and Cerberus Capital Management.
Bankers warn that such provisions, along with so-called white lists that detail which funds can buy the loan, could hurt liquidity if investors can’t unload loans in troubled companies to the sort of funds that specialize in taking on this risk.
This is just what happens when central banks push interest rates way down while flooding the market with new currency. Lenders find themselves with too much money to lend and borrowers can, as a result, can write their own tickets. With eventually disastrous results.
When things get tough, as they always do after a long debt binge, the private equity borrowers will suck as much money out of their captive companies as possible, while layering on new debt at unfavorable terms. Then they’ll let those companies default and hand off the near-worthless carcasses to creditors.
You have to feel sorry (and, yes, a bit of disgust) for the victims of this recurring scam. Pension funds, for instance, are saddled by their political masters with unrealistically high return assumptions of 7% – 8%, which are unattainable in a world where long-term bonds yield next to nothing. So the prospect of even an extra percentage point of yield is tantalizing for pension fund managers whose jobs are on the line if they can’t do the impossible.
A personal aside: My first serious finance job was as a junk bond analyst with a high-yield mutual fund, and my days boiled down to reading bond covenants and answering the question, “how can they screw us?” The assumption was that if the borrowers could screw us they would, and we wanted to see it coming.
But with bubbles of today’s magnitude, seeing it coming isn’t much help for either the owners of this increasingly toxic paper or the economy as a whole.