Part 1: Covenant Lite -- Rising Like a Phoenix
Today we are posting our first blog in a six-part series that details the Ravinia Capital approach to working with our middle market clients. We hope you enjoy reading it. Write back and let us know what you think!
We say it over and over again: it’s a sellers’ market. Its beginnings can be traced back to the end of the Great Recession in 2010, when the trends we see today first surfaced. Bond yields were low and have remained low. The stock market has become more and more overpriced. Interest rates were near zero and have remained extremely low. And lenders – both banks and alternatives – have remained eager to put their money to work. While at one time companies would get 2x or 3x leverage on their cash flow, today they can get a much more aggressive 5x or 6x cash flow, with lenders and private equity firms lowering prices as they search for yield.
Through all this activity, we are also seeing the resurgence of covenant-lite.
Covenants first emerged several decades ago as the least costly means for banks to manage risk; they were ubiquitous and nonnegotiable. Typically a loan agreement contained five or six covenants linked to accounting-based risk and performance ratios that were indications of financial health. Falling out of compliance served as a warning sign to the bank and its customer that trouble was brewing and corrections were needed to maintain the loan; covenants were generally considered useful tools that could help ward off major disasters.
Covenant-lite -- an easing of lending terms -- became common in the years before the Great Recession. Markets were robust and banks clamored for this tool to help them compete against increased activity from non-traditional lenders and private equity funds that had less oversight and governance. Covenant lite stripped away the warning signals and suddenly borrowers could get by with fewer restrictions on collateral, payment terms, and income levels.
But everything changed in 2008. The Great Recession hit, markets dried up, all matters of business turned conservative, lending virtually disappeared, and so did covenant lite. In fact, everyone joked that covenant lite would never be seen again.
And now, like a phoenix rising from the ashes, covenant lite is back. According to a report from the ABI (see graph below) covenant lite has surged significantly in recent years.
We are seeing a trend of looser lending practices and higher company valuations. Thus far, nobody has paid a huge price. The economy is humming along, and when problems with a loan emerge, another lender is willing to come in and take it out, making the distressed market almost nonexistent. The situation we have today could go on for another ten years. Or, it could end in a week. Or, it could end overnight. It’s anybody’s guess. But as we know from the past, someday there will be reckoning.
Write back and let me know what you think.