This week we welcome an appearance from Sabrina Fox, a leveraged finance attorney and high yield bond covenant analyst with over 15 years of experience in the European leveraged finance market. She currently acts as Executive Advisor to the European Leveraged Finance Alliance (ELFA), a trade body comprised of investors in European bonds and loans formed to support the resilience of the market through increased engagement, disclosure, and transparency.
PETITION: Dun & Bradstreet was a recent test for the capital markets. What were the results there and what do they portend for capital markets activity going forward?
There are three important lessons to take away from Dun & Bradstreet.
One: Sponsors are thinking tactically about managing their investments through a down cycle. They want to maintain flexibility to access dividend capacity and reshuffle the capital structure, especially when the issuer is heading into stressed territory. The covenants for Dun & Bradstreet’s bonds and loans maintain significant documentary flexibility (including, in the bonds, access to dividend capacity even if the issuer is in default) despite pushback from investors, and the new owners were willing to pay up for it. That’s telling.
Two: Law firm restructuring advisors are talking to the capital markets guys. This means that the capital markets guys are amending and adding provisions to covenants in the primary that will foreclose potential arguments by bondholders about aggressive uses of covenants down the line. This will make it easier for issuers to (for example) use Unrestricted Subsidiaries to benefit equity and other junior stakeholders to the detriment of bondholders if things get choppy. In Dun & Bradstreet, this played out through a broader definition of what constitutes a “Similar Business” (expanding potential capacity for investments in Unrestricted Subsidiaries), and the inclusion of language that makes it crystal clear that recent shenanigans playing out in the retail sector (and the courts) is contractually permitted, essentially ripping a page out of the bondholder playbook.
Three: Covenant flexibility has become an element of arbitrage by borrowers, increasing the competitive pressure between financial instruments that is fueling the race to the bottom in covenant erosion. Large LBOs are often financed with a mix of bonds and loans, and if an issuer can get covenant flexibility in a loan that it’s struggling with in a bond, it may decide to upsize the loan, making it easier to push through covenant flexibility in the bond – or vice versa. The rise of the private debt market only increases sponsors’ arbitrage opportunities.
PETITION: High-yield investors suffer from a collective action problem and issuers take advantage of the information dislocation, too much money chasing too few deals, and FOMO to squeeze investors, flex pricing down and weaken/eliminate covenants. What can investors do better to combat these efforts and level the playing field?
Stay smart and engage effectively.
Covenants are a lot more complicated than they were a decade ago, and advisors to borrowers have months to prep deal terms that investors get only a few days to review. Investors who stay abreast of new covenant loopholes and focus on potentially problematic flexibility are best placed to weather challenging markets.
And as the markets become more challenging, the ability for investors to engage effectively is more important than ever. Investors need a forum to speak with a single voice – which is one reason that the European Leveraged Finance Alliance came into existence earlier this year. ELFA is an independent buyside trade association focused on improving disclosure, increasing transparency, and encouraging engagement between market participants in the European leveraged finance market. As Executive Advisor to the group, I’m working hard to guide the development of ELFA for the benefit all who access the capital markets, from individuals investing money so they can retire comfortably or send their kids to college, to companies seeking to access capital, and everyone in between.
PETITION: There has been a lot of talk lately about leveraged loans. But private lending through BDCs (public and private) and other direct lending vehicles is exploding. Is this an area fraught with danger and what are the ramifications?
Absolutely. This growing source of capital gives sponsors one more way to divide and conquer to get more flexible terms. The industry is largely unregulated, opaque, with redemption structures that vary widely from fund to fund, creating unpredictable risks of potential runs. As with so many elements of the financial markets, the best way to address the risks is first to understand them, and the Alternative Credit Counsel (ACC), an organization sitting under the Alternative Investment Management Association (AIMA) are doing excellent work to focus the debate about financial stability in the private debt market. If regulation is the answer, these groups are helping to gather information that would facilitate the formulation of a sensible regulatory approach to the issues.
PETITION: What are the biggest issues confronting the European market that US investors don't have to deal with currently? What are one or two things that investors haven't been as focused on as they should be?
Europe is a far more fragmented market than the U.S. There are more banks and law firms competing for business, creating intense competition. These competitive pressures are one of the factors driving covenant erosion, as advisors seek to differentiate themselves through documentary innovations as a way of gaining market share. If one law firm or bank won’t give a sponsor the terms they want, they can go to the next in line – and there’s a long line of institutions vying for business.
PETITION: What is the best book you've read that's helped guide you in your career?
It’s not a book, but the ABA Model Negotiated Covenants and Related Definitions holds pride of place in my bookshelf. Covenants have strayed far from those humble beginnings, so it’s important to remember the guiding principles reflected in that document.
PETITION: What question should we be asking that we haven't?
You guys are clearly great at what you do, because I can’t think of one!
Aw shucks. 😍