The European leveraged loans market has traditionally required a borrower group to comply with three maintenance covenants—interest cover, leverage and cashflow cover—and these covenants generally are tested quarterly. These three covenants have nearly always been coupled with annual capital expenditure limitations. In recent years, this sturdy four-legged structure has come under increasing threat from the arrival of covenant-lite loan terms from the United States.
As early as Spring 2012, we discussed the return of “covenant-lite” in the United States after its scarcity during the financial crisis (see “Springtime: The Return of “Covenant- Lite” Financings,” The Debevoise & Plimpton Private Equity Report, Spring 2012). Since that time there has been a continued trend toward covenant-lite loans in the United States. With the increased influence of U.S. practices on European loan markets since the financial crisis, it was never going to be long before covenant-lite loans came to Europe.
Covenant-Lite Breaks Through in Europe
Deal statistics suggest that 2015 was the year in which covenant-lite become a significant feature on the European leveraged loan landscape, with nearly a quarter of deals and just over half of institutional issuances in the leveraged loan market being covenant-lite. Covenant-lite in the European context involves incurrence style covenants, often coupled with a single financial covenant (usually leverage) being tested only at times when the revolving facility is utilized in excess of a specified threshold (usually between 30% to 40% of commitments and, in 2015, most commonly 35%). This combination of incurrence style covenants and springing financial covenants gives European borrowers a flexibility they have never previously been able to access in the European syndicated loan market.
It’s not just the financial covenants that are getting lighter. European covenant-lite deals now rarely contain a revolver clean down, i.e., a requirement to repay all revolver borrowings and maintain a zero balance for a set number of consecutive days each year or half-year. The equity cure, which allows the sponsor to contribute equity to cure financial covenant breaches, is also changing to the U.S. approach of allowing the cure amount to be added to EBITDA rather than subtracted from debt. With this change, the requirement to apply cure amounts to repay debt has also all but disappeared.
Covenant Loose Rises Too
“Covenant-loose,” where regular testing of maintenance covenants is retained but fewer financial covenants are tested, also increased in popularity during 2015. When covenant-loose first re-emerged in Europe after the financial crisis, it generally involved testing of both leverage and interest cover covenants. In 2015 this shifted, with nearly a third of covenant-loose deals only testing leverage. Deal statistics show that fewer than 10% of deals in 2015 retained the three traditional financial maintenance covenants. Capital expenditure limitations are now also very frequently omitted from European loan agreements.
But all of this is not without some compromise.
Europe As Compared to the United States
A European borrower should not necessarily expect the same flexibility to incur secured indebtedness as is available to its U.S. counterparts. Without the benefit of Chapter 11 in Europe, we have seen some arrangers require that secured indebtedness, whether incurred as ratio debt or through another exception to the indebtedness covenant, be required to be made subject to intercreditor arrangements to ensure that the original senior lenders’ position on insolvency is preserved. In our experience, however, market practice on this varies widely among deals, with some arrangers being more focused on the point than others. From a borrower’s perspective the point is important, as requirements to make future secured indebtedness subject to pre-agreed intercreditor arrangements may materially impair flexibility to incur that indebtedness as arrangers may be unwilling to provide the financing on the basis of the previously agreed intercreditor terms.
Some arrangers are also questioning relatively settled U.S.-style EBITDA add-backs and calculations (such as the ability to take account of projected synergies for an extended period of time) as European lenders confront the fact that it is not just the testing of the financial covenants but also the underlying definitions that borrowers want Americanised.
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Covenant-lite has never been a permanent or ubiquitous feature of the U.S. leveraged loan market, where lending conditions and lender appetite frequently changes. We should not expect anything different in Europe. Therefore, and given its relatively recent arrival in Europe, it would be foolish at this stage to say that the covenant-lite tide will not recede. Given its increased prevalence in the leveraged loan market recently, however, covenant-lite is likely to be given significant consideration for years to come, particularly in larger transactions.