Standard & Poor's Ratings Services is requesting comments from market participants on our proposed definition of covenant-lite (cov-lite) loans. Given recent trends in the leveraged loan market, the robustness of loan covenants has taken on greater importance as a key analytical factor in determining post-default recovery prospects for loans in collateralized loan obligations (CLOs). In the article, "
The Covenant-Lite Juggernaut Is Raising CLO Risks—And Standard & Poor’s Is Responding," published June 12, 2007, on RatingsDirect, we alerted the marketplace to our concerns over the proliferation of cov-lite loans and the additional credit risk posed to CLOs. Furthermore, we announced a change to our criteria whereby we will explicitly account for these risks in CLO credit enhancement levels and ratings. (This article is also available on Standard & Poor's Web site at www.standardandpoors.com. In the left navigation bar, select Ratings, then Structured Finance, and then CDOs & Derivatives. Finally, click on the Criteria tab to locate the article.)
Following the publication of the June 12th article, investors demonstrated a declining appetite for acquisition-related leveraged loan and bond offerings as evidenced by the failed execution of several high profile issues. The main drivers behind the investor push back are weak covenant provisions, loose repayment terms, and credit quality concerns. While it is too early to tell whether this trend will lead to a longer term shift in market power away from borrowers and in favor of investors, we are seeing strong evidence that the marketplace is once again factoring covenant quality more explicitly into pricing and investment decisions.
Proposal Summary
To reflect the incremental risks posed by cov-lite loans in our CLO ratings, we initially propose to first establish a means for identifying such loans through the use of a standardized definition. The proposed definition is that cov-lite loans are loans that have only "incurrence tests" but no "maintenance" tests. Incurrence tests involve a point-in-time review of a specific operating performance measure relative to a predetermined "trigger" level after the borrower has taken a certain action such as debt issuance, dividends, share repurchases, merger, acquisition, or divestiture. A violation of these trigger levels in the absence of such predefined actions does not result in a default. Maintenance tests, on the other hand, involve regular reviews of operating performance measures relative to the trigger levels without regard to any borrower action, thus providing lenders with greater control over the quality of their investment by requiring the borrower to more strictly preserve its credit quality. This "incurrence test only" proposed definition is the current basis for Standard & Poor's cov-lite-related criteria changes for all global CLO transactions closing after Aug. 31, 2007. In the June 12th article, we announced the rollout of new analytical criteria for incorporating cov-lite loan features that would offer new "rep/warranty away" or "recovery haircut" alternative approaches for those CLO managers not yet using asset-specific corporate recovery ratings (RRs). In other words, there are two alternatives to the RR approach:
The CLO asset manager or sponsor provides a representation and warranty that the asset pool excludes defined (for example, incurrence test only) cov-lite loans; or
Post-default recovery assumptions to be used for Standard & Poor's cash flow modeling will be haircut or stressed by an additional 10% off the Standard & Poor's U.S. and European/Asian tiered corporate RRs for any such defined cov-lite loans.
For situations in which a given loan is not assigned a RR or the asset manager has not elected to use RRs, we seek to develop a workable methodology and process for identifying cov-lite loans in CLO portfolios. Therefore, we are asking market participants to give some thought to the alternatives we are considering and submit their views on other options that we may not have considered. We would like to encourage market participants to submit written comments on one or more aspects of the proposed criteria. During the consultation period, which will end Aug. 9, 2007, we will be meeting with various market participants to solicit their views on this proposal. We will review the comments received and inform the market in due course on our progress. In particular, we would like to draw attention to the following questions.
1. Do you believe that the proposed definition of cov-lite (incurrence tests only) is appropriate for determining whether a loan in a CLO pool is cov-lite?
2. Do you believe that the proposed 10% haircut off of Standard & Poor's tiered corporate RRs is an appropriate penalty for loans deemed to be cov-lite?
3. Alternatively, should Standard & Poor's use a more granular definition of cov-lite by designating specific types of financial maintenance tests that must be present to avoid a cov-lite designation, along with the allowable headroom that would apply to each covenant trigger? Please specify the types of tests you would want to see included in the definition, the corresponding headroom limits, and the applicable financial performance benchmarks. For example, if you specified a debt to net worth test, you might create a covenant that requires that the debt to net worth ratio must not exceed x% of the borrower's actual or projected debt to net worth ratio as of the inception date of the loan.
4. Do you think that Standard & Poor's should not try to create a standardized definition of cov-lite, but instead agree to perform a full covenant analysis on every loan? Under this alternative, we would develop our own opinion on the robustness of a loan's covenants and make a case-by-case decision on whether to apply the 10% recovery haircut.
5. Ultimately, should Standard & Poor's take a more holistic approach to loan level recovery analysis by requiring the use of asset-specific RRs and not focus specifically on cov-lite loans or any other factor impacting recovery?
6. What other issues or alternatives should Standard & Poor's consider when attempting to identify and measure the risks to CLOs posed by cov-lite loans?
Response Deadline
Please submit your comments on this proposal through Aug. 9, 2007, to CriteriaComments@standardandpoors.com.
For U.S. inquiries, please contact David Tesher, New York (1) 212-438-2618; david_tesher@standardandpoors.com or Calvin Wong, New York (1) 212-438-7495; calvin_wong@standardandpoors.com.
For European inquires, please contact Katrien Van Acoleyen, London (44) 20-7176-3860; Katrien_VanAcoleyen@standardandpoors.com.
For Asia-Pacific inquiries, please contact Mei Lee Da Silva, Melbourne (61) 3-9631-2053; mei_dasilva@standardandpoors.com.
Proposal Discussion
Standard & Poor's recognizes that any attempt to create a standardized definition of cov-lite—although necessary for identifying and evaluating the risks to CLO investors—is fraught with challenges. On one hand, a standardized definition of cov-lite provides the market with a transparent and easy-to-use benchmark for differentiating covenant risk in leveraged loans within CLO structures. A transparent definition is especially important to asset managers who must make decisions on which assets to assemble before the actual CLO issuance date and on an ongoing basis for those CLO structures that are actively managed. On the other hand, borrowers and their agents can "game" such a standardized definition by adding maintenance tests to the covenant package that are "out of the money"–that is, the covenants impose no substantive checks and balances on borrowers when their financial condition deteriorates.
To address this problem, we could add more granularity and substance to this definition by prescribing restrictive covenants and maintenance tests by category (for example, restricted payments, leverage, and debt service coverage) that must be present to avoid a cov-lite designation. Additionally, we could also specify for each maintenance test some corresponding trigger levels with performance variance limits ("headroom") that are tied directly to a measure of the borrower's actual or pro forma operating results. Such a cov-lite definition, if constructed appropriately, can differentiate higher quality covenant packages from the weaker cov-lite ones, while at the same time provide a transparent and functional benchmark for facilitating asset selection and credit risk assessment in CLOs.
However, we recognize that even the most robust cov-lite definition is an imperfect benchmark for differentiating covenant quality. Loan covenants can be highly detailed and nuanced. The definitions of key terms and any "carve-outs" are important factors impacting the integrity of covenant terms. The relative importance of a given type of financial covenant and the appropriateness of the headroom around each covenant trigger will vary across industry sectors and regions. The relevance of a specific financial covenant can also change over time since a borrower's financial and business profile may be dynamic rather than static. Furthermore, the effectiveness of financial covenants that are tied to pro forma financial statements depends on management's ability and willingness to provide accurate projections of future operating performance. Therefore, in light of these considerations, it may be difficult to construct a single definition of cov-lite having the right mix of specific maintenance tests and performance thresholds that are appropriate over the life of the loan and across all industries and regions.
A Standard & Poor's RR, which CLO managers can elect to use for purposes of assigning an assumed RR rate to each asset in the collateral pool, already "bakes in," or incorporates, our assessment of covenant quality. However, the RR may not yet be a practical solution in all cases since RRs are not currently available for all leveraged loans, thus, the reason why CLO managers have the option to use our standard tiered corporate RR assumptions. As an alternative, we could consider conducting a full covenant analysis for each loan not yet assigned a RR. While such a full covenant analysis approach may result in the most accurate covenant-related risk assessment outside of a RR, however, it may be a more time consuming, expensive, and less transparent alternative for CLO managers and issuers.
Ultimately, we believe that covenant quality is best analyzed case-by-case through a full review of the loan documentation and in the broader context of the borrower's creditworthiness and post-default recovery prospects. For this reason, we believe that RRs will eventually replace the standardized recovery tables as the methodology of choice for determining the post-default recovery assumptions we apply to loans in CLOs. The advantage of this approach is that RRs take into account several factors that we believe can impact loan level post-default recovery, including collateral, covenants, position in the capital structure, and any special payment features that have been structured into the loan.
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