c.2013 New York Times News Service
c.2013 New York Times News Service
A small, little-known company from Missouri borrows hundreds of millions of dollars from two of the biggest names in Wall Street finance. The loans are rated subprime. What’s more, they carry few of the standard protections seen in ordinary debt, making them particularly risky bets.
But investors clamor to buy pieces of the loans, one of which pays annual interest of at least 8.75 percent. Demand is so strong, some buyers have to settle for less than they wanted.
A scene from the years leading up to the financial crisis in 2008? No, last month.
The company involved was Learfield Communications, of Jefferson City, Mo., which owns multimedia rights to more than four dozen college sports programs and which made almost $40 million last year in a common measure of earnings. But its $330 million loan package from Deutsche Bank and GE Capital on Oct. 9 highlights how five years after a credit bubble burst, a new boom is taking shape.
Companies like Learfield are the belles of the ball this year. Wall Street and private equity firms, hedge funds and other opaque financing pools have grown frustrated by low returns on other forms of debt and turned instead to riskier but more lucrative bets on ever-smaller companies.
The Learfield case is notable for the leverage involved — the company was able to borrow more than eight times its earnings — and that has raised eyebrows in some credit circles.
“Weaker credit is traveling down to smaller companies that ordinarily would not have this kind of leverage,” said Barbara M. Goodstein, a banking and finance lawyer at Mayer Brown in New York who is knowledgeable about the industry.
The loans to the privately held Learfield came in the form of what is known in Wall Street parlance as a leveraged loan, a lightly regulated stepsibling to junk bonds, another species of below-investment-grade debt. Such loans go to companies that often already have a lot of debt or are otherwise considered speculative bets.
Leveraged loans became popular before the 2008 collapse but nearly disappeared afterward, regarded as a symbol of unbridled lending. But they started to return in 2010 and are now back in force, with volumes of $548.4 billion this year through Nov. 14, already exceeding the precrisis level of $535.2 billion in 2007.
The type of leveraged loans that Learfield took out are known as covenant-lite, financial lingo for loans that lack the tripwires that could alert investors to any potential financial troubles at the company that could affect repayment. More than half of all leveraged loans issued this year have been the so-called cov-lite types, double the level seen in 2007 on the eve of the credit crash.
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Dell said in September that it would use a $9.1 billion cov-lite loan to help finance the $24.9 billion buyout by its founder, Michael Dell, and the private equity firm Silver Lake.
Learfield, however, is only a small fraction of the size of Dell.
Matthew O’Shea, a credit analyst at Covenant Review, a research firm, noted that smaller companies historically had more volatile earnings. “The increasingly lackadaisical tolerance for cov-lite drifting further down into the middle market,” he said, “increases risk for lenders to the smaller, less resilient borrowers in that space.”
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Regulators, finance lawyers and even the ratings agencies have also grown increasingly uneasy about the return to credit risk. In March, the Federal Reserve, the Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency, in a note on the boom, said, “Prudent lending practices have deteriorated” and urged lenders to tighten their standards. The agencies cited cov-lite loans, in particular, as having “additional risk” and called the loans one of their “primary issues of concern.”
In May, Moody’s wrote that signs of a “covenant bubble” were emerging. (Christina Padgett, a senior vice president at Moody’s, said that assessment still stood.) When Learfield announced its loans, Standard & Poor’s noted that the company was among the first with less than $50 million in earnings to take such loans and said the loans signaled “increasingly aggressive” lending.
The lending boom underscores a sea change in financing practices since 2008. In the face of regulatory restrictions put in place since then, banks are ceding much of their precrisis role in bankrolling and owning leveraged loans. That role has been taken up by private equity firms and investment funds, which slice up the loans and then pool them for sale to other investors.
Those shadow banking players, which are typically more aggressive than banks, now make up 60 percent of new cov-lite loans, according to the Loan Syndications and Trading Association, the trade group and lobby for the leveraged loan industry. “Most funding is from nonbank lenders,” said James Parchment, a senior director at Standard & Poor’s.
Companies use leveraged loans primarily to bankroll acquisitions of other companies, to enter into private equity deals or to refinance debt. Documents for loans to private companies are generally not publicly disclosed, giving investors little insight on how they are structured.
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Learfield has let Providence Equity Partners, a private equity firm that bought the company, use the proceeds of the loan to pay Shamrock Capital Advisors, another private equity firm, for its stake in Learfield. Providence Equity said in September that it planned to buy Learfield for an undisclosed amount.
The $330 million package consists of a $215 million loan, an $85 million loan and a $30 million line of credit.
Providence Equity, Learfield, Deutsche Bank and GE Capital declined to comment on the deal or the loans.
Unlike leveraged loans with covenants, or protections, cov-lite loans contain few or no pledges by a company to keep its debt below certain levels or even to report quarterly financial results in a timely fashion. But investors like these loans because, unlike bonds, their payouts “float” in tandem with the global benchmark interest rate in London, thus protecting them against rises in interest rates set by the Federal Reserve. Cov-lite loans are secured by a company’s assets, and they give lenders priority over bondholders and stockholders if the company goes bankrupt. But that does not mean an investor will actually get paid if the company goes bankrupt.
“You are relying on the cash flows of the company, so if earnings go down, you don’t have the cash flow and may not see a dime,” said Ronald A. Kahn, a managing director at Lincoln International, an investment bank in Chicago that underwrites leveraged loans to smaller companies.
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The loans have their advocates. Companies that issued cov-lite loans from 2005 to 2007, the height of the credit bubble, defaulted at a rate of 7.8 percent compared to a rate of 10.45 percent for companies that issued loans of all types, including those with tripwires, according to Moody’s. Loans that came due in 2009, a year after the financial crisis, fared well, as did other types of loans, because of the infusion of cash from the nation’s central bank.
“When you examine underlying factors, such as historical default and recovery data, you’ll find that covenant-lite loans actually may be a better bank loan investment than many loans containing covenants,” Kevin Egan, a senior portfolio manager at Invesco, a fund management company, wrote on the company’s investing blog in July.
But at the leveraged loan industry’s annual conference on Oct. 17, nearly 1 in 4 participants voted to label cov-lite loans “the devil incarnate.”
A senior banker who sells leveraged loans said cov-lite loans were “more like purgatory, because you can watch your company degrade but not trip any covenants that allow you to call a default.”
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Some 61 percent, the largest group of participants, said they “don’t love them, but can live with them.”
James H. Gellert, the chief executive of Rapid Ratings, an independent ratings firm, said the danger was that smaller companies with cov-lite loans could find it tough to refinance those loans in coming years if interest rates rise, credit tightens and lenders seek to bankroll larger, more stable companies.
“You risk a higher default cycle,” he said. “This is something to pay attention to.”