Through the looking glass with leveraged finance

Those searching for a better example of the current through-the-looking-glass mood of the European leveraged finance market won’t find a better example than the current fuss regarding “covenant-lite” debt.

The deals that the have attracted the most attention are from JP Morgan – advised in both cases by Linklaters (see story).

On one level is it unsurprising that Linklaters would draw attention to its role on a piece of genuinely innovative financing for one of the top banks in leveraged lending. Yet step a back a moment and you could argue that a bank (and its lawyers) that arranged debt without most of the traditional protections and reporting requirements might want to keep it under its hat.

Still, the sponsor’s counsel on the latter deal, Allen & Overy, will be glad to get one under its belt for a private equity client.

Lawyers are scrambling now to see if JP Morgan received any pricing benefit for its covenant sacrifice. However, early indications are that the terms say more about the unprecedented power being exercised by private equity borrowers than arrangers achieving better terms.

What is clear is that it has been a long time since a voguish financing technique has so strongly split advisers’ opinion.

“This shows the brutally competitive pressure in the market place and is as clear a signal as any that anarchy is prevailing - the market is in free-fall in terms of protection for lenders,” says Ashurst’s Mark Vickers, summing up the wary stance of many who make it their business to guard banking clients’ interests.

Herbert Smith’s Malcolm Hitching agrees: “A number of banks are expressing serious reservations about the emergence of these deals and are watching to see how the market develops before stepping into (or out of) cov-lite transactions".

Another camp of advisers argue that cov-lite is just a reflection of market reality, representing the latest in a line of sponsor-driven wheezes like equity cures and covenant mulligans.

“Sponsors have been chipping away at covenants for years so the ‘shalt nots’ are outweighed by the permissions,” says one partner. “Cov-lite terms are possibly more flexible in some ways and give more concrete, measurable tests when it comes to what amounts to a default.”

Linklaters’ Adam Freeman adds: “A while ago we saw second lien and people said it was weird to have that product in Europe but now it’s almost standard. Now we are seeing incurrence covenants and people are saying the same. It’s just different from what has gone before.”

Whatever view advisers take, current indications are that cov-lite and similarly-themed financings are only going to grow – as long as arranging banks can move the debt on the secondary market.

Freeman says: “Hedge funds are interested in the yield and are comfortable in buying incurrence or maintenance-based paper. What’s driving it is the banks knowing they can sell the debt.”

Another partner comments: “I see a drop coming in the not-too-distant future and I predict that this ‘trend’ will end with the first deal to get stuck in syndication.”

Which is, of course, the contradiction. While advisers are understandably shifting their finance teams towards sponsor-friendly lines, Simpson Thacher-style, the same banks and law firms are also looking to bulk up on restructuring.

And the message is the same every time: advisers aren’t recruiting for Marconi-style mega-workouts - they're getting ready to move when debt-laden private equity-owned businesses start to struggle.

It will be interesting to see how many sponsor-facing legal teams we’ll be seeing then.

caroline.grimshaw@legalweek.com