From S&P:
For the 12 months to Oct. 30, 2008, we found there were 38 covenant breaches, waiver requests, or related restructurings, compared with 18 in the previous 12 months - an increase of over 100%. In addition, the time from financing to experiencing problems with covenant tests has decreased dramatically in 2007 and 2008 compared with 2006. The number of companies experiencing covenant difficulties within three years of their last financing has increased to 29 in 2007 and 23 in 2008 year-to-date, from four in 2006.
And as for the nature of those figures:
In total, there were 64 companies that we found experienced covenant problems during 2006, 2007, and so far in 2008. Of these, 48% were covenant breaches, 34% were waivers or covenant resets prior to an actual breach, 3% were equity cures to avoid breaches, and 14% were financial restructurings.
There haven’t yet though, been a great number of defaults of any kind. (Though those are expected in the not too distant future).
There might be a few of reasons for that.
Firstly, it’s not exactly as if the terms of most debt issues in 2005, 2006 and the first half of 2007 were particularly onerous. Covenant-lite loans were the apotheosis of an originate-to-distribute syndication model that left most banks just desperate to be on the financing team and to hell with the rest. Covenants aren’t being breached in great measure yet because they were so relaxed. And indeed, as S&P note:
…when economic conditions worsen, some companies will likely default before a breach even happens.
Secondly, the development of the CLO model means the holders of a lot of loan paper - be they CLO managers or banks which have synthetically transferred their risks via total return swaps to CLO managers - have little interest in engaging in (potentially) lengthy restructuring talks with individual companies. So a lot of breaches - 34 per cent, as S&P notes - are simply being waved.
Thirdly, the major trauma has yet to hit. The archetypal covenant tests debt to EBITDA. And corporate earnings are only now beginning to fall significantly. Indeed, S&P notes that so far covenant breaches have been caused not by the direct impact of a credit crunch or consumer downturn, but rather by the extraneous spike in raw material prices that so defined the first half of this year:
Rising raw material prices - such as oil, grain, or steel - affected many companies included in our study during 2007 and most of 2008. In a large number of cases, rising costs damaged liquidity positions as the need for working capital increased.
Going into a far more severe consumer recession then, coupled with a dramatic credit crunch in the corporate debt market, covenant breaches will increase exponentially among Europe’s speculative-grade companies.
And it is - surprise surprise - cyclical businesses which are the most exposed. We say “surprise” here because one of the more remarkable apparent assumptions of the private equity boom during the Great Moderation was the projection of a historically stable EBITDA levels across the business spectrum.
To wit:
Cash injections by private equity appear to be rising. During 2008, the number of transactions where private equity owners injected new equity in response to a breach, covenant waiver, or reset increased to 11 out of 24 deals, or 46%. This was up from 33% of deals where financial sponsors made a new equity contribution in 2007, and 20% in 2006… Financial sponsors may be injecting new equity in order to buy time while raising funds.
