Do Lenders Still Monitor? Leveraged Lending and the Search for Covenants.

• Author: Tung, Frederick

1. INTRODUCTION 155 II. TRADITIONAL BANK LENDING: COVENANTS AND MONITORING 159 A. The Structure of Bank Lending 159 B. Traditional Covenant Structure 161 1. Covenant Setting to Control Agency Costs 161 2. Covenant Violations 163 3. Lender Governance 164 III. THE NEW LOAN MARKETS 167 A. Traditional Syndicated Bank Lending 168 B. Demand for Leveraged Loans 171 1. Banking Deregulation and Financial Firms' Consolidation 171 2. Junk Bonds and Leveraged Buyouts 174 3. Modernizing Bank Capital 175 4. Securitization: Collateralized Loan Obligations (CLOs) 176 C. The Shape of Leveraged Lending 177 D. Fear of Flying: Regulators' View 179 IV. THE NEW LENDER GOVERNANCE 182 A. Split Control, Monitoring, and Renegotiation Costs 183 B. Earnings Add-backs and Informativeness 186 C. The Turn Toward Efficient Covenants 190 V. CONCLUSION 194 I. INTRODUCTION

   Forty-odd years ago, financial economists began to study the important interactions between capital structure and corporate governance. In particular, they offered theories to explain why the structure of firms' debt contracts matters for corporate governance. (1) The finance literature continues to document the ways that various features of lending contracts constrain managers' behavior. Lenders routinely influence corporate decision-making, even outside the distress context. The pervasiveness of lender influence in public companies suggests that lender constraints--loan covenants--may often substitute for or complement shareholder-centered corporate governance mechanisms. (2) Indeed, banks may enjoy advantages in monitoring borrowers even compared to corporate boards, which do not enjoy the regular stream of information that banks receive. Banks enjoy enormous advantages over other outsiders--even the borrower firm's outside directors--in terms of access to the firm's managers and private information. (3) The beneficent effects of bank monitoring on firm value have been well documented over the past few decades, (4) and the finance literature continues to expand the mapping of lender governance. (5)

   Various observers of the lending markets, however, including regulators and rating agencies, foresee potential trouble ahead. Covenants are disappearing; lender interventions are becoming rarer. (6) Without loan covenants, there is no lender governance or monitoring. The leveraged loan market raises special concern. Leveraged loans are relatively risky, below-investment-grade loans. (7) Over the last decade, this market has exploded, more than doubling in size. From 2010--a low point for leveraged lending in the aftermath of the financial crisis--to mid-2019, leveraged lending grew from about $500 billion to $1.2 trillion. (8) In that same period, the share of so-called covenant-lite ("cov-lite") leveraged loans jumped from under 5% to about 85%. (9) "Cov-lite" loans are worrisome because they contain no financial maintenance covenants. (10) Traditional loan agreements include covenants, which constrain various aspects of the borrower's operations or investments or financing decisions, in order to protect the lender from borrower risk taking over the life of the loan. (11) A financial maintenance covenant requires the borrower to maintain a specified level of financial constraint, for example, a certain ratio of debt to cash flow or earnings relative to interest expense. (12)

   With no financial maintenance covenants, a cov-lite loan is riskier than traditional loans. (13) "Cov-lite takes away the canary in the coal mine for lenders." (14) Borrower firms seem happy to take up these risky loans since the scarcity of covenants means fewer constraints on firms' operations and risk taking. At the same time, lender-investors appreciate the high interest rates and fees that come with risky loans. Moreover, as the costs of credit continue to decline as leveraged loan credit supply expands, lenders may enjoy less and less clout to demand covenant protection. The explosion of leveraged and cov-lite loans over the last decade naturally leaves regulators with misgivings about the quantum of risk taking in loan markets. (15)

   In addition to the prospect of riskier loan markets, fewer and weaker covenants and an observed decline in lender interventions may portend weakened corporate governance. Financial economists have demonstrated empirically that judiciously crafted covenants can improve firm value. (16) Through covenants and monitoring, lenders routinely exercise significant influence over corporate decision making. Weaker covenant protections and fewer lender interventions may therefore detract from effective corporate governance. (17) Covenants screen borrowers ex ante. They also act as tripwires ex post to catch the attention of both the lender and the borrower's management. A covenant violation triggers a reevaluation of the lender's constraints on management, and perhaps a renegotiation of loan terms, often well before a borrower firm approaches distress.

   In this Article, I offer an updated and somewhat optimistic perspective on the leveraged loan market and lender governance. Despite important changes in lending markets that could plausibly exacerbate systemic risk and blunt the efficacy of lender governance, I show that lending practices have evolved that may address the new risky lending. While the steep growth of the leverage loan market may portend lenders' debility to demand contractual protections, lender governance may tend to persist, even as syndicated lending has become more complex.

   One artifact of today's leveraged lending is the greater number and more diverse types of lenders involved in a leveraged loan deal as compared to traditional syndicated loans. A few decades ago, traditional syndications typically involved only banks, which held their loans to maturity. Today, banks continue to arrange syndicated loans, but they sell most of their loans in secondary loan markets to non-bank institutional investors. Larger and more disparate lender groups make loan renegotiations ("workouts") more difficult. Different types of institutions hold differing priorities. A non-bank lending group may include collateralized loan obligations (CLOs), (18) loan mutual funds, insurance companies, foreign investors, and pension funds, among others. The presence of heterogeneous lending institutions complicates the renegotiation of a loan agreement.

   Another practice worrisome to regulators involves borrowers' excessive leverage, relative to traditional ratios of leverage to earnings. Especially in the context of acquisitions and other extraordinary transactions, borrowers and lenders have taken to the practice of earnings "add-backs." The parties craft bespoke accounting provisions in their private loan contracts that allow for adjustments to projected earnings, which affect earnings-based financial covenants. With the justifiable aim of presenting a fair picture of the borrower's future earnings, the post-transaction borrower will adjust (augment) its earnings by adding back non-recurring items that affect cash flows or accruals--for example, one-time charges or expenses of the transaction. The firm's debt-to-earnings ratio is a typical leverage measure. Upward adjustments to earnings reduce the firm's reported leverage, which may create an excessively rosy picture. To the extent the borrower overstates adjusted earnings through add-backs, the leverage measure may become even less reliable.

   Lenders have adapted to these concerns, however. Lenders have evolved new covenant structures and other contractual innovations to address the new and more complicated renegotiation frictions that arise with leveraged loans. First, loan arrangers have created so-called split control rights. An examination of individual cov-lite leveraged loans might suggest an absence of covenant constraints, but it turns out that very few leveraged loan deals are issued without maintenance covenants. Taking account of all the loan tranches in a given deal, the banks continue to enjoy the benefit of maintenance covenant constraints on the borrower firm. The typical leveraged loan deal includes a bank-sponsored loan, which almost always contains traditional financial covenants. (19) At the same time, the bank group will arrange one or more additional loans for the borrower, but these loans will be sold to non-bank institutional lenders. (20) In many deals, the bank-held loans and institutional loans will include identical covenants. But only the banks, and not the institutional lenders, enjoy the right to renegotiate covenants or waive violations. This split control effectively leaves the banks in charge of renegotiations with the borrower, reducing bargaining frictions. Traditional covenants in the banks' loan constrain the borrower firm. The absence of maintenance covenants in a particular loan, then, does not mean that the borrower is free from covenant constraints. (21) Contractual innovations have also emerged to facilitate renegotiation of institutional loans. "Amend-and-extend" provisions and "refinancing facilities" enable institutional loan borrowers to extend maturities or refinance with only a subset of their lenders. (22)

   Second, with respect to add-backs, though upward adjustment of projected earnings carry real risk of understating borrower leverage, new research suggests that permissive use of add-backs may improve the informativeness of EBITDA-based contract terms like financial covenants. (23) Tailored accounting provisions for financial performance covenants in private loan agreements predict future cash flows better than GAAP-based measures. (24) Better earnings information may eliminate noisy features of accounting earnings, such that add-backs may facilitate both tighter covenants and fewer false positive covenant violations. (25) It remains to be seen, however, how the trade-off between potentially overstated earnings and improved informativeness will work out.

   Lenders have recrafted...