Secured lending and the perfect storm: nontraditional lenders and covenant light loans


Financier Worldwide Magazine

March 2015 Issue

March 2015 Issue

A commonly expressed theme among those who comment on the relationships between lenders and borrowers is that secured creditors hold too much power, and that this power stifles a struggling company’s ability to recover and survive. In the US, some have called for changes to the US Bankruptcy Code, changes which are aimed at stemming the perceived control that secured creditors have over the Chapter 11 bankruptcy process. However, an examination of the evolution of commercial lending reveals a number of truths. The perceived heightened control that secured creditors have in the restructuring process arises from at least two factors that have nothing to do with any flaws in the US Bankruptcy Code, or restructuring laws generally. Instead that control arises from a changing landscape of secured lending that at once gives borrowers better overall borrowing terms, and greater flexibility, but also exposes them to more severe consequences when they fail to timely and properly manage their financial difficulties.

The secured lending landscape is a product of a lending market that: (i) is increasingly populated by non-traditional lending sources, such as hedge funds, that do not make lending decisions by the same set of standards as traditional commercial lenders; and (ii) is flooded with what have become known as ‘covenant light’ loan agreements. These two features have created a perfect storm, a lender that is more likely to aggressively pursue remedies and that is not afraid to (and is often very happy to) own the borrower’s business, and a borrower who is given the flexibility (under covenant light loan agreements) to run its business to breaking point or beyond before being forced to face its lender in a default scenario.

Non-traditional lenders: not your father’s banker

The last 10-15 years have witnessed the emergence of major new players in the credit markets, namely hedge funds and private equity funds. In the wake of the financial crisis, these non-traditional lenders emerged to fill a significant void as traditional commercial banks substantially tightened their lending standards.

Financially distressed borrowers have come to learn that these non-traditional lenders operate with a vastly different playbook compared to traditional commercial banks. While banks have generally looked to loan repayments as their primary goal in any extension of credit, the same cannot be said for hedge funds and other non-traditional lenders. In fact, these non-traditional lenders will quite often extend credit to a distressed company, or purchase its outstanding debt, often at a discount, and will have no problem either taking control of the company outright by converting their debt to equity, or liquidating the company’s underlying assets in order to realise gains on the purchased debt. Hedge funds and similar distressed investors may pursue these strategies because they are generally not as heavily regulated as traditional commercial banks, leaving them free to invest at multiple levels of a company’s capital structure. Therefore, while a traditional commercial bank might be more incentivised to work with a distressed company on a consensual workout, so as to preserve the company’s enterprise value as a cash-flow-generating going concern, the same incentives may not exist when the company’s primary secured creditor is a hedge fund, which has a different business model entirely. As a result, a distressed company that has taken loans from a non-traditional lender may find that such a lender is far more willing to play ‘hardball’ in a default scenario than a traditional commercial bank.

Examples of this ‘new normal’ in the secured lending world abound. In 2012, an out-of-court restructuring of Barney’s was completed, which saw the company’s largest secured lender, Perry Capital, join with Yucaipa Capital to take control of the iconic retailer. In 2014, the Chapter 11 case of GSE Environmental Inc, saw the firm taken over by a group of investment funds that had purchased GSE’s first lien debt at a discount, provided a DIP loan to fund the bankruptcy, and then converted their pre-petition first lien debt into equity in the reorganised company as part of its Chapter 11 plan. More recently, in January 2015 UniTek Global Services Inc emerged from Chapter 11, having seen the majority control stake in the company handed to its largest pre-petition secured creditors, a group of private equity funds, as part of a debt-for-equity swap.

Covenant light loans: borrower beware

Covenant light loans, generally speaking, strip away many of the typical financial performance metrics that lenders often require borrowers to report, and meet, during the lifetime of a commercial loan. In the post-recession period, an enormous volume of covenant light loans have been booked, as syndicated lenders have aggressively competed for attractive refinancing opportunities. Lenders feel compelled to ‘race to the bottom’ of the covenant light scale in order to win the lending business. Borrowers revel in the relative freedom and flexibility that covenant light lending provides. Gone are the days of extensive financial reporting and sweating out the next quarterly results to ensure compliance with required financial ratios.

Also gone, however, is the ‘early warning system’ that more standard financial covenant lending provided. If nothing else, financial covenants gave borrowers and lenders a reason to talk, and lenders had a firm seat at the table because financial covenant defaults were, by definition, defaults. The existence of the default gave the lender a legal justification to talk about problems and solutions, and borrowers were required to listen. In the normal course, borrowers and lenders could identify these problems and potential solutions, including securing assistance from financial consultants – before the financial distress became too severe to correct. Lawyers, turnaround professionals and other financial advisers make their livings saving, or at least reasonably salvaging, financially distressed companies because of the ‘early warning system’ that financial covenants provide. In a covenant light world, the early warning system is missing, and has been replaced only with the self-monitored business judgment of the borrower. The concern, of course, is that in the absence of borrower discipline – including the self-awareness to identify and address problems when they are not being compelled to do so in the face of a loan default – the borrower is ‘dead on arrival’, or close to it, by the time it actually defaults on its loan.

The perfect storm

No lender gives a warm greeting to a near dead-on-arrival credit. But today’s frequent roster of non-traditional lenders is much more likely to act swiftly to exercise remedies – and to fulfil the second half of the ‘loan to own’ model. Thus, the perfect storm is the borrower putting itself in the most vulnerable and defenceless of circumstances, while staring across the table at a lender who is less likely to be accommodating.

The ‘fix’ to this problem is not legislation. The true medicine, if borrowers are willing to swallow it, is financial awareness and discipline. If financial covenants cannot serve as the fiscal governor, who or what will? Those borrowers who construct for themselves a satisfactory answer to this question can survive a crisis. Those who cannot will continue to fuel, and may ultimately be consumed by, the perfect storm.


Mark M. Maloney and Michael C. Rupe are partners, and Christopher G. Boies is a senior associate, at King & Spalding LLP. Mr Maloney can be contacted at +1 (404) 572 4857 or by email: Mr Rupe can be contacted at +1 (212) 556 2135 or by email: Mr Boies can be contacted at +1 (212) 556 2327 or by email:

© Financier Worldwide


Mark M. Maloney, Michael C. Rupe and Christopher G. Boies

King & Spalding LLP

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