Debt Jenga: Avoid a Topple
Understanding the myriad ways your debt could get primed is essential to effective credit analysis. This is why we cover subordination in such granular detail in our Leveraged Finance Covenant Training, as illustrated by this video lesson we've shared direct from our online curriculum.
Going back to basics: the obligation to repay sums owed to lenders is the most important promise that a borrower makes.
Security and guarantees (credit support) serve to protect your investment by providing another route to reclaim sums loaned to the borrower. In the event that you are not repaid at maturity, you can go to court to enforce your rights to be repaid.
The value of your credit support will likely diminish over time depending on myriad factors. Imagine your credit support is a solid tower at the start of Jenga, and the borrower’s optionality under the covenants is like sliding blocks out of that tower.
First, consider the borrower’s ability to pledge your collateral to other lenders. Covenant flexibility will undoubtedly give the borrower flexibility to dilute your credit support to pledge in favour of other lenders.
Second, note that the borrower will also have the ability to layer in debt ahead of you. This can occur in several ways, explained in the video lesson above.
Third, remember that the borrower will be able to invest in Unrestricted Subsidiaries, at which point your collateral will be released.
Finally, don’t forget that the ability of the borrower to sell your collateral will result in the removal of more blocks, and some deals will allow the proceeds to be used for dividends rather than requiring reinvestment or debt repayment.
When the borrower has exhausted these options, lenders might watch their claims topple (with recoveries in the 40s or even 10s) as a result of the value extraction permitted by the covenants.
We examine all of these avenues of potential value depletion in our Leveraged Finance Covenant Training course, empowering our students to protect against downside risk so their investments don’t tumble.
By Sabrina Fox