SPECIAL COMMENT. Covenant-Lite Defaults and Recoveries Time Is Catching Up with Covenant-Lite

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1 JUNE 24, 2014 CORPORATES SPECIAL COMMENT Covenant-Lite Defaults and Recoveries Time Is Catching Up with Covenant-Lite Debt cushions are beginning to erode, which could lead to lower recovery rates Table of Contents: COVENANT-LITE COMPANIES NO LONGER HAVE A LOWER DEFAULT RATE THAN OTHER SPECULATIVE- GRADE COMPANIES 2 MANY COVENANT-LITE COMPANIES ARE OWNED BY PRIVATE EQUITY FIRMS 3 RE-DEFAULTS MAY CREATE PROBLEMS 5 RECOVERY RATES REMAIN CONSISTENT AS DEBT SUBORDINATED TO COVENANT-LITE LOANS CONTINUES TO TAKE THE PAIN 5 THE DEBT CUSHION BELOW COV-LITE LOANS IS ERODING 6 MOODY S RELATED RESEARCH 9 Analyst Contacts: NEW YORK Julia Chursin Associate Analyst julia.chursin@moodys.com David Keisman Senior Vice President david.keisman@moodys.com Jessica Reiss Vice President Senior Covenant Loan Officer, Leveraged Loans jessica.reiss@moodys.com Tom Marshella Managing Director - US and America Corporate Finance tom.marshella@moodys.com» Covenant-lite companies no longer have a lower default rate than the overall speculative-grade population. The US covenant-lite companies we examined for this report had a default rate somewhat above the average for US non-investment grade companies. This is a change from our 2011 research, which found that covenant-lite issuers defaulted at a rate somewhat below the historical averages for speculative-grade issuers. However, the default rate for US covenant-lite loans remains roughly comparable to that of the US non-investment grade universe.» Many covenant-lite companies are owned by private equity firms. Of the 29 cov-lite defaults we examined, 20 had private equity owners a group that executes a large number of out-of-court restructurings, such as distressed exchanges, in an effort to avoid bankruptcy filings. These restructurings diminish the loss-absorption capacity of senior secured covenant-lite loans by reducing the amount of debt cushion below them.» Re-defaults may create problems. First-lien cov-lite loans are normally not part of distressed exchanges, as the lower-ranked debt in a company s capital structure takes the brunt of the losses. But once companies move from distressed exchanges to actual bankruptcies, their cov-lite loans could be at risk if the companies initial out-of court restructurings did not sufficiently resolve their fundamental issues. For example, among the re-defaults we examined, Hawker Beechcraft Acquisition Company LLC s firstlien cov-lite loans experienced losses.» Recovery rates for first-lien cov-lite loans remain consistent with those for loans with more covenants. Debt in the tranches beneath cov-lite loans continues to take the brunt of the losses, cushioning senior secured creditors and helping to ensure robust recovery rates.» The debt cushion below cov-lite loans is eroding. This suggests we might see lower instrument-level and firm-wide recoveries if the US speculative-grade default rate surges. In addition, our Covenant Quality Assessment Service reports that provisions being added to cov-lite credit agreements may contribute to diminished recoveries for cov-lite lenders going forward.

2 Covenant-lite companies no longer have a lower default rate than other speculative-grade companies Covenant-lite loans, which limit bank lenders ability to force a company to restructure, are even more popular today than they were during the credit-bubble era prior to the Great Recession. According to Thomson Reuters LPC, covenant-lite loan volume reached $95 billion in the first quarter of 2014, up from $88 billion in the fourth quarter of 2013 and close to the $108 billion in volume for all of 2007, which marked the top of pre-crisis issuance. EXHIBIT 1 Covenant-Lite Loan Issuance ($ bil.) Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Source: Thomson Reuters LPC This popularity reflects yield-hungry investors seemingly insatiable appetite for leveraged loans and is further fueled by how well covenant-lite investors fared in the wake of the Great Recession. During the credit crisis, cov-lite debt, although widely viewed as risky and even reckless by creditors, allowed many companies to postpone default and address their problems while the Federal Reserve took steps to stabilize the US economy. The idea worked, with bubble-era covenant-lite issuers defaulting at a rate somewhat below the historical averages for speculative-grade issuers. (Please see Seeing Where it Hurts, June 2011.) But based on our analysis of 423 US issuers that originated covenant-lite loans (as classified by Thomson Reuters LPC and Dealogic) between 2005 and the first quarter of 2014, this appears to be changing. The US covenant-lite companies we examined for this report had a default rate somewhat above the average for US non-investment grade companies during the same time frame. Among the cov-lite issuers we reviewed, there have been 29 defaults, providing an average three-year cumulative default rate of 18.8% over the study period. This compares to an average three-year cumulative default rate of 13.4% for all US non-investment grade issuers during the same period. This is a change from our 2011 analysis, which found that covenant-lite issuers defaulted at a rate somewhat below the historical averages for speculative grade issuers. At that time, our sample of 15 cov-lite defaults provided a cumulative 2.5-year default rate of 7.8%, compared to a 10.35% default rate for similarly rated North American corporate issuers. This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history. However, the default rate for US covenant-lite loans (as opposed to cov-lite companies) remains roughly comparable to that for the US non-investment grade universe. As shown in Exhibit 2, the three-year average default rate for all cov-lite bank debt, both first- and second-lien, was 14.8%, while the threeyear average default rate for first-lien only cov-lite loans was 1.7% lower than the comparable default rate for a broader speculative-grade universe. 2 JUNE 24, 2014 SPECIAL COMMENT: COVENANT-LITE DEFAULTS AND RECOVERIES: TIME IS CATCHING UP WITH COVENANT-LITE

3 EXHIBIT 2 Historical Default Rates 20% 15% 10% 5% 0% 3-Year Average Default Rate, Cov- Lite Loan Issuers All Cov-Lite Loan Defaults* First-Lien Cov-Lite Loan Defaults 3-Year Average Default Rate, US CFG Comparable Companies *Both first- and second-lien loan defaults Sources: Default data from Moody s; dataset of more than 420 covenant-lite loan issuers provided by Thomson Reuters LPC Our updated analysis, with its larger sample size and longer observation horizon, also confirms that covenant-lite loans do indeed defer default, though they do not escape it. The average time between cov-lite loan origination and an initial default is 3.3 years, versus 2.1 years for non-cov-lite term loans originated during the same period. The latter figure is based on Moody s Ultimate Recovery Database (URD), which tracks more than 1000 defaults dating back to Many covenant-lite companies are owned by private equity firms Our analysis also confirms the continued above-average use of distressed exchanges and pre-packaged restructurings by covenant-lite companies, reflecting the high percentage of ownership of these companies by private equity firms. Private equity backers often choose distressed exchanges over regular bankruptcies in order to influence recovery rates and maintain their stake in a company. Of the 29 cov-lite defaults we examined for this report, 20, or 69%, had private equity backing (see Exhibit 3). Private equity defaults typically have higher firm-wide recovery rates and tend to strike hardest at the debt tranches subordinated to the cov-lite loans, which are protected by their more senior position in the capital structure. EXHIBIT 3 Defaulted Cov-Lite Issuers PE Owned vs Non-PE Count % PE-sponsored companies Non-PE companies 9 31 Total sample size 29 Source: Moody s 3 JUNE 24, 2014 SPECIAL COMMENT: COVENANT-LITE DEFAULTS AND RECOVERIES: TIME IS CATCHING UP WITH COVENANT-LITE

4 Exhibit 4 shows the breakdown by type for the covenant-lite defaults we analyzed for this report, compared with data from Moody s URD. Of all cov-lite defaults, 31% were distressed exchanges, a significantly higher percentage than seen in the other samples. Of cov-lite defaults sponsored by private equity, 40% were distressed exchanges. The groupings shown in Exhibit 4 are:» All 29 defaulted cov-lite issuers» All PE-sponsored cov-lite defaults. A cohort of 20 private equity-backed defaults drawn from the sample of 29 cov-lite defaults» All defaulted LBOs in the URD. A subset of 224 defaults in the URD» Moody s URD, which tracks more than 1000 defaults dating back to EXHIBIT 4 Type of Default 120% Distressed Exchange Pre-packaged Bankruptcy Regular Bankruptcy 100% 80% 60% 40% 20% 0% Source: Moody s All Cov-Lite Defaults ALL PE-Sponsored Cov-lite Defaults ALL Defaulted LBOs Ultimate Recovery Database Among the private equity-backed defaults, eight were prepackaged bankruptcies and four were regular bankruptcies, while eight involved distressed exchanges, where in each case first-lien covenant-lite lenders were not part of the restructuring. (For Jacuzzi Brands, which issued both first- and secondlien cov-lite loans, the second-lien lenders suffered a loss in the company s distressed exchange, while the first-lien was not affected.) Companies execute distressed exchanges, which usually result in higher firm-wide recoveries than either Chapter 11 proceedings or prepackaged bankruptcies, for many reasons. During the Great Recession, many issuers used distressed exchanges to buy time and avoid a bankruptcy filing. But as we noted in 2011 in Seeing Where it Hurts, covenant-lite introduces another element: Private equity firms have been willing in many cases to pay fees in exchange for covenant-lite structures, easing the way for eventual distressed exchanges that may have been harder to execute in a more restrictive covenant structure that would have allowed senior lenders to exert more influence. The finding that covenant-lite companies frequently have utilized distressed exchanges supports the view of our Covenant Quality Assessment Service that covenant-lite might be used by equity ownership not only to defer defaults but also to increase them through distressed exchanges. 4 JUNE 24, 2014 SPECIAL COMMENT: COVENANT-LITE DEFAULTS AND RECOVERIES: TIME IS CATCHING UP WITH COVENANT-LITE

5 Re-Defaults may create problems Distressed exchanges preserve value for the private equity sponsor and tend to leave the top of a company s capital structure unscathed. But problems arise when distressed exchanges and other out-ofcourt restructurings do not sufficiently resolve a company s fundamental issues, and are therefore followed by additional defaults that cause additional credit losses, including for first-lien cov-lite loans. For example, when private equity-backed Hawker Beechcraft Acquisition Company LLC executed a distressed exchange in June 2009, its first-lien cov-lite loans remained intact and suffered no losses. But when the company filed for a pre-packaged bankruptcy in March 2012, it hurt all of its creditors, including its cov-lite lenders, who ultimately recovered approximately half of their original investment. Hawker s senior unsecured and subordinated lenders fared substantially worse (recovering 11% and nothing, respectively). Similarly, Neff Corp s second-lien cov-lite loan was unscathed by the company s distressed exchange in December 2008, but took a hit in a pre-packaged bankruptcy, filed in May The second-lien cov-lite lenders, who were subordinated to the regular first-lien credit facility, recovered only 21%, while unsecured debtholders received barely five cents on the dollar. Meanwhile, Movie Gallery Inc. s cov-lite lenders suffered no losses when that company filed for bankruptcy in 2007, but received nothing when Movie Gallery was liquidated after it filed a Chapter 22 bankruptcy three years later. Recovery rates remain consistent as debt subordinated to covenant-lite loans continues to take the pain We compared the recovery rates for 26 of the 29 covenant-lite defaults we analyzed to the rates for the broader set of more than 1000 defaults in Moody s URD and for the 224 defaulted LBOs in the URD. As shown in Exhibit 5, ultimate recovery rates for the first-lien cov-lite loans in the liability structure of cov-lite defaulters are roughly the same as those for the debt instruments in the larger URD universe. If we look at all 25 first-lien cov-lite loan tranches in our sample, the average ultimate recovery rate was 84.6% and 78.6% for the 18 that actually defaulted, while the eight defaulted second-lien cov-lite loan tranches in our sample had an average recovery rate of only 22.1%. Given the small sample size for the second-liens, we will not draw any conclusions. EXHIBIT 5 Instrument and Family Recovery Rates (All tranches) Cov-lite All LBOs in URD All URD First-lien bank debt 84.6% 84.7% 84.7% Subordinated loan* 30.7% 38.8% 55.9% Senior unsecured bonds 42.4% 25.4% 48.3% Subordinated bonds 40.4% 42.4% 28.3% Family recovery rate 63.3% 55.2% 54.8% (Excluding non-defaulted tranches) First-lien bank debt 78.6% 81.2% 81.9% Subordinated loan* 22.1% 38.5% 53.2% Senior unsecured bonds 30.4% 33.3% 43.6% Subordinated bonds 17.2% 22.9% 25.4% *For cov-lite issuers, subordinated loans consist only of second-lien cov-lite loans; for the broader populations, subordinated loans include some unsecured loans. Source: Moody s 5 JUNE 24, 2014 SPECIAL COMMENT: COVENANT-LITE DEFAULTS AND RECOVERIES: TIME IS CATCHING UP WITH COVENANT-LITE

6 The average family-level recovery rate for cov-lite issuers was higher than for larger cohorts in the URD, which is attributable to several factors, including a substantially higher number of distressed exchanges and prepackaged bankruptcies in our sample. These types of defaults typically have higher average family recovery rates than regular bankruptcies. As shown in Exhibit 5, the other debt in the cov-lite capital structure takes the pain, consistent with our findings in earlier research. The debt cushion below cov-lite loans is eroding Opponents of covenant-lite loans have long argued that companies would lose value between the time they would have tripped traditional covenants and when they do actually default. So far this does not appear to be the case, as cov-lite companies, which in most cases are owned by private equity, have executed distressed exchanges and pre-packaged bankruptcies. For first-lien cov-lite loans originated between 2005 and 2008, the presence of an ample debt cushion lower in the capital structure also helped preserve value. When these cov-lite issuers did default, debt tranches below the covenant-lite loans bore the brunt of the losses. In order to accept cov-lite, banks usually demanded a first-lien claim on collateral and sufficient loss-absorption capacity to protect the loans in a default. For our current study, we reviewed the debt structures of more than 950 cov-lite loans, originated from 2005 through Q1 2014, to see if there had been a deterioration in credit quality after the recession. Senior first-lien bank loans issued between 2005 and 2008 had an average debt cushion at origination of over 33%. But for those issued between 2011 and Q1 2014, the debt cushion had dropped to around 21%. We also discovered a significant presence of bank-debt only structures, including cov-lite loans and a growing number of second-lien cov-lite tranches with no loss-absorption capacity. This is a trend we did not observe in 2005 through The incidence of bank-debt only structures for these cov-lite loans has almost quadrupled, to 19% from 5% in our earlier study. Exhibit 6 shows this trend in credit quality deterioration. EXHIBIT 6 Credit Quality Is Deteriorating 35% 33.15% Debt Cushion below First-Lien Cov-Lite Loans Bank Debt Only Structures as % of total deals 25% 30% 27.51% 27.94% 20% 25% 20% 23.67% 21.07% 15% 15% 10% 10% 5% 5% 0% Q2014 Source: Moody s 0% Cov-lite companies showing a propensity for distressed exchanges or reducing their debt cushion does not bode well for recovery rates on cov-lite loans in the next default cycle. Newer, post-recession covlite loans have significantly less debt cushion to protect them in case of default. Historically, debt cushion has been a very important determinant of recovery rates and its deterioration will have a 6 JUNE 24, 2014 SPECIAL COMMENT: COVENANT-LITE DEFAULTS AND RECOVERIES: TIME IS CATCHING UP WITH COVENANT-LITE

7 negative impact on recovery rates. This suggests that if the US speculative-grade default rate were to surge, we would likely see lower firm-wide and instrument-level recoveries than in the past. In addition to an overall deterioration in cov-lite credit quality, provisions now being added to cov-lite credit agreements can lead to significant deterioration in the value available to secured creditors in the event of default. This is more fully explained by our Covenant Quality Assessment Service, below. A Legal Perspective from Moody s Covenant Office While cov-lite is usually associated with a longer average time to default, we are seeing provisions being added to credit agreements that could affect cov-lite creditors recovery rates. Below are several provisions we believe could lead to significant deterioration or dilution of value available to secured creditors in the event of default. The sidecar facility carve-out from the liens covenant allows a company to incur senior secured debt at the same level as, and secured by the same assets as, the lien securing the credit facility. The company can incur a new series of secured debt, provided by a separate group of lenders, but the assets that would otherwise be available exclusively to repay lenders under the credit agreement will now be shared between two distinct creditor groups. This is contrary to the expectation that first-lien lenders will be alone at the top of the capital structure and will have first rights to collateral. The cap on the sidecar facility is usually tied to the permitted amount of the incremental or accordion facility available to be borrowed under the existing credit agreement, but existing lenders no longer have the option to increase their commitment and maintain their pro rata share of any recovery. Instead, lenders under the credit agreement and creditors under the sidecar facility will each receive a smaller portion of the assets. We have also seen a rise in the number of incurrence-based (or ratio) baskets found throughout the negative covenants. These baskets allow companies to take certain actions as long as they are able to meet a certain leverage or coverage ratio on a pro forma basis after taking such action. An incurrencebased basket in a restricted payments covenant will permit a company to make unlimited dividends within the limits of the ratio test, diminishing the amount available for creditors while giving away more value to shareholders. A similar basket in the debt incurrence covenant will allow a company to incur unsecured debt and, if there is a corresponding carve-out in the liens covenant, secured debt. The secured debt basket may allow for first-lien debt beyond what is permitted by the sidecar facility, diluting the assets available to credit agreement lenders even further. Exhibit 7 is based on a sample population of publicly filed loans drawn from 2008 to the present and depicts the scores for the Financial Covenants and Definitions risk category (representing 15% of the overall Loan Covenant Quality score). 1 Seventy-six percent of the sample loans from the cohort scored in the weakest scoring category. This compares to only 53% of loans from 2012 and 20% of the loans from None of the sample loans from the time frame has weaker scores than lower-tier moderate. The return of covenant-lite loans is the prevailing cause of this distinction. Our loan covenant scoring criteria takes into account several variations of covenant-lite: absence of maintenance covenants; the presence of springing maintenance covenants that are tested only after a triggering event has occurred; and the presence of maintenance covenants that apply only to revolving and term A loans and not to institutional term loans. 1 Moody s Loan Covenant Quality Scores were launched on 8 April 2014 and assess the protections that US and Canadian leveraged loan covenants provide to investors. The scores are presented on a five-point scale, with LCQ1 representing the most protective loan covenant packages and LCQ5 the weakest packages. The overall scores are determined based on component scores assigned to individual loan covenants and provisions in seven key risk areas. 7 JUNE 24, 2014 SPECIAL COMMENT: COVENANT-LITE DEFAULTS AND RECOVERIES: TIME IS CATCHING UP WITH COVENANT-LITE

8 This weakness, coupled with the increasing appearance of provisions such as those described above, may contribute to diminished recoveries for cov-lite lenders if companies use such provisions to divert assets away from their creditors. EXHIBIT 7 Covenant-Lite Loans Have Been More Prevalent Since Financial Covenants Score 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: Moody s 8 JUNE 24, 2014 SPECIAL COMMENT: COVENANT-LITE DEFAULTS AND RECOVERIES: TIME IS CATCHING UP WITH COVENANT-LITE

9 Moody s Related Research Special Comments:» Covenant-Lite Defaults and Recoveries: Seeing Where It Hurts, June 2011 (133473)» Covenant-Lite is Back, Along With Its Risks, January 2012 (139198)» US Power Projects: Project Finance Rides the Covenant-lite Wave, May 2013 (153088)» Covenant-Lite Loans May Prove Riskier in the Next Downturn, March 2011 (131595)» Covenant-Lite Trends in High-Yield Bonds Issued , August 2010 (126245)» Leveraged Loan Covenants: Loan Covenant Quality Scoring Criteria, April 2014 (166381)» Frequently Asked Questions: Moody's Loan Covenant Quality Scoring, April 2014 (166454) To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients. 9 JUNE 24, 2014 SPECIAL COMMENT: COVENANT-LITE DEFAULTS AND RECOVERIES: TIME IS CATCHING UP WITH COVENANT-LITE

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It would be dangerous for retail clients to make any investment decision based on MOODY S credit rating. If in doubt you should contact your financial or other professional adviser. 10 JUNE 24, 2014 SPECIAL COMMENT: COVENANT-LITE DEFAULTS AND RECOVERIES: TIME IS CATCHING UP WITH COVENANT-LITE