Analysis of the Recent Moody’s Study on Leveraged Lending Recovery Rates

Recent Moody’s Study on Leveraged Lending Recovery Rates and Application to the BancAlliance Portfolio

On August 16, 2018, the Wall Street Journal published an article titled “Leveraged Loans Not as Safe as They Once Were”.  The article made some interesting observations on trends in the marketplace as well as a broad claim about the overall recovery rate of leveraged loans.  The article borrowed much of its analysis from a recent Moody’s study[1] (the “Moody’s Study”) and claimed:

“The typical recovery on leveraged loans would likely decline to 61% of face amount in the next downturn, compared with the 77% historical average, Moody’s says.  Recoveries on riskier so-called second lien loans would fall even further to 14% from about 43% previously, the ratings firm estimates.” 

After reviewing the Moody’s Study, Alliance Partners (“AP”) believes that the Moody’s Study made generalized observations of the overall market and did not provide much support behind its reasoning for the causes of recent trends or for the arithmetic driving its forecast.  The Moody’s Study neither bifurcated the recovery rates of loans with or without covenants, nor did the Moody’s Study comment on any differentiation in default rates between asset classes or industries. Furthermore, many of the observations in the Moody’s Study focused on the broadly syndicated market and do not directly apply to BancAlliance’s portfolio, which is mostly concentrated in the middle market. It is also worth highlighting that both the Moody’s Study and the Moody’s Corporate Default and Recovery Rates Publication (1920 – 2017) acknowledge that default rates in both the leveraged loan and high yield markets are expected to remain low next year supported by strong liquidity and economic expansion.

The Moody’s study pointed to the factors listed below that could potentially cause worse recoveries for lenders in the next downturn.  Please see the bold italics for AP’s response:

1.Aggressive demand for leveraged loans by lenders combined with aggressive private equity borrowers has led to more bond like structures which cause lenders to lose control over debt terms and credit protections. This has given way to covenant-lite structures as well as credit agreements allowing actions such as collateral-stripping asset transfers, incremental secured-debt incurrence and greater retention of asset- sale proceeds. These actions are creating the potential to upend or dilute the position of first-lien loans.

Most investors agree that recovery rates could potentially be lower with covenant lite structures as lenders have to remain on the sidelines in the face of credit deterioration. The Moody’s study is also correct in that the rise of covenant-lite loans (i.e. loans with no financial maintenance covenants) now account for nearly 80% of new loan issuances. However, the 80% number referenced is representative of the broadly syndicated market and does not factor in the middle market.  Standard & Poor’s Leveraged Commentary & Data (“LCD”) Q2 2018 Middle Market Review states that “Roughly 45% of total middle market loan issuance in 2Q was covenant-lite, in line with a 44% cov-lite figure in 2017.[2]” 

The majority of BancAlliance’s cash flow loan portfolio is concentrated in the middle market[3], which typically has experienced a higher recovery rate. Per LCD, “Historically, middle market loan investors have enjoyed slightly higher recovery rates than investors in the broadly syndicated loan world, in part due to what traditionally have been simpler capital structures and a shorter time in bankruptcy.[4]” 

Furthermore, BancAlliance’s risk acceptance criteria dictates that loans offered to the membership must include at least one financial covenant. Data from S&P Global Ratings show that weaker covenant protections can lead to lower recovery rates for lenders.  The rating agency studied companies that came out of bankruptcy between 2014 and 2017, and found that lenders which included maintenance covenants in loan contracts recovered an average 82.2%, well above the 71.6% recovery rate for lenders without such contractual protections. The divergence was wider for the median recovery rates, which were 84.1% for loans with maintenance covenants and 63.5% for those without.[5]”

Lastly, AP’s credit committee focuses on diluting mechanisms, such as “free and clear” incremental facilities and other credit weakening terms.    

2. Investors, driven primarily by CLOs, remain under pressure to fulfill fund mandates and meet yield targets.  This dynamic makes it more challenging for investors to be selective.

The connotation here is that agents can structure loans loosely and they will still be absorbed by the market due to the pressures to lend.

Again, the middle market has typically been insulated by the market swings of the broadly syndicated market.  While there has been some structural loosening in the middle market over the past several years, BancAlliance’s risk acceptance criteria conforms to the leveraged lending guidance and does not include dollar or yield targets. 

As an asset manager, AP is patient and evaluates a large number of loans in a variety of asset classes and industries without dollar or yield targets. AP evaluates each loan on the merits of its credit and expects each participating member to do the same as well.

3. Debt cushions between first lien loans and first-loss equity positions (i.e. junior debt) have eroded to historically low levels.  This is reflected in Moody’s credit ratings trending downwards.

The Moody’s Study states “There’s a high positive correlation between strong debt cushions and ultimate recovery rates based on our Ultimate Recovery Database with data going back to 1988.”  However, the endnotes to the Moody’s Study state that “The importance of “debt cushion as an underpinning of Moody’s expected loss rating methodology is reflected in the review of ultimate recoveries on over 140 unique debt classes taken from 223 bankruptcies between 2006 and 2017.” It is unclear why they mention the database goes back to 1988 but the analysis of debt cushion only goes back to 2006.

Unfortunately there is no comparative time period to compare with the current market and the Moody’s Study debt cushion analysis appears to be spread across multiple debt classes, including high yield debt.  The Moody’s Study also does not comment on the size or industry of the bankruptcies.  For example, there were more oil & gas bankruptcies in 2016 and 2017 due to exogenous factors rather than structural concerns.  Additionally, the Moody’s Study fails to acknowledge reasons for the lowering of cushions.  One reason could be the emergence of the unitranche product, which is a first-lien only facility that acts as a senior and junior debt product.  

Most importantly, the Moody’s study does not focus on equity contributions.  This increase in equity contributions is filling the void of junior capital.  Per S&P, “private equity sponsors are kicking in a higher share on middle market LBOs than in the pre-crisis period. By the first half of 2018, that number had hit 43% (after dipping a bit from 2017). Toward the peak of the last credit cycle, sponsors were chipping in a relatively paltry 32%.”[6]

Regardless of the reasons, the cushion analysis that the Moody’s Study uses to prove its point of deterioration focuses on the debt cushion of covenant-lite loans and does not bifurcate between loans with covenants and loans without.  The analysis also does not comment on the middle market. 

AP’s aggregate leverage profile is below that of the overall loan market (See the AP 2017 Annual Report), which provides additional cushion.  AP’s underwriting looks to multiple forms of valuation to support its view on cushion in the form of junior capital or equity.  AP also performs an exit analysis to demonstrate what impact a decline in EBITDA and exit multiple would have on coverage of the first lien facility.

4. To support its arithmetic, the Moody’s Study states “Based on these factors, Moody’s has utilized a mean recovery of 50% for structures with only first-lien debt that is covenant lite and 65% when a first-lien only structure includes covenants.”  Moody’s further explains that “Because of these factors and an increase in cov-lite first-lien only structures, expected recovery has weakened and debt instrument ratings are lower relative to CFRs (Corporate Family Ratings). Based on our loss given default assessments, we expect first-lien senior secured term loans to recover in the 61% range, on average, versus the long-term historical average of 77% (from 1988 through 2018).”

The determination of a historical recovery rate for the entire market based on averages is a difficult exercise to undertake and apply as a forecast with no time horizon or insight into variables used.

Loss given default is a mathematical formula that is default rate multiplied by recovery rate.  The Moody’s Study did not comment on the default rate used and instead focused on an average lower recovery rate. Additionally, more detailed support for a 50% and 65% mean recovery would have been helpful to determine why such a low recovery percentage was used compared the Moody’s Annual Default Study: Corporate Default and Recovery Rates 1920 – 2017 study, which reflects average recovery of 80.4% from 1987 – 2017[7] for first-lien loans or the more recent recovery rates cited by S&P Global Ratings between 2014 and 2017. 

The Moody’s Study also acknowledged the more frequent use of distressed exchanges which can be a more expedient form of restructuring and lead to higher recover rates.

There is little doubt that we may be at the latter part of the credit cycle, as economy has enjoyed almost 10-years of growth and positive performance.  Moody’s can make the claim that the default rate is expected to go higher at some time in the future with some degree of certainty, however, AP believes a more detailed and robust analysis of recovery rates would be helpful, rather than a general warning on recovery rates that may occur at some point in the future for an unspecified segment of the market.

[1] Convergence of bonds and loans set state for worse recovery in the next downturn.  Moody’s Investors Service.  August 16, 2018.

[2] S&P Global Market Intelligence. LCD Middle Market Review.  Second quarter, 2018.

[3] BancAlliance 2017 Annual Report.

[4] S&P Global Market Intelligence. LCD Middle Market Review.  Second quarter, 2018.

[5] Scaggs, Alexandra.  Loan covenant quality hits record low, says Moody’s. Financial Times.  July 24, 2018.

[6] S&P Global Market Intelligence. LCD Middle Market Review.  Second quarter, 2018.

[7] Moody’s Investors Services.  Annual Default Study:  Corporate Default and Recovery Rates, 1920 – 2017.  February 15, 2018.