US ratings agency Moody’s has warned that the resurgence in covenant-light loan financing for buy-out deals could be laying the groundwork for catastrophic fall-out for private equity firms in the next downturn.
According to the Financial Times, Moody’s Investors Services have claimed that the rapid bounce back of cov-lite loans – which carry few if any conditions for the borrower – may lead to substantial losses for private equity firms in the event of a more protracted downturn in future.
According to the agency, the action taken by the US government to resuscitate the financial markets led to a unexpectedly quick rebound allowing lenders to refinance, masking the risk of cov-lite loans.
However, other parties claim that Moody’s may be overstating the risk, as only the strongest leveraged borrowers, the least likely to default, were granted cov-light terms in the first place, according to Standard & Poor’s. Covenant-lite loans had a lower incidence of default during the crisis than more standard loan terms.
The model has bounced back, with $22bn of all new syndicated loans issued this year counting as covenant-lite, 25 per cent of new syndicated loans. The score puts cov-lite loans on track to match the $100bn of issuance seen in 2007.
Moody’s said that the record of covenant-lite loan defaults would not be so mild in the event of a more prolonged downturn, which would lead to greater investor losses.
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