Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Decoding Corporate Credit: Unraveling Loan Covenants and Lender Behavior with David C. Smith (S2 E3)
The headlines today are full of scary references to how corporate lending has become too agressive with phrases like "cov-lite" and "wall of maturities". What does it all mean?
Discover the fascinating dynamics of corporate credit and loan covenants with Edward Finley as he sits down with the esteemed professor of finance David C. Smith from the University of Virginia. David and his co-authors have studied the evolution of loan covenants and particularly whether there is any cause for concern today.
David unravels the complexities of credit risk and lender behavior, especially in the realm of syndicated loans. Learn how large banks transform these loans into investment opportunities and uncover the crucial differences between bank loans and bonds, from their public versus private nature to how their interest rates are structured.
Explore the nuanced world of corporate loan covenants and the strategic decisions lenders face when borrowers violate these agreements. Instead of immediately declaring defaults, lenders often prefer renegotiation. Delve into the reasons behind this approach, including the costs and complexities of declaring defaults, and see how financial covenants serve as vital performance benchmarks. This episode also highlights the challenges bonds present due to their weaker covenants and dispersed bondholder structure, offering listeners a comprehensive view of the current financial landscape.
In the final segment, trace the evolution of financial covenants and the syndicated loan market. Understand why the shift towards an "originate and distribute" model has influenced covenant stringency and learn about the improvements in covenant quality over time. David also shares invaluable insights on following your passion within the investment world, leaving listeners inspired to pursue what truly excites them. Don't miss the chance to gain unique perspectives from a leading expert in the field.
Show Notes:
Griffin, Nini, & Smith, "Losing Control? The Two-Decade Decline in Loan Covenant Violations" (forthcoming)
Nini, Sufi, & Smith, "Creditor Control Rights, Corporate Governance, and Firm Value" (2012)
Kahle & Stulz, "Is the US public corporation in trouble?" (2017)
Kashyap & Stein, "Monetary Policy When the Central Bank Shapes Financial Market Sentiment" (2022)
Jang, "Are Direct Lenders More Like Banks or Arm's Length Investors" (2024)
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a sometime professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment Podcast. Here we explore topics in markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley. Well, today we've got a tremendously interesting guest Today my former colleague and my friend, David C Smith, the Virginia Bankers Association, eminent professor of commerce at the University of Virginia's McIntyre School of Commerce, where David teaches third and fourth year undergraduates about credit and restructuring. His research primarily focuses on corporate credit and restructuring. His research primarily focuses on corporate credit, restructuring and bankruptcy. David, welcome to the podcast.
Speaker 2:Thanks, edward, it's a pleasure to be here.
Speaker 1:So you and your co-authors, tom Griffin and Greg Nene Tom is at Villanova and Greg is at Drexel have a forthcoming paper that's sort of an update on your original paper from 2012 that you wrote with Greg and with Amir Sufi at the Chicago booth, and in your new paper, take a close look at the way in which credit and its riskiness and the behaviors of lenders all change over time in different environments, and so I'd love if you could set the backdrop here and talk about that original paper in I guess was 2012?.
Speaker 2:Yeah, and so, just as a backdrop, the original paper looks at firms, and these are publicly traded firms. So think really large firms that skew on the large side, that most of them have publicly traded equity, some have publicly traded debt, but they also take on loans, and the loans are private agreements that fund the companies through debt in addition to raising bonds or notes. Are these mostly banks? So they're typically originated by banks. That means the banks set them up and underwrite the loans. They're in the hundreds of millions to mostly single-digit billions in terms of their size, but then the banks that originate them syndicate them out to a network of investors.
Speaker 1:What does that mean to syndicate loans out to other investors?
Speaker 2:What the banks that?
Speaker 2:So the banks that originate these loans are the large banks that we would be familiar with, the large multinational big money center banks JP Morgan, bank of America, ubs and banks like that and they will have to have a relationship with a large company that's publicly traded.
Speaker 2:And of course, these can also don't have to be publicly traded, but the sample we look at and observe and study are publicly traded firms and observe and study are publicly traded firms. Those loans that the banks originate. They'll underwrite them for billions of dollars, but then the banks don't want to hold all that debt on their books. That's a large exposure. So then the banks turn around and they have a network of smaller banks, financial institutions, funds, a variety of sort of players that will come in and buy a piece of that loan and hold a piece of that loan. That's called the syndicate. That's how you syndicate it and each person, who, each group or investor that owns a piece of the loan, then gets their cut. They put money forward as part of the loan in the syndicate and then they get their cut of the principal and interest as it gets repaid.
Speaker 1:And when we're talking about this, how is this different than a bond?
Speaker 2:There's several differences between bank loans and bonds to large corporations. One of them is I already just mentioned. The loans are private credit agreements. They are not public securities that are registered under the Securities and Exchange Commission, whereas the bonds are. The bonds are considered a public security or considered to be public securities, and that means they're regulated by the Securities and Exchange Corporation under the Securities Exchange Acts that were set up in the 1930s. So bank loans stay private, Bonds are public. Another big difference this just is I'm not even sure why this is, but bank loans are floating rate. That means that when you set an interest rate on a bank loan, it can fluctuate with the market. So it's typically defined as a spread above a market rate that can change, whereas bonds are fixed rate.
Speaker 1:And what about the terms of the borrowing? So I think the difference. You make the distinction between a bond and a bank loan pretty clear. I like that distinction. Is there any difference or similarities in the terms of those loans?
Speaker 2:Well, there are two types of loans that are very common to corporations. Sometimes they're packaged into one deal, sometimes they're just done as separate loans. The first type is what's called a revolving facility or revolving line of credit and that's like a credit card. It's essentially a gigantic credit card that the bank and the syndicate of lenders that the bank farms the pieces out to fund. They fund a credit card. It'll have a maximum amount that the bank farms the pieces out to fund. They fund a credit card. It will have a maximum amount that the corporation can borrow under this revolver. They can draw on it, that is, they can charge it, use it to charge to buy something or to pay for something anytime they want, up to that limit, and they can repay it and then use it again, just like a credit card. That's very, very different from the bonds.
Speaker 1:That's different from a bond. Yeah, yeah, bonds, you don't see, because a bond, you get funded all at once, right? Yeah, you issue bonds, you get the money. That's it Exactly and you owe the money at that moment.
Speaker 2:That's right, and so the second type of loan, the most common, is a term loan B. It even has cash flows like a bond, and that is you get the money up front, borrow that money, get it up front and you pay it back over time. But you really don't. You just actually just make your interest payments, much like you make coupon payments on a bond. You make these interest payments on the loan, you pay a little bit principal back, maybe 1% of the principal per year, but most of the principal you repay at maturity. It's called a balloon payment, much like you would repay a bond at maturity. So a term loan B looks a lot like just your garden variety bond, got it and so.
Speaker 1:OK.
Speaker 2:Great, except it's floating rate, whereas a bond is fixed rate.
Speaker 1:Which is an important distinction both for the borrower as well as people who are going to be the lenders.
Speaker 2:Yeah, as I'm sure borrowers now that have low fixed rate bonds versus floating rate loans are finding out as interest rates are risen.
Speaker 1:Find out the hard way.
Speaker 2:OK, so with that as a backdrop, thanks, that was excellent. With that as a backdrop, then tell listeners what was in addition to in a loan agreement that's the contract between the borrower and the set of lenders. In addition to there being sort of a requirement that you repay your interest and repay your principal on time, these agreements also have other rules and restrictions. Many of them we refer to as covenants. Covenants are things that contractually, the borrower agrees to do or not to do when they sign the contract. That if beyond just make sure you pay your principal an interest on time, that if you break one of those rules, then you're in default on the contract, at least from a contractual perspective, as if you skipped an interest payment or weren't able to pay your principal.
Speaker 2:And what we were interested in was whether or not these covenants themselves, and a particular type of covenant called a financial covenant whether they had some impact on how the borrower behaved.
Speaker 2:They had some impact on how the borrower behaved because from the academic literature there's like oh, there's just these large contracts, you have a bunch of rules in them, but for all intents and purposes, these rules don't matter to how the borrower behaves.
Speaker 2:And but we so my co-authors and I Greg and Amir and I we're like well, but if you really look at these agreements, they have all sorts of restrictions on borrowers' behavior. There's restrictions on what dividends they can pay, restrictions on what new debt and equity they can raise, there are restrictions on how much they spend on acquisitions and capital expenditures. And then there are these covenant financial covenants which are essentially performance benchmarks that the company has to meet on a quarterly basis, that if they don't meet those benchmarks, they're in violation of the contract. And so we were really interested in, first, how these covenants influenced borrower behavior. And then, whenever a borrower violated a covenant, we asked well, what happens? And part of the answer to what happens is if something happens when they violate a covenant, then that in itself means the covenants are having some sort of impact, and that was the genesis of the 2012 paper.
Speaker 1:And the point, obviously, is because these covenants are meant to protect the lender, and so whether there's an impact or not is important in understanding whether they're serving the purpose that they were put there for.
Speaker 2:Correct, correct. They're in there to protect the lender. Now there's another side of the academic literature that also said well, but that's also are the lenders being too restrictive? Side of the academic literature that also said well, but that's also are the lenders being too restrictive in the sense, are they tying the hands of the company's managers through these restrictions, through these covenants that are preventing them from deploying capital in a way that grows the firm, that makes the firm better off?
Speaker 1:And when banks put these covenants into their loan terms, are they motivated exclusively by making sure that the loan doesn't go bad, or do they have other incentives, other issues that might drive them to create covenants, like, say, bank capital regulation requirements and the like?
Speaker 2:There is this tension, though, when a lender puts these contracts together, on how much protections do they want there? How strong do they want their restrictions to be that prevent the borrower from doing things that jeopardizes the borrower's ability to pay back the lenders?
Speaker 2:That is these restrictions are there to the lenders. I think in some ways think of the restrictions as being guardrails on a windy mountain road where the lenders would like the borrowers, with these guardrails, to stay on the road. Else to stay on the road, because if they didn't have the guardrails and they just went off the cliff going off the cliff is not being able to repay your loan then it's too late to not only rescue the borrower but also to get the loan paid back. And so those restrictions are in place to sort of guide the borrower to repaying their loan, an issue that's come up in recent years. It's been around for a long time but it's become a sort of a topic du jour.
Speaker 2:Is that, at least recently and through time and this really plays into our second paper that we're going to talk about today these contracts have become looser in the sense that the restrictions will be in the contract. You look at the table of contents, it will have all sorts of restrictions listed on borrower's behavior, but if you go to the restriction itself, it will look very restrictive in the very first sentence and then it will say you know, you should not do this, you should not raise new debt except for, and then it will list a lot of exceptions, I see, and the exceptions themselves can be, can go pages, pages, pages, and then the idea is, then what you're really doing is opening, potentially opening up a lot of holes that will allow the borrower to do things that you were originally trying to restrict them from doing so.
Speaker 1:The idea is to protect the lender. Yep, and these restrictions are aimed at making sure that, if there's anything happening with the borrower that could put the loan at risk, this will be a trigger to protect the lender. Who polices these covenants?
Speaker 2:protect the lender? Who polices these covenants? So the syndicate will usually have one bank that's typically one of the arranging banks who's deemed to be the agent or the administrative agent or just the agent. That agent is contractually sort of the go-between the borrower and the lender syndicate and that agent oftentimes will be the one who is in charge of monitoring the borrower, assuring that the borrower is complying with its covenants and warning or alerting the lender network when something's going awry.
Speaker 1:So at least I mean, at least in theory if I'm a lender and let's say I'm the organizing lender, I might have incentive to throw everything plus the kitchen sink in as a covenant, right, why not? But at the same time, if I have to monitor it and I presume that there are costs to monitoring it well then I don't have that incentive, do I? I don't want to throw everything plus the kitchen sink. I'm going to try to pick things that I think are going to be pretty indicative but also pretty objectively measurable. Is that fair? Sure, absolutely Right. Ok, and so then, when we're now let's flip over to the borrowers. So when the borrowers have these covenants and one of these covenants is triggered, does the borrower say oh shit, now I have violated a covenant.
Speaker 2:Strictly speaking, the covenant violation is what the lenders would say is an event of default, that is, the lenders can declare a default and start seeking remedies or taking actions when the default has been declared. Actions when the default has been declared. However, typically, even though the lender could declare a default upon a violation, a covenant violation, they don't. Why not? Because to them, first, it's costly, once you declare a default, to seek remedy and it creates all sorts of knock-on effects.
Speaker 1:So not even the cost of enforcement. Beyond that, it's also that if I declare a default, I now am triggering a whole other set of costs.
Speaker 2:Yeah, because there will be cross-default provisions in other debt contracts. They'll also be in default. Once a default is declared, then the company will probably react by filing for bankruptcy. So there's a lot of costs associated with declaring the default and oftentimes what the lender wants is not to penalize the borrower or put them into bankruptcy. They just want to make sure the borrower, if they're sort of sliding the wrong way in terms of their performance or in terms of their ability to repay in the future, the lender would like to do things to sort of encourage the borrower to correct those things. And so typically, when you see a covenant violation there's, you don't declare default, you renegotiate the contract and you, as part of the renegotiation, you waive or forbear on the covenant violation. And typically you waive and these lenders do want to get they're in the business to make money, so they will charge a waiver fee, but they will waive the violation, oftentimes after negotiating with the borrower to change their behavior or to do something or even to renegotiate or what they call amend the contract.
Speaker 1:So make the maybe a higher interest rate or a different repayment schedule or something like that.
Speaker 2:Could be a higher interest rate. It could be a lower interest rate. It could extend the maturity, it could change the. So if it's a revolving line of credit like a credit card, maybe they reduce your max on your credit card. But then you can also change all those restrictions and those protections. You can make some of your covenants more restrictive than they were before while loosening the others. So all of those options are on the table once you renegotiate your contract.
Speaker 1:So in your papers you focus on financial covenants. Walk us through what that really means financial covenants.
Speaker 2:Financial covenants, which are the performance benchmarks, that is, they're essentially they're either they're typically ratios or maybe dollar amounts that the company has to hit, or maybe dollar amounts that the company has to hit and if they don't hit them and they're checked on a quarterly basis then they're in violation of the contract and those quarterly checks are both around cash flows and asset debt sort of status, so yeah, then the balance sheet versus cash flow distinction comes in.
Speaker 2:How do you measure performance?
Speaker 2:The performance, either way, is almost always going to be measured relative to some level of your debt or how much interest you're being you're required to pay, and so a typical performance measure will be what's your total? The total amount of debt that you've taken on, including, I suppose, that loan, including that loan and maybe other loans, right, sure, divided by some measure of your profitability. Ok, and the typical way we see that today is we see debt in the numerator and then a measure of cash flow in the denominator, and the common measure is EBITDA earnings before interest taxes, depreciation, amortization. That's a cash flow-based measure. It's a measure of your operating income after adding back non-recurring or sorry, non-cash expenses like depreciation and amortization. That ratio tells you how much debt you have relative to your cash flow generating ability, say over the last 12 months. That's a cash flow measure. Another way to measure the level of your debt is to take how much debt you have in the numerator same numerator and then divide it by something like total book value or assets, and so it's like a debt-to-asset ratio.
Speaker 1:See how levered you are.
Speaker 2:How levered you are on a sort of balance sheet accounting basis. Why would they care about that accounting basis? Why would they care about that? Well, I mean, that's a good question, because I think what you see is measure of debt to the book value of your assets is not a very informative measure of your ability to repay that debt.
Speaker 1:Okay. So I'm a company. I want to borrow money. It sounds like I can do one of two things. If I'm a big, profitable company, I can issue a bond to the market, get the money all immediately, have to start servicing the interest on that bond. Is that bond going to? Oh, I think you already answered me and that bond is typically not going to have any of these so-called covenants.
Speaker 2:Bonds have covenants too, but they tend to be a lot weaker and they're very hard much harder to act on because even though loans and bonds both are farmed out to a group of investors, after a bond is issued and farmed out to a group of investors, it's much harder to find those bondholders to then ask them if they can, if we want to renegotiate the contract and renegotiate it, because you need support from the group of bondholders or a group of lenders in these behind these loans to approve any change to the contract. You need a lot of times you need a simple majority, sometimes you need a super majority, sometimes you need unanimous consent from the entire network. It's very hard to go find the bondholders to ask them to vote, much less just get the information to them.
Speaker 1:So, as a practical matter because that's true, it sounds like whatever covenants there are in bonds that are issued publicly are really rather benign.
Speaker 2:Benign is probably I don't know if I'd say benign, but they certainly they're fewer of them. They are weaker. They don't have these quarterly checks like you have in loans and you and I think in practice they a default, a covenant default, doesn't occur on the bonds, it occurs on the loans. The difference is that on loans, even though it's shipped out to a group of investors these agents on the loans that we talked about earlier they keep track of all the investors, so they know how to contact them immediately to get a vote for a change in the contract.
Speaker 1:Right. So if I'm a company I need to borrow money, I can issue these public bonds. They're going to have some covenants, they're typically weaker and harder to affect and if there's any problem I'm going to default. That's going to be the consequence with a public bond, and then we go into something like bankruptcy to try to reorganize or restructure that debt.
Speaker 2:By default, a principal payment default or an inability to make your coupon payments.
Speaker 1:Make your coupon payments, but if I'm at the same company, I can also borrow money from a bank, and that bank might syndicate that loan to a lot of other banks or a lot of funds or other financial intermediaries, and in that case, my loan is going to have these covenants you're describing, and in particular among the financial covenants.
Speaker 1:There have historically been financial covenants that deal with balance sheet type issues ratios of my debt to assets and such and there are some of the financial covenants that are really cash flow type covenants, where it's ratios of my debt or my interest to the kind of free cash flow that my company has. These covenants, though, aren't weak in the historic sense like we just said on public bonds and they're easier to monitor, because one of the banks is going to be following this every quarter and knows how to get people involved. And then, third, if I'm understanding you, if something goes wrong, it's not a question of default, and now we're in bankruptcy and we have to restructure the debt. It's like OK, the banks that lent to me want to work with me to figure out what changes should we make if there seems to be a risk of any of the covenants violating. Have I done so far? Am I getting a good grade in your class on expressing this stuff?
Speaker 2:Yeah, you're doing great. Okay, You're doing great. And I'll just caveat the last one, the last part, the third one One yeah, if you violate a covenant, typically, especially if it's the first violation, the banks are not going to the lenders, are not going to declare a default, they're going to work with you. And that's very hard to do with bonds, absolutely dead on. It could be that if you go on and on and on, you keep violating covenant, keep violating covenant, you become a serial violator Sooner or later.
Speaker 2:The lenders are going to may push you and declare a default. They're going to if they don't think it's going to get better. If they think you're going to, you've knocked through the guardrails, or you hit the guardrail so hard. The next time you're going to go through the guardrail then they'll take more serious action. But it's very unusual for them to do that when you first violate a covenant Right, and that's because the lenders have a lot at stake.
Speaker 1:We're not relying on the market to sort of trade these loans like we would have them trade bonds and somehow in theory incorporate into price the risk of default etc. Here we have active monitoring by the lenders of default et cetera. Here we have active monitoring by the lenders and, like we said, it's likely the case that the lenders are going to want to put in covenants that are effective, not covenants that they have in these loans. And if I understood you that was sort of the early motivation for y'all's paper is you wanted to sort of take a look at these covenants and measure their successes and see how they work.
Speaker 2:What we do in our current paper is and also, for that matter, what's changed through time. A lot is the borrowers that are publicly traded themselves have changed a lot through time and so, stepping back for a moment, what our 2012 paper did is it looked at how companies behave when they first violate a covenant, and our sample for that period was from 1996, which just goes back to the sort of the earliest time we can observe public filings related to credit agreements and covenants and covenant violations through a SEC service called EDGAR. We started in 1996 because we could easily electronically gather information on these contracts and on whether or not there was a covenant violation, because companies are required to disclose if they're in danger of violating a covenant or if they violated a covenant, so we can observe that. Required to disclose if they're in danger of violating a covenant or if they violated a covenant, so we can observe that. So it started in 1996 and our sample then ends in 2008. So, right at the edge of the global financial crisis, what we found in the original 2012 in, and try to become, restrict the borrower's behavior in terms of not allowing them to raise new debt or not restricting their ability to spend money, restricting their ability to pay dividends, sort of pushing them to save more cash on their balance sheet to protect the lenders. So that's not a surprise we found.
Speaker 2:Something that was more surprising, though, is that we also found that there was an operating turnaround in the sense that a company violated the covenant. They violated the covenant because their performance was declining, typically measured in terms of their cash flow performance. They tripped the covenant, and then what we observe is actually afterwards, after the bank has stepped in, the company actually improves. It improves in terms of its profitability, its stock price goes up, and so there's like this V-shaped turnaround Once the covenants trip, they turn around. They actually do better.
Speaker 2:I don't think the lenders care so much how much better the firm does, as long as they can get repaid, but there's a knock-on effect that's actually beneficial to the company and even to the equity holders, because the company turns around, and we could talk, if we wanted to, about the reasons why we observe this operating turnaround, but what happened shortly after we published the paper in 2012? This is actually happening before we published the paper, but there was a sense that, as this syndicated loan market grew and expanded, that actually the protections and the contracts themselves were getting weaker. The covenants were getting weaker. The covenants were getting looser. Covenants were getting dropped.
Speaker 1:And this is still. This is headline stuff. Any of our listeners who read the financial press right in the last 12 months might not know what it is they're talking about, but they're all going to recognize the phrase you just used.
Speaker 2:They're all going to recognize headlines that talk about weaker covenants, weaker covenants, covenant-like contracts, weaker covenants, weaker covenants, covenant-like contracts that's a very cute name that came. That sort of arose around the time of the global financial crisis back in the late aughts and then became very popular after the global financial crisis because everybody observers saw that many loans were covenant-like. That means they essentially covenant-like loans mean they've taken out all the performance-based financial covenants. So we kept scratching our head a little bit and thinking, wow, ok, everybody's talking about weaker covenants, weaker contracts, covenant light. What does that mean? What's the impact on our 2012 paper? Our 2012 paper says that covenants are important because, if nothing else, they help to turn the company around, make the company better. If we remove those protections, do these companies get worse.
Speaker 1:That was kind of our thinking, which gets to the core of why we have the covenants in the first place?
Speaker 2:Exactly, yeah, exactly, and what we so? Ultimately, you said well, we got to collect more data. Our data set before ended in 2008. A lot has happened since then and, through time, we ended up collecting the data to extend our data set all the way through 2019. 23, 24 years of data where we get to observe companies in the sense of how frequently are they violating covenants? What do their covenants look like?
Speaker 1:So you're able to also in your data track the kind of changing complexion of covenants over that time period. Yes, we are.
Speaker 2:Interesting we are. We are, and, indeed, what we find, is pretty startling. We find that consistent with the popular news, the popular observation, and what we're doing here, though, is we're documenting these cycle, or because there's some boom rate going now. Consistently, there's been what we say term is a secular decline in the number of financial covenants in a contract, and for those financial covenants to remain, and how tight they're set. By tight, that means how restrictive are you in terms of that borrower hitting their performance target, are you kind of giving them wide berth? Are you being very restrictive? They become much less restrictive, much looser through time, so fewer.
Speaker 2:Fewer, so about half as many financial covenants in 2019 and a contract in 2019 as there were in, say, 2000.
Speaker 1:So fewer and looser.
Speaker 2:And subsequently much fewer observed covenant violations. So the rate of covenant violations from we could take it to 1996, but take it from the top of the beginning of the century, from 2000 through 2019, because 2000 was about the peak year of covenant violations. They've declined 70 percent since that time. Violations have Covenant violations have declined. So we see many fewer covenant violations today that we saw, say, the first part of the in the early 2000s.
Speaker 1:Which is rather intuitive, because if there were fewer and they're looser you would expect you'd have fewer violations, right? And do you find that that means that these loans are going bad at higher rates and that this has been a real mistake? Or what do you find is driving things here?
Speaker 2:The answers somewhat surprised us, because the simple answer, given our 2012 paper, is like oh my gosh, things got to be much, have to be much worse. Because there are fewer. The guardrails have essentially been taken away. There's got to be a lot more firms going over the side of the mountain crashing burning. To come back to that analog, that is, that there's, to the extent there were benefits from turning around a firm after a covenant violation early. Those benefits should be gone and we should observe big changes in sort of how many companies go into bankruptcy, what the performance of these companies are, and so forth.
Speaker 1:What we actually observe is not a big radical change, not a big radical change meaning you don't see that the decline in the number of covenants, the looseness of the covenants that remain, the resulting fewer covenant violations you don't see results in more financial distress, more default, more failure to pay back.
Speaker 2:Right, we don't see it's not obviously.
Speaker 1:How in the world can that be possible?
Speaker 2:Yeah, Well, that's what really, that's what our new paper is all about. Maybe even from an ego perspective, to find that in 20, whatever 2019, 20, when we were finishing up this paper, writing our first drafts that, yeah, the world is much worse because in 2012, we said covenants are really important, those guardrails are really important, and now they're gone.
Speaker 1:Not just important but apparently additive to the financial health of borrowers.
Speaker 2:Yeah, made companies better off, and that would have been a fun story. It's just not what you found.
Speaker 1:It's not what we found.
Speaker 2:In some sense, it's seeking the truth and trying to figure out how things work is more fun, ultimately, even if you're stuck scratching your head for a while first, so yeah, so what we find, though, is the story, as the listeners might expect, is a lot more complicated, and so, to talk about that more, let me just set things up, and then I'll fire away at me. Edward. One is, the world's changed a lot between. The world changed a lot between 2000 and 2019. As I already hinted at, the types of companies that are publicly traded those companies we're actually studying have changed a lot the lenders, and the types of lenders Take them up in turn.
Speaker 1:I mean, I think it would be good to flesh it out.
Speaker 2:This is not. We're not the first to point this out. This is there are several papers that have been written about this and there's a McKinsey report. I think about this. There's a McKinsey report, I think about this.
Speaker 2:But the average publicly traded company today, in 2024, is much different from the average publicly traded company at the turn of the century in the early 2000s. The average publicly traded company today tends to be much larger. It tends to be much financially healthier, in the sense that the average credit rating, that is for those firms that are rated by credit rating agencies. They're healthier today than they were back in the early 2000s. They tend to have more cash on their balance sheets. I think they may be more profitable.
Speaker 2:I can't remember all the characteristics and it's not because firms have just gotten better and bigger. It's because those firms that are still publicly traded, that is, they haven't gone bankrupt, they haven't been merged into a private institution or they aren't private companies that could have gone public that decided to stay private, or public companies that have gone private. Those are the companies that are left over. But the world has changed a lot because just a lot of companies decide the companies that would have gone public in the late 90s, early 2000s decide to stay private. Companies that have been public are taken private through large buyouts Yep or through a buyout, and companies have merged a lot.
Speaker 2:Buyouts and companies have merged a lot. So it's just a different world we live in today, for publicly traded firms and for private firms too. But our sample? We have to be able to read these SEC filings to get our data, and so we're stuck looking at these publicly traded firms.
Speaker 1:So that's changed a lot.
Speaker 2:The borrowers have changed a lot Bigger healthier, more stable, yeah, healthier from a financial lot. Bigger, healthier, bigger healthier.
Speaker 1:More stable, yeah, healthier from a financial perspective, and fewer of them. And fewer, yeah, many fewer of them.
Speaker 2:Oh my gosh. I don't know the numbers off the top of my head, but the number of firms that are publicly traded has probably declined by 40, 50 percent since those days yeah, yeah, sounds right.
Speaker 1:Okay so, yeah, sounds about right. Sounds about right. Since the 90s. Those days yeah, yeah, sounds right. Okay, so that's borrowers.
Speaker 2:Yeah, borrowers and lenders, and so I hinted at this earlier. The lender networks have become much bigger, and the supply of capital that investors want to deploy into this world of syndicated loans has grown immensely, and the Biggest player in this market who buys these loans is something called a collateralized loan obligation.
Speaker 1:And listeners who have listened to season one's core episodes would have learned all about CLOs.
Speaker 2:Oh good, well, great obligations. Are these structured entities, sort of investment vehicles that take money from investors and tranche it up so that the investors can take a risky position in the structure, or less risky position, and then these structures turn around and just buy these loans? As I'm sure you covered in an earlier episode, these CLOs are the dominant investor in these markets, especially for the term loan Bs.
Speaker 1:More dominant than the big banks.
Speaker 2:Oh yeah, the big banks don't hold the debt, do the big banks still do the organizing. Big banks still organize it, but it's really become an originate and distribute model, much like mortgage brokers did or have done in the past. So banks originate, underwrite the loans and then they just sell it all off. They oftentimes don't even hold a piece.
Speaker 2:Don't keep, any Don't keep any Of the term loan Bs. Fair enough, the term loan Bs, and then they get sold off and then 70, 75 percent of the debt that's held. The syndicated loans are held by CLOs.
Speaker 1:And so that's a very different lender now.
Speaker 1:Like the story that you were telling a little while ago was a story about a lead bank and lots of other banks, and maybe there were some others. But there's a lot of bankers in the room and they're looking at these covenants as ways to protect the loans that they've made and that what's happened in the interval is that banks are maybe organizing these things, but they don't have any skin in the game. Is there any reason to think that the change in the number and strictness of covenants is something to do with more attenuated lenders than used to be the case when banks themselves had skin in the game? By attenuated, you mean the investors in CLOs are, I would argue, a bit more attenuated from what covenants should or shouldn't be there.
Speaker 2:So the CLO investors are first. They're limited right in what kind of things they can do. They're looking to get interest in principle back. They're willing to put their votes in on an amendment on a loan and so forth, but they're probably not as willing to go down a heavy path of restructuring or thinking about what to do. We spend a lot of time thinking how to fix the borrower. So that's point number one. So the answer is yes. Point number two is just a simple issue of math. As you increase the number of syndicate members, essentially, if you think of a syndicate as a party that invites these investors to participate in a loan, you start off with smaller parties, intimate parties, intimate dinners with maybe a dozen.
Speaker 1:They're civilized, aren't they?
Speaker 2:Yes, a dozen lenders, a dozen investors. Now we're in a world where there's hundreds it's a rave. Hundreds, it's a rave.
Speaker 2:It's a rave, not so civilized, not so civilized, but what it means, too, is just the cost of remember any time you violate a covenant. You want to sort of help the borrower through renegotiation and sort of help them adjust so that they can fix things before they end up in a payment or a payment default. If you got to get the support of hundreds of investors even if you can contact them all the costs of doing that become much higher, and so it's just as simple. You know, in the old days you could maybe amend or renegotiate a loan with a dozen people at the party. It was pretty straightforward. When you have hundreds, it's a lot harder to do something like that. Exactly Now, edward, you asked what else has changed, and I do want to pick up on that, because the other thing that's changed and I'm not sure what all the causes are is that covenants have gotten better through time.
Speaker 2:We show evidence of that. That is. That means, if you, what's a good covenant versus a bad covenant? We're talking about financial covenants these performance measures bad covenant. And we're talking about financial covenants these performance measures. We define a good financial covenant to be a financial covenant that only gets tripped when the borrower really is in trouble. Okay, but early on before it's too late. That's a good covenant. A bad financial covenant is one that trips when the borrower is not on the path to distress, or doesn't trip when they are.
Speaker 2:When they are Right. And then really in our paper we start, we put this in the sort of characterize this in the sense that whenever the test comes back positive oftentimes met with bad news, but hopefully caught early is a good thing Then you want a test that comes back giving you that says you have the disease. When the test comes back positive, a test that comes back a lot of times, says you have the disease and you actually didn't have the disease. That's a false positive, that's not a good thing. So the same with covenants. You want covenants to trip when the company's in trouble, they're diseased, and not to trip when they're not diseased.
Speaker 1:And for our nerdy listeners, those are type one and type two errors.
Speaker 2:They're like type one and type two errors.
Speaker 1:Yeah, sorry, carry on.
Speaker 2:Yeah, so, and so you can imagine some financial covenants, some performance benchmarks, being better in that sense than others. Yeah, sure, and if you have a really good financial covenant, then you don't need a lot of financial covenants. If it's a really good, well, you got one and it's the one that works the best and trips when you need it to trip and doesn't. Otherwise, you don't really need a lot of covenants.
Speaker 1:And so, and that would be true sorry to interrupt that would be true, irrespective of this change in the size and health of companies, correct and the types of lenders.
Speaker 2:Right yeah because you're able to measure, have more lenders and you could have bigger. You have to worry less about monitoring all the time if you have really good covenants. So that's another thing. We see through time and we have some. We have evidence that, at least for a while, covenant technology improved and we associate that with the change from balance sheet covenants to cash flow covenants. Because actually, if we see through time, I mentioned that the number of covenants in a contract have declined over the 20 plus year period that we observe. How do they decline? Well, actually, what's been dropped from these contracts is primarily balance sheet covenants, like debt to asset, ratios-to-net worth or something like that. Those have been dropped, but the cash flow covenants have remained debt-to-EBITDA, ebitda coverage ratios, which suggests that there's something that people like about the cash flow covenants and don't like the balance sheet covenants, that people like about the cash flow covenants that are and don't like the balance sheet covenants, could it?
Speaker 1:be that that may be why they're looser, that if you know the covenant does a better job of avoiding the false positives and false negatives, I can loosen that up a bit it doesn't as the press sometimes reports, looser covenants is usually signaling to people riskier lending.
Speaker 2:But it sounds like maybe not necessarily. That's right. That's right. If you have a really good covenant, it can be a looser covenant. It can be a test that's not as stringent.
Speaker 2:And so, yeah, one way to characterize our paper is describing this 20-plus year decline in covenant violations and increases in the looseness of covenants could be due to a variety of factors. It can be due to changing samples of borrowers, changing lenders. It can be due to technological improvements. It also can be due to sort of what's in the press. A lot that there is this like crazy move toward this market has exploded in popularity. There's billions, and now trillions of dollars flowing into the market and just by the very nature of this being a hot market, you get weaker covenants and you get weaker contracts, and in the paper we call this sort of an increase in financial market sentiment. That term comes from another paper by Anil Kashyap and Jeremy Stein, but that could be part of the explanation too. And really what our paper does is it seeks to sort of disaggregate and sort of classify how much of these changes we've observed through time are due to these different factors.
Speaker 1:And so what do you find? How much of it is due to these kinds of better technologies, better covenants, more healthy borrowers kind of situation.
Speaker 2:What we find is that a big part of the observed drop in the frequency of financial covenant violations through time is due to the drop in false positives. We characterize a false positive as a violation that occurs where nothing really changes after the violation. There's no treatment by the doctor, we just see the violation being waived without anything else happening.
Speaker 1:It's almost like so no, renegotiation, renegotiation, so it's like.
Speaker 2:You have a test that comes back positive. You got to do more diagnostics and you end up you're OK. So we call those. Those are false positives. Uh and um, the overall rate at which false positives occur over this 20 period plus period declines by 90 percent. Wow, I mean really. The number of false positives drops immensely. That alone explains about 60 percent of the entire decline in covenant violations over that time.
Speaker 1:It's probably tricky though, isn't it, to sort of disambiguate what part of that 90 percent is because borrowers are bigger and healthier and what part is because the covenants themselves are better.
Speaker 2:What we find in terms of how much of the decline is due to an improvement in technology getting better covenants versus how much of this is actually just a drop in not just false positives but also true positives. Maybe because just the cost of monitoring has gone up, maybe because just the cost of monitoring has gone up. What we find is that we find strong evidence of a covenant technology improvement. That occurs sort of in the early part of our sample from between 2004 and 2010. So through the global financial crisis, we see that this is where we see the big shift into cash flow-based financial covenants. We see improvements in technology. Improvements in technology means that you get an increase in accurately identifying distress without bringing along with that a bunch of false positives, so you just get more accurate.
Speaker 2:After 2011, beginning in 2011 to the end of our period, what we see, although the covenant technology are now better, any further declines we see in covenant violation frequencies aren't explained by further increases in technology. So they are either the samples changing so that that's why the false positives are going down, or part of it is, too, that companies are just finding or, I'm sorry, lenders find that the costs of false positives are high enough that they're willing to take on covenants or to set covenants such that they can get the false positives down, even if that means giving up on some true positives too, so that they're actually more tolerant of false negatives, failing to catch distress when a company becomes distressed, because they just like to have.
Speaker 2:If it's a large lender network, they don't want to be dilly-dallying around with every little covenant violation.
Speaker 1:The costs have gone up. This gets back to that point of a lot more dispersed and heterogeneous lenders. Yes, exactly, you've got lots and lots of investors through CLOs who are in turn buying the loans. They're OK with false negatives.
Speaker 2:They're OK with false negatives. And, by the way, we also measure the cost of false negatives, and false negatives are costly. That is failing to stop the car from going over the cliff. We find that that essentially lowers creditor recovery rates by somewhere between $0.07 to $0.11 on the dollar, so it's not a trivial amount and when you might only recover $0.50, $0.07 to $0.11 is a big deal.
Speaker 2:Right, it's a lot, but in the aggregate, though, if there's savings to be gained from not dealing with every false positive, perhaps that cost is worth it. If you sort of aggregate up the how much 7 to 11 cents on the dollar is times the number of firms that go actually default, into payment default, go into bankruptcy their proportion is relatively small. That proportion itself has been declining through time. Small, that proportion itself has been declining through time. So an inference from our paper is that there's been a sentiment change to where the market now tolerates more false negatives, fewer true positives, just to reduce false positives.
Speaker 1:That's great, david. One last question yeah, offer our listeners a pearl of wisdom.
Speaker 2:A pearl of wisdom. Ok, well, I'm first going to, I'm going to give it two ways and you can cut it later. Ok, pearl of wisdom. Here's my proloism.
Speaker 2:Actually, I was talking about some work I had done and how I got to be interested in restructuring and how I'd written a paper for a World Bank book with a Swedish colleague of mine who went on to head the Swedish Academy of Sciences Nobel Committee for Economics, and I think I was talking about some of my publications, where it seemed this student was listening, it's like, I think, to him it sounded impressive and I was just talking about this one area that I had done some work in and was successful and was very happy with.
Speaker 2:And he says how did you plan to get where you got to today? And I said I didn't. I mean my friend Per, my Swedish friend. We were a couple of guys in our late 20s who just got our PhDs. We met in Scandinavia and we really hit it off and a lot of times we were spending drinking and getting drunk and talking shit. But we both loved the subject and decided later on to write a paper together after procrastinating forever on it, and that's sort of my success story. But no, that's wisdom number one.
Speaker 2:Wisdom number one go to scandinavia, get drunk, get drunk a lot, and have really smart friends to get drunk with, listen to abba and stuff like that you know, um, but uh um.
Speaker 2:The second pearl of wisdom would be no. The second second point is this look, look, I I'm successful. To the extent I'm successful at all, that's to be debated. I just love what I study. I love. I feel like I've been very fortunate in that I've taken a path that's enabled me to do what I have a passion for, not only to be a professor, researcher and teacher, but also to study the things that I'm really excited about, and in that sense I feel fortunate. But my pearl of wisdom would be to find something that excites you. Don't set aside concerns about how you're going to get paid or what's going to pay you the most. Find what you're excited about and then pursue it, but be motivated, work hard and have confidence in yourself.
Speaker 1:Great David, thanks for joining the podcast. This was fun.
Speaker 2:Yeah, great Edward, thank you. I had a lot of fun, so thank you for inviting me.
Speaker 1:You've been listening to Not Another Investment Podcast hosted by me, edward Finlay. You can find research links and charts at notanotherinvestmentpodcastcom. And don't forget to follow us on your favorite platform and leave comments. Thanks for listening.
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