March 25, 2014

A resurgence in lenient lending conditions and continued interest in high-multiple/high-concept IPOs combine to underscore the reality that – in certain sectors – we are seeing a moment when capital comes with many fewer strings attached than has been the historic norm.

“No Strings” Debt Markets:

In a troublingly eerie echo of the pre-crash period, S&P Capital IQ has reported that, in both the U.S. and Europe, the volume and percentage of loans deemed to be “cov-lite” has exceeded the levels seen prior to the financial crisis.

Cov-lite (or covenant light) are corporate loans without the usual package of lender protections. These protections have often taken the form of covenanted ratios regarding, for example, total debt to EBITDA. Cov-lite loans are frequently extended by banks and then syndicated to a variety of other investors. In an era of Central Bank pump priming and prolonged low interest rates these investors are abandoning protective measures in a quest for yield.

S&P Capital IQ’s data suggests that in 2013 almost €8 billion of covenant light loans were arranged in European markets. This compared to €7.73 billion in the period immediately before the credit bubble crisis of 2007. Likewise, the percentage of cov-lite loans to total loans also exceeded the previous peak of 2007. The same state of affairs prevails in the United States. Credit bankers appear to be largely unconcerned, noting that the incidence of default around cov-lite loans during the financial crisis was limited (more on this below).

The Bank of England and the European Central Bank have both taken notice and are watching the situation with considerable interest. Apparently the U.S. Federal Reserve is somewhat more alarmed: dollar volumes are higher and the U.S. experience in the credit crisis was somewhat different.

Credit bankers rightly argue that the 2007 period was characterised by massive leveraged buyouts such as the $44.4 billion TXU Corporation deal (announced in February 2007 and led by TPG, KKR, Goldman and Lehman) and the $27.6 billion Harrah’s Entertainment transaction (announced in October 2006 and led by TPG and Goldman Sachs Capital Partners). Credit professionals argue that deals of this size are absent from the current market and that, at any rate, concerns over refinancing these deals largely proved unfounded, with the vast majority of LBOs actually finding refinancing to have been both easy as well as profitable. (When the time came to re-finance interest rates had fallen and stability had returned to markets.) That is not to say that equity providers did not suffer during the process: both TXU and Harrahs experienced significant business challenges and TPG’s fifth buyout fund, which contained these deals (as well as a multi-billion dollar investment into Washington Mutual, later seized by the U.S. government) has a generated an anaemic net IRR (as reported on the Washington State Investment Board website) of 1.18%.

The concern of the U.S. Federal reserve is thus unlikely to be about refinancing; rather it would appear to be about the impact of volatility on capital ratios in the banking sector. As noted above, when TXU and Harrahs struggled during the crisis some banks (notably Citigroup) had to absorb massive mark-to-market losses associated with LBO debt they had kept on their books. The current accounting fetish for over-weighting the balance sheet through mark-to-market accounting may have solved one set of historic problems, but has created another.

At any event, for corporate borrowers, the resurgence of the covenant light market can only represent an opportunity to optimise the debt portion of their capital structures.

“No Strings” Equity markets:

In the past we have written about the fact that technology companies perceived to be attaining critical mass are able to command two things when selling equity into the public markets: high valuations and multiple voting structures that favour company founders and endow them with a strategic “carte blanche”.

The latest example of this is Box, a cloud storage company focused on enterprise customers. Unlike DropBox, a consumer-focused cloud storage firm leveraging Amazon’s AWS infrastructure, Box does run its own data centres. On the other hand Box also generates substantial losses. Box doubled sales in the last fiscal year (January) from $59 million to $124 million. On the other hand losses rose from $112 million in January 2013 to $168 million in the last fiscal year. The firm, states the filing, does not expect to be profitable in the forseeable future. Billionaire Mark Cuban, an angel investor in the company, had the following to say on Twitter: “I wish @BoxHQ the best, but I would combust if 8 years in I was responsible for $169mm in losses against less revs. I hope IPO gets them going.”

Box plans to raise $250 million in an IPO. This follows a $100 million capital raise in December of 2013 (by way of private placement) that cemented a $2 billion valuation. The IPO is expected to come at a premium to the December deal.

Venture capital firms (including DFJ and US Venture PArtners but also including PE/growth investor General Atlantic) own 53% of the company. The two co-founders own slightly under 6% of the firm. Existing investors will be granted multiple voting shares having ten votes. These will convert to single voting common when sold. Once the venture capital firms have exited their investments the two co-founders will have voting control supported by a 5.9% equity position.

The combination of high valuation and multiple voting shares is understandably alluring. As Facebook (controlled by its founder via multiple voting shares) demonstrated with its $19 billion purchase of Whatsapp, high valuations and multiple voting shares can encourage animal spirits.