Incremental lending has grown so much in part because investors agreed to allow it in the first place. For much of the year, money managers were so eager to make loans that they would consent to just about any terms, including allowing companies to add on more loans. The growth of incremental debt underscores how permissive lending markets have become, and why so many money managers and rulemakers are watching corporate borrowings warily now. “Lenders have been providing what feels like unlimited capacity to borrowers to incur additional loans,” said Vince Pisano, a senior analyst at Xtract Research. “A lot of the extra debt is paid out to private equity owners as dividends, so at some point you should be investing in those firms and not the loans.”
With that refinancing, a company ends up with more debt that’s first in line, reducing recoveries for everyone at the level known as the first lien, and fewer lenders to absorb losses when things go wrong. The crowded first lien is a problem for lenders who have agreed to receive less interest in exchange for taking what they thought would be less risk, said George Goudelias, of Seix Investment Advisors.
Applied Systems is using a $210 million incremental loan to pay its private equity owners $200 million, a third dividend. Hellman & Friedman bought the Illinois-based firm in 2014 in a deal including an investment from JMI Equity. Some incremental debt deals have even sought to add a piece of debt that matures ahead of the term loan, effectively subordinating borrowings that would otherwise rank equally in the repayment order, according to Chris Mawn, head of the corporate loan business at investment manager CarVal Investors.