NEW YORK, Aug 15 (LPC) - The private debt market has largely been immune to the covenant-lite trend, but a recent spike in so-called covenant-loose lending suggests funds are finding ways to offer more aggressive terms while sticking to investor demands to maintain certain restrictions on borrowers.
Traditional buy-and-hold middle market investors have largely steered clear of covenant-lite deals because of the lack of protections and liquidity available to lenders when a company runs into financial trouble.
A recent report from law firm Proskauer found that for deals arranged in the private debt market, covenant-loose structures jumped to 59% in the first half of 2019 compared to 26% recorded in all of 2018.
Conversely, covenant-lite structures, deals without a maintenance covenant, dropped to 8% from 14% in the previous year. Covenant-lite was only present at the upper end of the middle market for deals above US$50m Ebitda, the law firm said. Ebitda is a measure of a company’s operating performance, considered to be a significant indicator of financial health.
“In larger deals there are no covenants, but if they’re looking for some sort of guardrail then covenant-loose has been a compromise,” said Stephen Boyko, partner at Proskauer. “We’ve seen a shift in the market and it’s across the board. Borrowers have choices and they’re trying to find flexibility.”
Covenant-loose is defined by Proskauer as a leverage cushion from closing leverage greater than 40%, meaning that Ebitda could decline by 40% before raising alarm bells with lenders. The covenant-loose figures refer to all deals that private debt funds participate in, whether as lead arrangers or in more passive roles.
“Covenant-loose is a relatively new term. It first started in Europe and has crept into the market over the last year,” said Ted Goldthorpe, head of BC Partners Credit. “The only time we’ve really seen it is on a really good business, not in energy or auto, but for example on recurring revenues on software businesses.”
Proskauer notes that the covenant-loose structure has also cropped up on deals with Ebitda below US$50m, citing one transaction where covenant-loose terms were secured on a company with an Ebitda below US$25m.
Fund managers report that such instances remain a rarity in the core middle market, but speak of deals with increasingly wider cushions that surpass the conservative range of 25%-30% to 35% and above.
“If your headroom is more than 40% then you’re getting into enterprise value. I hope the market doesn’t keep marching in this direction, but there is a point at which some lenders can’t resist it,” said Tom Newberry, head of private credit funds at CVC Credit.
As record amounts of capital have poured into the private debt market in the last several years, many direct lenders have migrated beyond the core middle market to underwrite bigger deals in order to compete for business that would typically be executed in the broadly syndicated loan (BSL) market.
Private credit fund managers are more routinely underwriting larger transactions, in the US$300m-US$500m range, with some deals in recent years surpassing the US$1bn mark.
Those types of deals mean funds are regularly competing for deals at the lower end of the BSL market. To win such mandates funds have to be just as aggressive on terms, offering the same flexibility on documentation that the banks offer.
“A number of traditional middle market lenders have decided to raise mega US$5-US$6bn private credit funds,” said Ian Fowler, co-Head of Barings’ North American Private Finance Group. “You can’t put that money to work efficiently if you stay in the traditional middle market, so managers have expanded the middle market footprint upwards, financing larger companies and bigger deals, which has resulted in a disintermediation of the lower end of the BSL syndication market.”
Investors in private credit have increasingly trained their focus on covenant structures in an environment where regulators have raised alarms about covenant-lite lending. A large proportion of those investing in pooled funds or separate managed accounts are pushing lenders to avoid underwriting covenant-lite structures.
But the rise of covenant-loose has raised questions that the maintenance covenants direct lenders are securing on deals lack the security investors in private debt funds crave.
Funds can report to investors that a deal has a maintenance covenant, but this can be a crude metric and does not fully tell the picture of the level of risk.
“A lot of discussions are around ongoing headroom in the life of the deal. When does the covenant get triggered? How far into the deal do we trip the covenant?” said Niels Bodenheim, senior director at bfinance, an advisory firm to investors.
Ebitda adjustments have been a big focus for investors into private debt funds as many fear that if borrowers fail to hit such projections then the lender is exposed to greater leverage than expected. Proskauer’s report shows that what lenders are willing to give credit for is increasing.
For instance, caps on non-recurring expenses are less common at the higher end of the market, but borrowers securing a cap 30% or above increased to 22% of deals in 2019, from 8% in 2018.
So far this year, 70% of deals had a 25% cap or higher on run rate synergy add-backs, up from 60% in 2018, Proskauer’s report shows.
“The headroom is one element to review, but a key question is what are the allowances for Ebitda adjustments. It can be a fictitious manipulation of the cash flow,” Bodenheim said. (Reporting by David Brooke. Additional reporting by Aaron Weinman. Editing by Leela Parker Deo)