The case for covenant-lite

Are fears of a lack of red flags in deal structures overblown? There’s little doubt what equity providers think, but some lenders believe the same.

“If there’s an unexpected downturn or the company has a blip for a year or two, it gives you breathing space and you don’t have to bring down capex for the sake of hitting some arbitrary covenant.”

This is the view of one senior executive at a private equity house talking to PDI about the benefits of deal structures which either do away with covenants completely or at least keep them to a minimum. In sum, it’s all about flexibility – the freedom to fix any problems that crop up without being hauled in for a serious conversation (and a possible demand for remedial action) by a portfolio company’s lenders.

But does this simply reflect that, when you have a supply/demand imbalance, there will always be a winner on one side and a loser on the other? In this case, the enormous amount of liquidity in the market has arguably created a situation where the equity side can pick and choose their debt providers, and the terms they are willing to provide, from a very wide selection. From the lending side, it’s an unseemly race to the bottom.

Are the worries about covenant-lite really justified, though? If it’s hard to leave aside the fact equity firms clearly have a vested interest in proclaiming “nothing to see here”, their claims should also not be readily dismissed. One concern you hear expressed is that covenant-lite is a symptom of a toppy market in which leverage is being pushed up to pre-global financial crisis levels. In this environment, a lack of covenants will hide from public view the scale of problems within businesses – up to the point where the whole artifice comes crashing down.

But is it really a toppy market? Data from S&P show that, in the run-up to the crisis between 2003 and 2007, debt to EBITDA in leveraged buyout deals rose sharply from 4.1x to 5.9x. In the years following the crisis, from 2010 to 2017, the trend has also been upwards albeit not at quite the same rate – from 4.2x to 5.1x.

This increasing leverage appears a justified concern until you look at the ability of cashflow to cover interest payments. Here, the data reveal that, pre-crisis, EBITDA minus capex divided by interest (the measure of the amount of cashflow required to service a year’s worth of interest) fell from 2.6x to 1.8x. Post-crisis, the multiple started at 3.0 in 2010 and remained at 3.0 in 2017. These days, in other words, much more cash is available to service debt, meaning companies are significantly more robust.

Bear in mind also that criticism of covenant-lite often comes from rating agencies, academics and other market observers – but not particularly often from the lenders. Many do not have fond memories of dealing with covenant breaches in the past, finding such situations a big drain on resource with the possibility of taking the keys to a business that they’re not really set up to run well. Some say they would rather engage with the equity side, and place trust in their ability to right the ship.

This view is not shared by all lenders, including those who may see covenants as a useful way of potentially calling for a refinancing and bumping up the margin. But to see covenant-lite as an unwanted and dangerous sign of structuring indiscipline forced on lenders by market circumstances does not reflect a far more nuanced reality.