There is a saying that history doesn’t repeat itself, but it often rhymes. Of late, many in the industry have pointed to covenant-light, or ‘cov-lite’, private credit transactions as having unwelcome echoes with the financial excesses of the past. Many view their growth as dangerous and likely to leave investors exposed in the event of an economic downturn.
Whilst investors undoubtedly should be highly cognisant of the risks involved in cov-lite financings, experienced and disciplined managers should be able to mitigate the risks of these structures through asset selection, proper monitoring and pro-active management.
The growth of the private credit industry, fuelled by the low interest environment, has increased competition for deals across the market and enabled borrowers to secure better terms than in the past. Significantly, borrowers have been able to consistently reduce financial and non-financial covenants which traditional lenders would have previously demanded. While this is beneficial for companies’ management teams, lenders find themselves with access to less information and protection.
With the transfer of power to the borrower, there is an element of truth in the fear that lenders could be caught out if the market turns. However, cov-lite deals are not an insurmountable challenge for credit managers which have the capability not only to pick the right assets but also to ensure they have the right internal procedures in place to monitor their investments.
First and foremost, asset selection is key; the strength of a covenant does not necessarily indicate lower credit risk. A credit with the wrong fundamentals, such as marked cyclicality, will struggle in a downturn to return capital to investors with or without hefty maintenance covenants in place. Put simply, extensive covenants in a business with structural weaknesses does not give you any more protection than a similar business with fewer covenants.
Credit risk should be assessed primarily based on a company’s quality and fundamentals. Investing in highly cyclical sectors like fashion retail leaves lenders much more exposed to shifts in market sentiment than businesses with more recurring revenue streams. Disproportionate EBITDA adjustments on a financing EBITDA that are unlikely to translate to immediate cash flows should also be a source of concerns. Strong covenants will not protect investors if the investment thesis is inappropriate in the first place.
Once the investment has been made, the success of deals relies less on covenants than the ability of the investment manager to monitor the health of their investments. Adequate monitoring requires access to regular high-quality information. Unfortunately, we have seen a shift in recent years to more irregular reporting which can easily lead to nasty surprises for lenders.
Obtaining good information requires the investment manager to be proactive by engaging early with the sponsor and management team, as well as requesting reports and updates on a more regular basis. Properly monitoring these risks requires investment managers to actively and regularly monitor their investments; this is easier said than done, and necessitates robust internal processes.
In addition, the manager must also have the right internal processes and culture to act proactively to address issues before they develop further. For instance, a manager that properly monitors the performance of a borrower will be able to anticipate problems early and take the appropriate initiatives that will mitigate potential losses. It may be a sale on the secondary market if the investment is liquid and too small to influence potential discussions, or alternatively engaging with the sponsor and management in particular if it is a larger position. The latter approach requires experience, access to and relationships with sponsors, which can only be acquired over the years.
It is undeniable that there has been a shift towards cov-lite structures in our market, in particular for higher quality and larger transactions, which are usually supported by private equity sponsors. As a private debt manager, we have therefore continued to adapt our own internal monitoring process and are advocating for regular monthly reporting from borrowers, in particular for larger or less liquid positions. While we are, like our peers, cautious about the continued changes in documentation (the covenant aspect being in our view just one of a long list of challenges), our focus continues to be careful credit selection, as this remains the main driver to lower default rates.
*Francois Decoeur is a managing director at MV Credit, a European credit fund manager with offices in London and Luxembourg.