“Covenants send a warning signal of under-performance,” says Bill Troup, managing director in the debt advisory team at London-based mid-market M&A firm Livingstone Partners. That being the case, the warning signal in European private debt deals appears to have faded almost to the point where it is undetectable.
Troup says there has been a major shift in the provision of loan covenants over the last five years, reflecting the relative decline of clearing banks and the emergence of debt funds in leveraged loan transactions.
The clearing banks have traditionally been insistent on the inclusion of four mainstream covenants, which are all ways of testing the health of the borrower and being alerted to any emerging problems. These covenants typically provide tests relating to cashflow, leverage, liquidity and net worth.
Debt funds started from a similar position five years ago, but Troup says they have been loosening their covenant requirements ever since (as can be seen in the accompanying chart from London-based data analysis firm Debt Explained). Today, most loans provided by funds are either covenant-loose (featuring just the leverage covenant or perhaps one other) or covenant-lite (with no covenants at all).
“You’re not expected to hit your earnings plan all the time. While it varies from deal to deal and from lender to lender, direct lenders have a relatively higher tolerance for under-performance,” says Troup. “Borrowers are often given 5 or 10 percent more headroom by direct lenders, allowing more latitude to miss EBITDA without anyone coming after them.”
Given the growing competition in the private debt market, particularly in the direct lending space, the trend is arguably no surprise. With so much capital chasing deals, borrowers can afford to be choosy – negotiating a loose covenant package, in order to grant themselves more flexibility, is seen as extremely useful from their point of view.
Naturally enough, there is concern over whether lenders have enough oversight of the business. Does allowing generous headroom mean under-performance can be obscured? Moreover, even if you are confident that problems can still be spotted in good time, a lack of covenants gives you less power to step in and address whatever problems have arisen.
Troup acknowledges that, while covenants have loosened considerably at the larger end of the market, there has been more resistance as you move down the deal size spectrum.
“What’s concerning,” he reflects, “is the direction of travel in favour of looser control. It makes you wonder how far it will go and whether we can strike the right balance. In the [global financial] crisis, lessons were learned. But that was 10 years ago. Are memories long enough?”