Cov-lite debt cushions PE industry against downturn ahead

While several market indicators have taken a negative turn since last year, fears of a sharp market correction remain muted.

Speaking to PDI‘s sister title Private Equity International on the fringes of the SuperInvestor conference in Amsterdam last week, several industry participants said that while high entry values and leverage multiples are as big a concern as ever, cheap, covenant-lite debt has given private equity firms the “whip hand” in dealing with creditors.

“Last time, the GPs that kept their companies alive made money,” said one senior Asia-based placement agent. “With covenants as they are, the onus is on credit funds to do what they can to stabilise these companies [in the event of a downturn]”.

According to the European head of a private pension fund with nearly $40 billion in assets under management, debt funds are “more sophisticated” in their risk management than many give them credit for. The number of private equity firms with strong institutional memory of the last crisis also makes the industry more resilient than before.

“We do a lot of number crunching to see how GPs performed over several funds, especially through the crisis,” the head said. “A first-time fund would find it difficult to get on our books.”

As of August, cov-lite loans accounted for 79 percent of outstanding loans in the US leveraged loan market, compared with 29 percent in 2007, according to data from S&P Global Market Intelligence. Cov-lite loans come without maintenance covenants, regular tests that a borrower is required to pass to demonstrate its health.

In conversation with sister publication Private Debt Investor, Ares Management chief executive Michael Arougheti said covenant-lite loans are likely to prolong the benign environment. The interpretation of novel contractual features, such as restricted payment baskets or alternative definitions of EBITDA, will pose a challenge when the downturn comes, he cautioned.

“When we do get to see distress, it will be liquidity driven,” he said. “That’s when we’re really going to test both the metal of the equity investors, to see which companies they will and are able to support, and how these documents perform. It could go either way.”

Purchase price multiples and leverage multiples are higher than a year ago, and coverage ratios are lower, Hamilton Lane noted at its annual market overview in London this month. The investment manager’s Worry Index, a composite index of several sentiment indicators, is at 63, up on 56 last year and some way below the 2007 high of 81.