Covenant breaches set alarm bells ringing

Performance issues are emerging within private debt portfolios, but plenty of lenders are getting fair warning and not panicking yet.

A September survey by Munich-based consultancy Bluemont may have caused some anxiety in private debt circles. It canvassed a selection of Europe-based fund managers and found one-third of them saying at least a quarter of their portfolio companies had breached covenants due to the economic impact of covid-19.

On the face of it, that is indeed worrying. Although it’s important to note that two-thirds cited a figure of a quarter or lower, it appears that the pandemic has produced significant stresses within portfolios if the managers canvassed by Bluemont are a representative sample.

It may not all be bad news, however. One of the worries about the private debt market has been how many bad practices have migrated there from the leveraged loan market when it comes to investor protection – or, more accurately, the lack of protection. The percentage of covenant-lite leveraged loans has shot up over the years – from pretty much zero after the global financial crisis to 90 percent or more today.

What will perhaps provoke some surprise in the Bluemont survey is the evidence that covenants are still alive and well in the private debt universe, even if their number in a typical deal may have reduced over the years from three or four to just one or two. If the rise in breaches sets alarm bells ringing, some would say that’s exactly why they’re a good thing – covenants allow all stakeholders in a deal, lenders included, to demand that action be taken before a company slides into the abyss.

Reassuringly, perhaps, few lenders appear to be panicking in the face of these breaches. Bluemont found that more than three-quarters of fund managers were offering support and guidance to company management following a breach and that more than half were willing to provide additional capital. Far fewer were taking drastic action, with a combined 20 percent either sending in an operations team to try and improve profitability or – at the extreme end – asking for an immediate return of invested debt capital.

Of course, covenant-lite loans are to be found in the private debt market and among these will be the problem deals of tomorrow. As far as today is concerned, plenty of issues are surfacing but the response from managers appears to be measured and proportionate. These managers will be grateful for the early-warning system that covenants provide.

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