Covenant dynamics are a constant source of tension

With a change in market conditions, changes in deal documentation might be expected. But shifts in the balance of power don’t always happen when expected.

When it came to covenants, the broadly syndicated loan and private debt markets have historically been bifurcated. While it was clear that many aspects of deal documentation would eventually find their way from BSLs to private debt by way of a ‘trickle down’ effect, the former became a place where covenant-lite deals were almost ubiquitous, while the latter was the last refuge of investor protection.

In today’s market, the distinctions are becoming less clear. As some operators in the private debt market proclaim their ability to lead multi-billion unitranche transactions, and act as a viable alternative to the public markets for the financing of sizeable businesses, the BSL and upper end of the private debt space have become, in the words of one industry source we spoke with, “parallel markets”.

Private debt deal agreements are generally hard to obtain the details of – the clue is in the name – but it may be assumed that the main trends being seen in the BSL market are true also of larger private debt deals in this ‘parallel universe’. And sources tell us that the balance of power in negotiating documentation in today’s market still – perhaps counterintuitively – rests with the borrower rather than the investor/lender, despite the chill winds of economic downturn beginning to be felt.

One area providing evidence of this is the cross-referencing of the restricted covenant and asset sales covenants, whereby sponsor-owned businesses facing tougher times see the disposal of certain assets as a means of keeping on track to deliver a stated return on investment. Asset sales as a way of meeting return expectations is arguably a subversion of the restricted payment covenant’s intent, which is to maintain as much realised value as possible within the company – in the form of reinvestment or senior debt repayment, for example – to ensure the ongoing creditworthiness of the borrower.

Below the larger end of the private debt market, it’s important to acknowledge a rather different picture. Here, in the mid- and lower-mid-market, maintenance covenants have been doggedly preserved even if there is some scepticism around their usefulness in the face of the onslaught of EBITDA addbacks. At this smaller end there was a meaningful shift in the balance of power towards investors/lenders in the immediate aftermath of the first major covid outbreak – proving that such a thing is possible – but it wasn’t long-lasting and the status quo swiftly resumed.

With economic clouds gathering, however, there is a sense that now is as good a time as any for investors/lenders to start flexing their muscles. Indeed, some say they see signs of this already in the form of pushback in areas such as soft call protections and company reporting (where the call is for increased regularity of reporting and better access to information). Whether this takes the form of piecemeal action in certain deals only, or becomes a wider resistance movement, will be in sharp focus over the coming months.

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