For a long time, discussion of a higher-default environment has been theoretical. Therefore, musing on whether the increasing prevalence of covenant-lite loans is storing up trouble for lenders has remained largely in the academic realm. With evidence of company stress thin on the ground, there has been no real sense of urgency.
As we head into 2020, things may be changing. In a report last week, S&P Global Ratings noted that its global corporate default tally in 2019 reached 117 – up 43 percent from the previous year’s number and the second-highest total since 2009. Many of these defaults relate to companies large enough to be beyond the scope of your average private debt firm – nonetheless, if market conditions are becoming more challenging, everyone needs to take heed.
It’s in this context that we take a deep dive into the topic of covenant-lite in the cover story for our upcoming February issue. What we portray is a tale of delayed action. The relative scarcity of covenants means forcing stakeholders to address issues in a formal way becomes less likely. It means that more faith is placed in equity sponsors to take whatever actions are needed to put companies back on the right track. This is not necessarily a recipe for trouble, but it does mean lenders have less control.
We would caution against a view of covenant-lite loans that is too simplistic. Private equity firms understandably want the flexibility to tackle problems without being dragged to the negotiating table by lenders every five minutes. Moreover, there is evidence that this freedom produces results – with historical data showing that covenant-lite loans sometimes outperform covenanted ones. Sources tell us that where covenants are sacrificed there can be a useful quid pro quo, whereby sponsors will ensure other aspects of the documentation are more lender-friendly than usual.
Sources also advise that investors should be alert to private debt managers overpromising when it comes to their ability to step in and restructure a portfolio company. In the current environment, that ability to jump in and take control of a problem loan is limited in many cases – bringing into question the credibility of a strategy that has been marketed with this as a major selling point.
With signs of the default rate creeping up, maybe 2020 is the year when deal documentation becomes a real practical issue rather than just the subject of interesting debate. Let’s hope that not too many lenders are left feeling powerless and regretful.
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