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 broadly syndicated loans 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 some 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 apparent 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. “The flexibility for sponsors to extract value through asset sales has been a huge focus and area of growth in flexibility over the last three or four years,” says Sabrina Fox, chief executive officer of the European Leveraged Finance Association.

“It’s all about return on investment and if you own something that has a high valuation and are pondering an eventual exit, along the way you might want to extract that value so you can justify the return you were originally trying to get. Asset sales has been an avenue for that to happen,” adds Fox.

Asset sales as a way of evidencing a likelihood to meet 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-market and lower-mid-market, traditional 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 again. Indeed, some say they see signs of this already and one area they point to is the EBITDA addback – the tool used by many borrowers to increase their available leverage on the basis of assumed revenues that may not actually materialise.

“The big thing is EBITDA definition addbacks, that’s really where we’re seeing documentation and covenants moving in favour of lenders across the board,” says Mikael Huldt, Stockholm-based head of alternative investments at AFA Insurance. “I think everyone is really keen to understand what the impact of inflation and higher input costs will be on EBITDA; you want to be on top of it so in terms of addbacks, whether it’s synergies or cost savings, there is less wriggle room being given to borrowers.”

A changing definition

Huldt says lenders are focused on risk and an unwillingness to saddle businesses with too much leverage. “Leverage levels have always been fairly stable, whether you’re looking at unitranche, senior secured or whether it’s first lien or second lien, but what’s been moving around is the multiple of ‘what’: it’s the definition of EBITDA that has been changing and I think there’s been more discipline around that from the lenders’ side.”

Other market sources agree that in the face of inflation, rising interest rates and an unstable geopolitical situation, the focus of managers is on the highest-quality companies that they feel can withstand the various pressures and successfully pass increased costs onto their customers.

Huldt adds that one specific issue he has noticed becoming a hot topic is factoring in cost savings initiatives or M&A-related synergies before they’ve happened. He says when a borrower is looking to make an add-on acquisition these days, it is becoming increasingly likely that lenders will agree to only add synergies that can be delivered over a short-term timeframe – generally six months up to a maximum of a year, unlike at the peak of borrower power, when several years was possible.

“Addbacks is a consistent area of pushback that we’ve been seeing, especially where sponsors want EBITDA addbacks to be uncapped,” adds Christine Tognoli, co-head of European leveraged loan research at 9fin, a leveraged finance intelligence firm. “We almost always see a cap inserted now. There is some discussion around the size of it. Some sponsors have pushed for 30 percent but we usually see that reduced to 25 percent or even 20 percent.”

Tognoli also says there is a lot more hesitation around allowing addbacks related to (supposedly) lost revenues from the covid pandemic. “We don’t really see borrowers getting away with that much anymore,” she notes.

According to David Miles, co-head of global leveraged finance at law firm Dechert, anything to do with pricing, information rights and understanding the numbers that make up covenant calculations is a key focus area. This includes “making sure companies can’t adjust their basis of reporting without it being properly understood and reconciled so that lenders can really work out what the numbers mean”.

On pricing, he says: “I think in a more difficult environment where there is recession risk, everyone will look to price things to get the best return they can for their investors, and I think pricing has moved a bit in favour of lenders even for really good deals.”

One specific area of focus is non-call features in loans, by which lenders are attempting to lock borrowers into terms that make it less attractive for them to seek a refinancing in the short term. This is significant in the current environment, where some borrowers may be going with the more expensive direct lending option on the basis that they can hopefully refinance themselves relatively quickly and without significant penalties should the public markets reopen.

Tognoli says she has seen a few recent deals extending the soft call protection period, in which a premium must be paid for early redemption, from six months to 12 months. “Whether that’s here to stay, there’s not really enough dealflow to tell, but it’s something we’ve noticed,” she says. “I think it stands out because six months has been so standard and not negotiated at all for so long.”

Given that there has been some movement away from terms that had become market standard, the question arises as to how willing borrowers are to give ground – are they adopting a pragmatic attitude in the face of changed circumstances, or are lenders having to fight hard for each and every concession?

Pragmatism required

“I think mature and experienced transaction professionals would see that some of the flexibility they have previously achieved was just that – a flexibility that really may not have been needed; ‘nice to have’ but not actually that critical,” says Miles.

“I would hope there would be some pragmatic behaviour around doing transactions on terms that work for everybody and that it doesn’t necessarily mean banging the table, getting your final word in the addback definition.”

However, Tognoli says she sees little evidence that borrowers will relinquish their demands without a fight: “I’d say sponsors at the moment still seem to be pushing for peak market terms, although I suspect they’re doing so fully expecting to have some of their requests turned down. But they’re throwing the kitchen sink at it, and I think they always will.”

While there have been some areas of pushback from lenders against some of the more egregious borrower demands, there has been little in the way of dramatic change. One theme that emerged during the covid period was fund managers gravitating to a small number of favoured sectors perceived to be relatively resilient to tougher conditions such as healthcare, technology and business services – a trend that has not gone away in the subsequent period. Because of the appetite for these sectors, are they a bastion of borrower negotiating power?

“There will always be competition for good transactions and this competition drives creative thinking when it comes to understanding why you can lend at a certain leverage level or why you as an equity investor might wish to buy a business at a certain multiple of EBITDA,” says Miles. “So, I do think every deal is unique.”

With M&A dealflow showing signs of drying up, Miles thinks competition may further intensify around the best assets. “When people have got capital, they want to deploy it and make returns for their investors. We’ve often seen in recessionary environments that some of the best deals get done in some of the worst market conditions,” he says. “They’re the best assets in terms of returns over a long period of time and competition for them will be heightened by the fact that the capital markets are either restricted or closed. That will play well into the hands of private credit funds that have got significant available capital.”

While some trends are universal, it’s also worth noting that there can be differences between markets. Huldt thinks things have moved further in favour of lenders in the US, perhaps because more had been sacrificed in the first place. “There’s been an improvement [for direct lenders] everywhere but I think it’s more apparent in the US,” he says.

“There, we were seeing more private lenders mimicking the leveraged loan and high-yield markets and having to do cov-lite deals. Going back a year or so, I would say 10 percent to 20 percent of mid-market loans were cov-lite, predominantly at the upper end of the mid-market, but I think there’s now a retrenchment going on. That contrasts with Europe, where we haven’t really seen the introduction of cov-lite in mid-market loans.”

With European deals looking relatively attractive, Miles believes this has spurred US managers to divert attention across the Atlantic. “We’ve noticed a lot more interest from US private equity houses in coming over to Europe to buy assets, which is partly because the exchange rate is beneficial and partly because they can see some attractive pricing points.

“In particular, we’ll continue to see heightened activity in public-to-private transactions because the public markets are relatively depressed across Europe and PE houses are keen to buy assets at a lower value than they were listed at.”

This hunt for value is part of a trend to greater discrimination in the selection of assets amid what is likely to be a generally depressed M&A market as 2022 draws to a close.

“I think what’s likely to happen is increased focus on quality, in the sense that it’s going to be apparent who are the ‘haves’ and ‘have nots’ and if you’re in the wrong sector or have the wrong type of cost structure, I don’t think an additional covenant would solve that,” concludes Huldt. “I just think no one would lend to you to be honest.”

Is it covid mark II?

Back in March 2020, amid the first surge of covid infection across much of the world, many financial markets froze up.

In private debt, a limited number of deals continued to be done – characterised by lenders able to wrest back some initiative in what was previously an extremely borrower-friendly market.

It didn’t last. Following unprecedented central bank action, M&A volume came roaring back and – amid the euphoria – deal documentation if anything was even more tilted in borrowers’ favour than it had been pre-covid.

Today, any changes in the status quo are expected to be more modest and gradual than they were a couple of years ago. “I think this is more measured,” says Mikael Huldt of AFA Insurance. “But I think the pendulum has swung back somewhat and going forward it is difficult to predict how things evolve. The balance of power could stay where it is or swing in either direction, but I think whatever happens it’s going to be more gradual than what we saw at the height of the pandemic in 2020.”


Covenants ‘not the be all and end all’

They are only “one part of the risk management toolkit”, says Nick Smith, managing director of private credit for trade body the Alternative Credit Council, the private credit affiliate of the AIMA.

He points out that the close relationship between private credit lenders and borrowers means covenants play a useful role but not necessarily a vital one. “No one’s just waiting around for a covenant to trip. If there’s a problem, managers will intervene early,” he says.

“Covenants are one of the more visible ways you can look at risk and aggregate it across a portfolio and they’re a bit more tangible than some other things, but we need to remind ourselves that they’re not the be all and end all.”