Excessive liquidity in Europe making unitranche riskier

In pursuit of opportunities, debt funds are loosening their covenant protections to close deals. A similar trend is reflected in the syndicated leveraged loan market.

An erosion of covenant protections across the European unitranche market has occurred over the last two years, but protections for lenders remain stronger than in syndicated leveraged loan transactions, according to a report from the ratings agency Fitch.

Excessive amounts of liquidity have pushed direct lending platforms to take on deals on riskier terms. In 2015, 60 percent of unitranche providers included the full set of four maintenance covenants, while the remaining 40 percent were either loose or ‘lite’ structures. Fitch figures for 2016 show a reverse with less than 20 percent including a full set of protections for lenders and more than 80 percent either loose or ‘lite’.

The syndicated leveraged loans below €200 million tracked by Fitch show no transactions including a full set of covenants in 2016 and less than 20 percent in 2015. It is a significant shift compared with 2013, when Fitch recorded more than 90 percent of transactions had a full set of protections for the lenders.

“In response to competition from banks and institutional loan providers in the club and syndicated markets, unitranche covenants have weakened since 2014. Nonetheless, covenant standards remain stronger than for syndicated loans of similar size,” Fitch said.

The evidence backs up a number of concerns expressed by those within the market of an import of covenant-lite structures increasing across Europe as funds look to put record amounts of dry powder to work. Last month, one fund of funds manager told PDI that the senior debt market has the characteristics of a market that is “expected to fail”.

Unitranche is popular among small and medium-sized enterprises backed by private equity sponsors because of the flexibility it offers. Unitranche providers can supply an extra turn of leverage, reaching 5.5x compared with their competitors in the syndicated leveraged loan market. Facilities are typically around the €70 million size.

However, the funds do face increasing competition from banks returning to the leveraged loan market following the introduction of negative benchmark rates, Fitch said. The ratings agency also identified the introduction of Solvency II requirements, which have pushed insurance companies into European leveraged loan funds, separately managed accounts and CLO vehicles.

The rating agency said there is a likelihood of the default rate increasing in the long term, but in 2017 there is likely to be little change. “Excess liquidity in the leveraged credit markets will mitigate the possibility of a material increase in default rates. However, many unitranche borrowers, similar to the broader leveraged credit market, are in sectors exposed to technological, regulatory or macroeconomic disruption, and the agency expects default to materialise,” the report said.

How the unitranche market product will continue to evolve depends on providers’ ability to negotiate macro-economic challenges.

“The future of the unitranche product will largely depend on its ability to better navigate an economic downturn and credit market correction than European mezzanine debt did in 2008-09, as well as generate superior recoveries in a default cycle.

“High default rates and poor recoveries translating into poor returns for credit funds and their end-investors could compromise future fundraising activity,” Fitch concluded.