Why investors may be living in ignorance

We have probably all been in meetings where we had no idea what was being discussed but were eager to hide our ignorance. The more obscure and exotic the jargon, the more feverishly we nodded our heads to feign comprehension.

The private credit market must have seen its fair share of these meetings, given the number of different terms used to describe different forms of debt, and the different protections on that debt.

In private credit, however, there is a particularly sorry twist to this tale: the experts in the room may not understand what the terms signify either. This is not their fault: they once understood them, but critics complain that some terms are being stretched so much that they risk becoming meaningless.

“Some terminology is thrown out in this market today that doesn’t mean that much,” says Jeffrey Griffiths, principal at Campbell Lutyens, the placement agent, in London, who sees this as a problem relating specifically to sponsored core mid-market deals.

He thinks, for example, that the term “covenant-lite” has become rather nebulous, but so too has “senior loan”. It typically used to mean a senior secured loan of no more than three to four times EBITDA, but can these days be used for a unitranche loan of six times EBITDA.

These considerations are highly relevant to limited partners, because those wanting to make investments in debt above the mezzanine level can no longer be as sure as before about what they are getting into.

Griffiths returns to the term “covenant-lite”. “Calling a loan covenant-lite generally means it has fewer covenants than the traditional full four, but as an investor you don’t really have much knowledge about what that means, unless you’re actually in there reading the agreement, which is a pretty cumbersome thing to do for an entire portfolio.”

Griffiths has a potential solution: for the industry to standardise terms, to give investors a much better knowledge of the relative risk of different deals. The market could create, for example, a “Senior Secured Standard”, to be set at a maximum of four times debt to EBITDA and include a minimum of three covenants. Those covenants would need to establish a minimum level of strictness on issues such as headroom. This standard should also include limitations on structural subordination. A deal not meeting these criteria could be termed “Senior Secured Non-Standard”.

However, Griffiths does not think it likely that such a standardisation of terms will happen until the credit market has suffered a downturn, revealing that managers with stronger contractual protection on deals suffer fewer losses on loans than those with weaker protection.

Ari Jauho, chairman of Certior Capital, the fund of funds manager, in Helsinki, agrees that the terms have become rather shapeless. “I’m not so concerned about whether it’s unitranche, senior, first-out, last-out or whatever – the definitions are not really clear,” he says. “We’d rather look at the details than at the label: the credit metrics, the returns, and so on.”

Another development in the senior debt market is the creation of debt terms in contracts that offer little legal clarity – a phenomenon that usually only becomes a problem when the financial situation of a particular company worsens.

One area of legal uncertainty is whether the US courts would recognise side agreements between unitranche lenders to the same company: in the US, lenders often sign an agreement with a borrower on identical terms, and then agree between themselves to give each other higher or lower priority in the event of default. This is known as an Agreement Among Lenders.

More choice

Observers say that both the increasing frequency of unitranche, and the ability to segment within unitranche, increase choice for the investor.

“The unitranche market did start off as one tranche,” says Haroon Chishti, director and specialist in private credit at FIRSTavenue, the placement agent, in New York. “But it has changed over time so that many deals effectively consist of first lien and second lien, which are priced differently and are attractive for different investor bases.”

Investors in this second lien – often known as last-out, with the first lien known as first-out – earn a premium determined by the Agreement Among Lenders, he says. This practice is much rarer in Europe.

His colleague Jess Larsen, head of the Americas at FIRSTavenue, says limited partners are becoming increasingly adept at finding the particular debt structure that suits them: “About 12 to 18 months ago there was a rapid change in the market, driven by some quite sophisticated consultants, who advised limited partners to select specific types of debt to suit their risk appetite, whether just senior, just mezzanine or just unitranche.”

It does not end there: he says that a number of fund managers specifically offer first-out or last-out unitranche debt, within segregated accounts.

Chishti says the extra yield to be earned from unitranche second lien comes at the price of greater risk. “It raises the question: at what point are you stretching too far and drifting into subordinated or mezzanine debt? Over time, if leverage does increase, last-out unitranche debt could take on a very different risk profile, and drift further away from what it was originally intended to do.”

Investors may also be running into the problem of not knowing precisely what risks they are taking on. Consider Agreements Among Lenders. Danelle Le Cren, partner at Linklaters, the law firm, in New York, says: “There are still no published opinions of any court that establish as a matter of law either that an AAL is a form of subordination agreement to be recognised under the bankruptcy code, or that a dispute involving an AAL to which a debtor was not a party would be a ‘core proceeding’ in a bankruptcy.”

This would mean that it was definitively within the scope of the bankruptcy court’s jurisdiction. “Perhaps it will take a downturn and some bankruptcies to see if the structure really holds up,” she adds. This is not a cheery thought for first-out lenders, should the courts not recognise their right to priority.

For limited partners that have concerns about how much risk they are taking on, the safest option is to choose managers drawing a line at minimum standards of deal documentation, and showing caution about how much leverage they are prepared to accept.

This is the approach embraced by Tikehau Capital, the alternative investment manager headquartered in Paris. Mathieu Chabran, co-founder, says the firm has accepted tighter cash spreads – down by perhaps 10 percent over the past three years, so that a deal that might have priced at LIBOR plus 750 basis points might now price at LIBOR plus 675 basis points. However, it has not ceded much ground on deal terms. Tikehau still insists on two covenants.

Moreover, Chabran notes that the total portfolio leverage on its Tikehau Direct Lending IV flagship fund, which started investing last year primarily in senior debt, is around four. This is very similar to TDL III, which began investing three years before. To illustrate Tikehau’s “discipline” on deal terms, he cites the example of a unitranche deal on which the firm lost out in February because it declined to offer leverage at 5.25. The deal was closed by a consortium of Tikehau rivals, with leverage at 6.2.