Private debt managers are getting tougher on covenants due to economic uncertainty and concerns over companies’ ability to withstand higher levels of interest.

Speaking at the Private Debt Investor Tokyo Forum on Thursday, Antonella Napolitano, global head of investor relations and capital formation at US mid-market firm Deerpath Capital Management, told delegates power was “coming back to the lenders” this year.

“Leverage has come down about half of a turn; some protections have increased; maybe the headroom with covenants have narrowed a bit, which is good news,” she noted.

Covenant-lite deals had last dominated prior to the global financial crisis and in recent years have become considered the norm for larger deals. Reducing covenants can prove risky because they also provide the means to catch and address potential issues early.

“The reality is right now the larger deals really don’t have covenants; some of the trickier transactions in much smaller companies tend to still have covenants but the larger deals don’t,” Kerry Dolan, managing partner at New York-based Brinley Partners and a PDI changemaker for 2023, said on the same panel.

“[Headroom] used to be 20 percent – now it’s well north of 30 percent. And so we’ve seen a movement in the past 18 months so that we are seeing more lender-friendly terms, we are seeing credit investors comment more and more recently, but we have a long way to go to get back to what we were seeing in 2018.”

EBITDA add-backs

Brinley, which invests across secured credit, unsecured credit and preferred equity, has three main areas of focus when it comes to covenants in 2023, with EBITDA add-backs the top priority, Dolan said.

An EBITDA addback is essentially money added back to the profits of a company. These can be controversial for their ability to disguise the amount of leverage a company is taking on because total leverage is normally expressed as a multiple of EBITDA.

“There’s lots of add-backs, and the reality is when you have to pay back your debt, you really have to look at cashflow and you have to figure out what real EBITDA is,” Dolan said.

Deerpath’s Napolitano added that managers can ensure the definition of EBITDA is not uncapped to mitigate the risks associated with EBITDA addbacks.

“That’s really important. Otherwise the covenant won’t be hit – they can keep kind of adding on to what that actually entails.”

Sponsor lending

The relationship between sponsors and the underlying portfolio companies is also becoming a focus of covenants, Dolan noted.

“We care a lot about how the private equity firms may be able to take money or take assets out, and we’ve seen a lot of loopholes over the years and a lot of creative moves on the side of private equity firms,” she said. “We try and be pretty careful about keeping our assets and… collateral in our restricted group.”

Deerpath’s Napolitano suggested lenders secure the ability to block payments to junior debt players or private equity sponsors. “As soon as our covenants are hit, we’re able to say to the borrower you’re not paying the private equity firm and you’re not paying junior debt anymore because we want that cashflow retained,” she added.

“The one important other covenant to concentrate on, besides the typical leverage covenant that most lenders who have covenants get, is the fixed charge ratio covenant, because that will include the interest expense. So I think a lot of managers who can get that covenant want to get that because a lot of borrowers could run into trouble quite soon with they’re already having issues with wages like inflation and just generally inflationary costs and then on top of that, having cost of borrowing.”

LP scrutiny

Getting stricter on covenants could give debt managers an advantage in the fundraising market.

Speaking on the Thursday panel, Kanako Yabuki, product manager for LP gatekeeper Mitsubishi UFJ Trust and Banking Corporation, said she checks the average number of covenants across a GPs’ portfolio while conducting due diligence.

“If they have a long track record, I will have to go from the first fund to the prior fund because the covenant numbers tend to get lower as the fund [family] gets older,” she noted. “I think it’s due to the market and also due to the extension of the target company size, because they tend to grow as the funds grow… it’s good to ask questions about covenants because it really shows how they think about the risk taking.”

For most Japanese LPs, however, covenant numbers are not yet dealbreakers when committing to a private debt fund.

“To speak in general, I don’t think that it will be a big trigger for the investor to not invest or invest in their fund,” Yabuki said.

“Japanese [LPs] are in very different stages [in] that some of the LPs already have a private debt portfolio and some are now still researching and thinking about that investment. And when I explain and introduce our private debt funds in our line-ups, I generally don’t receive much questions on the covenants… I think it’s not the focus for them right now.”