Lighter, looser and much more dangerous

The relaxing of lender protections in the European debt market could have grave implications for private funds.

Covenant-lite loans, which were originally designed for the large-cap leveraged finance market, are becoming a more common feature in the mid-market, PDI understands.

Looser covenants in general have come about as a result of an increasingly borrower-friendly environment. Vast amounts of liquidity and lacklustre deal flow have led to intense competition between private equity sponsors, and even more so between lenders. 

This is particularly acute in the mid-market, we hear, where the growing high yield market and the influx of alternative lenders have created an increasingly crowded environment, and the phenomenon it is causing is that lender protections are loosening.

In 2014, 16 percent of first-lien loans in Europe were cov-lite, according to a report from White & Case, Debtwire Analytics and Xtract Research. In 2013, there were none. This indicates that Europe is in the early stages of moving towards a US-style market, where nearly half of first-lien loans were cov-lite in 2014.

Without covenants, you lose the ability to see trouble ahead before it actually occurs. The thesis supporting cov-lite loans, whereby all four maintenance covenants (or warning signals) are removed, is that for large loans there is a liquid market where lenders can trade out of a position if the business gets into difficulty, albeit potentially at a discount.

The mid-market doesn’t work that way. It is an illiquid market, and therein lies the problem. James Ranger, co-head of acquisition finance mid-markets team at Lloyds Bank, this week questioned whether some lenders were getting paid enough for the risk they are taking on. 

“We are concerned that some credit funds are prepared to sacrifice covenants for yield in the mid-market. These loans are largely illiquid and there is limited opportunity to trade out if performance deteriorates. We are not convinced that risk is being properly priced and, in some situations, lenders are driving towards a future car crash,” he said at the launch of a debt report by law firm DLA Piper.

The tendency of private debt funds to provide loans these days with very little amortisation, if any, such as bullet or term B loans, combined sometimes with higher leverage and occasional payment-in-kind elements, such as the unitranche product, only serves to magnify the issue.

Thus far, cov-lite loans are not typically being offered to businesses with EBITDA below €50 million because of the low level of available cash flow. However, Ranger told PDI that for some businesses cov-lite loans are available “at a price”, well within that informal benchmark – at around €10 million EBITDA. 

In addition, cov-loose loans are also appearing, all the way through the size-range, he said. Cov-loose is a broad term though, he added, ranging from loans granted with wider headroom on covenants to loans where only a leverage covenant has been left in place. 

It is easy to find cause for concern in all this. Parallels to 2007 are a big talking point amongst practitioners, and any proliferation of looser and lighter protections is a clear indicator that default risk is on the rise. Lenders in general, and private debt funds managing other people's money in particular, need to proceed with caution. The danger is that taking on this more aggressive approach to lending will present their investors with greater risk exposure than they bargained for.