There’s a significant shift in favour of covenant-loose or covenant-lite deals in the European unitranche market – from 40 percent of the total in 2015 to more than 80 percent last year, ratings agency Fitch reported this week.
This is alarming for those who associate covenant-lite with the pre-crisis days, when lenders were seen to be advancing sizeable facilities in support of private equity deals while having little or no apparent control over the fate of the business. In retrospect, it may seem appropriate to view it as one of those risky indulgences that would not – and should not – be tolerated today. So why has it made such a forceful comeback?
The simple answer is that the supply of debt capital is currently outstripping demand, meaning that private equity sponsors can afford to pick and choose who wins the debt mandate. What the PE firms want more than anything else is the ability to manage the business in any way they see fit, including (or perhaps particularly) when the business runs into trouble. They do not want to be tussling with lenders to get their hands on the operational reins.
Hence, when it comes to deciding who wins the deal, the lender offering the fewest covenants will invariably be in the stronger position. Immediately post-crisis, the inclusion of a full package of four covenants – relating to the business’s leverage, cashflow, liquidity and net worth – was common. These covenants are effectively early warning systems, with any breach bringing sponsor and lender together to discuss the issue.
Until recently, covenant-loose (meaning fewer than four covenants) and covenant-lite (no covenants at all) had been largely the preserve of the larger deal end of the market. What’s changed is that mid-market deals are now increasingly ‘loose’ or ‘lite’. One source PDI spoke to said he is currently involved in four mid-market unitranche deals and, in each case, only the leverage covenant was part of the contract.
This shift to smaller deal sizes is significant, since syndication is still prevalent at the larger end and lenders are more easily able to trade out of any stressed position. In the relatively illiquid mid-market, this option is much less available – making the ceding of control associated with fewer covenants potentially a more serious issue for the lender. Only at the very small end (around €10 million EBITDA or less) are full covenant packages still commonly found.
In today’s market, lenders must accept that winning the deal often means ceding the ability to have a say when things start to go wrong in a business. This could be bad news not just for the lender but for all concerned – including the sponsor. For example, a lender may have greater experience of a sector than the sponsor and be able to bring that knowledge to bear if only it were not denied a seat at the table.
On the other hand, debt funds often tout their greater flexibility and willingness to provide tailored packages as a competitive advantage over the more rigid approach of the banks. Perhaps doing deals with less control is better than not doing deals at all.