‘Mezz without covenants is an aberration’

Panellists and delegates at PDI’s Capital Structure Forum in London this week agreed that covenant-lite deals have no place in mid-market lending. Why, then, are cov-loose agreements on the rise?

How much risk cov-lite deals introduce was discussed by panellists more than once at PDI’s third annual Capital Structure Forum in London this week.

While some pointed out that cov-lite deals performed better than their more restrictive counterparts through the most recent global financial crisis, most drew a clear distinction between covenant-lite for the large-cap syndicated leveraged loan market versus mid-cap private equity financing.

Pemberton’s managing partner Symon Drake-Brockman was the first to argue that while cov-lite may have a place in the large-cap market, it is wrong for companies with more limited enterprise values. Covenants are an essential key to underwriting for mid-market lenders, he asserted.

In an interview focusing on market cyclicality, ICG chief executive Christophe Evain echoed Drake-Brockman, saying that while looser terms can sometimes be justified for big deals he unequivocally opposes cov-lite for the mid-market. “In the mid-market giving up on covenants is absolutely crazy,” he said.

To illustrate his point, Evain referenced an ICG deal for a French restaurant chain in which the London-listed lender had to enforce on its security – a first for the French market. Without the ability to move on the back of the triggers built-in by the covenant package, the lender would have lost money, Evain said.

The deal in question was ICG’s €160 million loan backing sponsor Foundations Capital in its buyout of Courtepaille. Earlier this year, the French Competition Authority approved ICG’s takeover of the struggling firm via a pledge of shares and securities held by the main shareholders to secure the loan.

Evain’s concluding remark on cov-lite was even more emphatic: “Mezz without covenants is an aberration.”

Similar comments from a variety of investor and manager participants during the two-day event suggested market consensus that covenants are essential in mid-market lending.

That contrasts with recent data published by loan market research firm DebtXplained, which examines European leveraged lending agreements on an anonymised basis. Up to mid-October, 75 percent of leveraged financings under €250 million in size were cov-loose – defined as including only one or two of the four traditional financial covenants, DebtXplained found. The proportion was under 50 percent in 2014 and less than 10 percent in 2013.

Is cov-loose a stepping stone to cov-lite? The trickledown effect from larger deals seems pretty clear.

Loans between €250 million and €500 million are not typically defined as mid-market, but a growing number of European alternative lenders are bumping up their transaction size and competing with bank lenders for those mandates. And in that range, so far this year, more than 25 percent have been defined as cov-lite with less than 10 percent including a complete financial covenant package, the DebtXplained data show.

Yet the consensus at this week’s forum was that there was no place for cov-lite in mid-market lending. To avoid the risks they agree are inherent with loosening structures, private debt managers must do more than just talk the talk on covenants.