“Covenants send a warning signal of under-performance,” says Bill Troup, managing director in the debt advisory team at London-based mid-market M&A firm Livingstone Partners. That being the case, the warning signal in European private debt deals appears to have faded almost to the point of being undetectable.
Troup says there has been a major shift in the provision of loan covenants over the last five years, reflecting the relative decline of clearing banks and the emergence of debt funds in leveraged loan transactions.
The clearing banks have traditionally been insistent on the inclusion of four mainstream covenants, which are all ways of testing the health of the borrower and being alerted to any emerging problems. These covenants typically provide tests relating to cashflow, leverage, liquidity and net worth.
Debt funds started from a similar position five years ago, but Troup says they have been loosening their covenant requirements ever since (as can be seen in the accompanying charts from London-based data analysis firm Debt Explained). Today, most loans provided by funds are either covenant-loose (featuring just the leverage covenant or perhaps one other) or covenant-lite (with no covenants at all).
“You’re not expected to hit your earnings plan all the time. While it varies from deal to deal and from lender to lender, direct lenders have a relatively higher tolerance for under-performance,” says Troup. “Borrowers are often given 5 or 10 percent more headroom by direct lenders, allowing more latitude to miss EBITDA without anyone coming after them.”
Given the growing competition in the private debt market, particularly in the direct lending space, the trend is arguably no surprise. With so much capital chasing deals, borrowers can afford to be choosy; negotiating a loose covenant package, in order to grant themselves more flexibility, is seen as extremely useful from their point of view.
Naturally, there is concern over whether lenders have enough oversight of the business. Does allowing generous headroom mean under-performance can be obscured? Moreover, even if you are confident that problems can still be spotted in good time, a lack of covenants gives you less power to step in and address whatever problems have arisen.
Troup acknowledges that, while covenants have loosened considerably at the larger end of the market, there has been more resistance as you move down the deal-size spectrum.
“What’s concerning,” he says, “is the direction of travel in favour of looser control. It makes you wonder how far it will go and whether we can strike the right balance. In the [global financial] crisis, lessons were learned. But that was 10 years ago. Are memories long enough?”
Across the Atlantic, it’s a story familiar to Europe as borrowers revel in favourable market conditions. Stephen Hazelton, founder and CEO of New York-based data and analytics company Street Diligence, identifies four key trends:
A cure for all ills: An equity cure is an infusion of cash by a private equity sponsor, mainly due to a breach of a financial covenant. It allows the sponsor to more effectively manage extraction of cash from the balance sheet in the form of special dividends while adhering to the provisions set by the lenders. Traditionally three to four lifetime cures have been allowed, but the market is now moving towards five to six – giving sponsors more flexibility.
EBITDA doesn’t add up: Critics accuse ‘addbacks’ of being a way of artificially boosting EBITDA. For example, sponsor/management fees and cost savings based on pro forma financials may be added to EBITDA. In the past, such addbacks have been restricted to a 12-month look-forward and capped at 20 percent of total EBITDA. The market is trending to longer look-forwards and higher percentage caps (or, in some cases, no cap at all).
End of the broad sweep: The excess cashflow (ECF) sweep governs how excess cash must be used. As excess cash is generated, typically half of it must be used to prepay lenders. However, provisions known as a ‘downward stair step’ may – based on balance sheet deleveraging – drop this 50 percent provision to 25 percent and then to 0 percent. The stair step is detrimental to lenders as prepayment requirements go down as the company deleverages. In recent times the leverage metrics that trigger a decrease in the ECF sweep to lower levels have been softening – meaning lenders are getting prepaid in smaller amounts over time.
A dangerous basket case: The restricted payment covenant governs cash leakage from the balance sheet. Sponsors can use so-called ‘basket exemptions’ to, for example, pay themselves a special dividend to the detriment of the lender. Sponsors have increasingly tweaked this covenant to their benefit by increasing the ‘starter value’ (as a percentage of the borrower’s EBITDA) in the restricted covenant build-up basket. This is a trend favourable to the sponsor.