“They’re almost acting like loan sharks,” one LP told us. The source was referring to non-sponsored deals involving small businesses in which lenders have been imposing extremely tight covenants in the knowledge that they will reap reset fees once the company in question commits a technical breach. “Highly aggressive” was how the LP described the practice.
This emerged from a wider discussion with multiple sources in preparation for a cover story on covenants that will form the centrepiece of our February 2020 print edition. It was striking because it contrasts sharply with the frequently expressed view that this is a borrowers’ market. Which, of course, it is – at least for the most part.
A common view is that the increasing prevalence of covenant-lite loans that borrowers are forcing upon lenders means the latter will find it difficult to muster a meaningful response to problems surfacing at portfolio companies: without a covenant-related trigger, lenders will be unable to drag other stakeholders – including equity providers – to the table to discuss how issues should be dealt with.
However, our discussions so far reveal a more nuanced picture. Some of our sources believe having fewer covenants at larger businesses with long track records is less of a risk than having a similar number of covenants with smaller companies that have been trading over a shorter period. There is also a view that covenants are worth more where there is a sole lender rather than a broadly syndicated deal – the rationale being that covenants are only useful if you are able to act quickly when one is breached. In the case of a syndicated deal, the potentially large number of interested parties may militate against that.
In the course of our conversations, we mentioned to LPs that GPs still sometimes tell us that “only the best credits have no covenants” – in other words, why worry about seeking protections where the business is unlikely to run into trouble? Unsurprisingly, perhaps, this claim has not gone unchallenged. LPs puzzle over what is meant by “best credits” in a market where everything is supposedly priced to perfection.
It’s clear the main thing LPs are worried about is being able to force some sort of response when a company becomes stressed. It is sometimes said that covenants obscure issues with portfolio companies but, in a world where LPs continue to demand as much transparency as possible and receive regular trading updates, they can normally see problems coming some way off. The challenge is to do anything other than observe a car crash in slow motion.
This is particularly problematic in the case of managers that have marketed themselves as offering a hands-on approach in times of trouble. Our sources say that in the case of a portfolio highly diversified by company size and sector, it’s generally considered acceptable for around 20-30 percent of those loans to be covenant-lite – even if the strategy is relatively hands-off. But a large portion of covenant-lite held by a manager which hypes its restructuring expertise and ability to jump in and control the loan will have difficulty explaining how it can carry out that strategy effectively.
We will continue to have conversations and seek market information ahead of our February cover story. Look out for it in the New Year.
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