When lenders lose control

If you want to know how much competition there is in the private debt market, look no further than our global fundraising figures for the first half of this year. They show the second-most prolific first half on record and offer the possibility that the largest full-year total so far, from 2015, may be beaten. There is also a record number of 528 funds in market, jostling to try and raise some $270 billion in fresh capital.

Equally, if you want to know how many people in the market are talking about the maturity of the cycle and how the good times probably can’t last forever, you should have taken a seat at our recent Germany Forum in Munich. Trust us on this one: it was a talking point that cropped up numerous times.

The loosening of covenants in private debt deals is clearly a product of growing competition. In situations where a borrower has a range of lenders competing for a deal, the decisive factor could be how ‘flexible’ a given lender is prepared to be. And what does ‘flexible’ mean exactly? It’s often firms in trouble saying, “Lender, let me sort it out”.

That covenants are becoming looser is clear enough. In the European market, half of private debt deals featured between one and four traditional maintenance covenants as recently as H1 2014. In the first half of 2017, no deals had more than one traditional covenant, according to data from Debt Explained, a London-based loan and high-yield bond analysis service.

A similar trend is being seen in the US, where the balance has also shifted from lender to sponsor/borrower according to data gathered by Street Diligence, a New York-based firm providing analysis of covenants in bank loans and high-yield bonds. One example of this is the increasing use of equity cures, where the sponsor can inject cash to head off the threat of a financial covenant breach, with the cash treated as EBITDA. In some cases, this can allow sponsors to extract cash from the balance sheet in the form of special dividends while still adhering to the provisions set by the lenders – a case of operating within the rules but not exactly in the spirit of the rules.

But what does this shift mean with the possibility of less benign conditions ahead? When the last major downturn struck in the form of the 2007-08 global financial crisis, covenant-lite deals were in their infancy and conclusions cannot easily be drawn regarding their effect. Some speculate that deals with looser covenants are likely to perform better through a downturn as companies that would otherwise have breached covenants and gone into default are given longer to try and address their problems – with at least some of these surviving and eventually recovering.

However, from the lender perspective, having covenants in place is effectively an early warning system of trouble ahead, giving you the opportunity – and crucially the right – to step in and demand action be taken (and ultimately perhaps demand repayment). It’s a safety blanket that direct lenders appear increasingly willing to discard.