Trends have a habit of spreading around the world, whether in haute couture, fine dining or investment.

However, one trend that has taken both Europe and the US by storm has not – for the most part, at least – yet made much headway in Asia-Pacific. The documentation for private debt deals has proved remarkably tight.

“It’s quite amazing, how different the documentation in Asia is compared to what you see in Europe and North America,” says Nitish Agarwal, chief investment officer at Orion Capital Asia, a mid-market direct lender, in Singapore. “We still get away with very tight covenants. We still have very strong cashflow ringfencing in our structures.”

He argues that these stricter terms are “particularly” helpful in emerging Asian markets, “where obviously tight documentation does help you mitigate some of the more macro risks”.

In the areas in which Orion operates – every Asia-Pacific market aside from onshore China – he says that every deal done by the firm has a debt to EBITDA maintenance covenant. There is also an interest coverage (EBITDA over interest expenses) covenant for 90-95 percent of deals, and a debt service coverage ratio (EBITDA over interest expenses plus principal payments) for about half.

These stricter terms apply not just to the headline issue of how many maintenance covenants there are, but also to the fine print. Private debt investors in the US and Europe often complain of finding the devil in the details. Perhaps the biggest area of controversy in these two regions is how EBITDA is calculated with respect to covenants. As Agarwal puts it: “You can almost do a PhD in trying to figure out how to compute EBITDA: what to include, what not to include, and how to adjust this figure. But in Asia, things are relatively simple: we don’t do many of the adjustments that we have seen in Europe and North America.”

“It’s quite amazing, how different the documentation in Asia is compared to what you see in Europe and North America”

Nitish Agarwal
Orion Capital Asia

Agarwal’s observation about the strictness of documentation is echoed by Edward Tong, head of Asian private debt at Partners Group in Singapore, though with some reservations. “It depends on the nature and size of the deal, but if you compare region to region then there is an expectation that documentation is tighter – that there are proper financial covenants.” Partners Group mainly does mid- and large-cap sponsored deals in developed markets.

Explaining his caveat, Tong says that if deals are large enough – around $300 million-$500 million and above – investment bankers “are very good at pitching US capital markets financial solutions”. In this case, they are sold into the highly competitive US market, where underwriting banks and direct lenders can only clinch deals if they accept loose documentation. Deals involving big international sponsors have looser documentation too. Accustomed to negotiating flexible terms elsewhere in the world, they expect this in Asia-Pacific, say market observers.

Asia-Pacific ‘the sweet spot’

Bev Durston, founder and managing director of Edgehaven, an alternative asset investment advisory firm based in Sydney and London, has a similar view to Tong’s: documentation is very solid – for the most part. “The overall picture is that Asia-Pacific is the sweet spot for private debt,” she says. “It has the best risk-adjusted return because documentation has not deteriorated, which it has in the US and Europe.”

She notes one exception, however. “Because of the looser documentation, we tend not to do a lot of sponsored deals in Australia.” She sees, however, plenty of attractive opportunities in the Australian non-sponsored market.

This generally favourable situation for documentation reflects supply-demand dynamics: much less capital is chasing each deal. Market participants attribute this largely to the difficulty of serving the Asia-Pacific market. It spans an enormously wide geographic range; however, national markets are not generally large enough for large international private debt investors to concentrate on one small developed market, such as Singapore or Australia.

A possible exception is mainland China, but this market is itself highly fragmented; investors cannot set up an office in Shanghai and expect deals from everywhere in China to come to their door. The strong importance placed on personal relationships in many Asian countries creates an additional barrier to entry.

Andrew Lockhart, managing partner at Metrics Credit Partners, an alternative asset manager focused on Australia, sums up the situation for his home market: “There’s more dealflow than capital provided. As a result, we do not have an awful lot of competition over terms and conditions.”

Metrics conducts both sponsored and non-sponsored lending, although it does fewer of the large sponsored deals that tend to have looser terms. Lockhart’s view is slightly different from Durston’s. This reflects his different perspective: he says Metrics is prepared to accept looser terms if this is good for Metrics – forgoing amortisation if it will help the company grow, for example.

Market observers agree that documentation is tight in Asia-Pacific, except for the biggest international deals. However, there is some disagreement about the trend: even if documentation is strict, are protections diminishing slightly from a high level? Durston sees no general loosening trend at all in Asia-Pacific. In fact: “Those lenders already there have seen their negotiating positions actually strengthened by covid in the private market.”

She explains: “People withdraw to their home countries in times of trouble, including in the time of covid” – particularly because the virus has made it difficult to fly around Asia-Pacific seeking deals. Observers point to the December 2020 withdrawal from the Australian market by the Anglo-South African bank Investec, a major lender for sponsored deals.

Tong of Partners thinks, on the other hand, that documentation “may be a little bit looser” than 10 years ago. However, where loosening has been allowed, it has generally been “very considered”. For example, although private equity sponsors have gradually won the right to make addbacks when calculating EBITDA: “It is not an open invitation to have unlimited addbacks: there is usually some good data that allows the lender to feel comfortable about allowing for these addbacks.”

As Tong puts it, a general rule is “no to everything that is non-typical or has no sound basis, but yes to reasonable things like standard non-recurring items that are customary for leveraged transactions”.

Moreover, the lender might allow as many adjustments as the borrower wants, but up to a certain aggregate limit. Alternatively, the borrower might be obliged to have addbacks verified by an auditor, beyond a certain threshold.

European borrowers raise the stakes

Deal terms relating to incremental debt and majority lender consent demonstrate that, in Europe, there is no easing of the power currently being wielded by borrowers at the negotiating table

Incremental debt capacity: More borrower flexibility
“It used to be standard that incremental debt capacity was capped by a hard amount. However, it has become more common for it to be expressed as a ratio-capped amount plus a free and clear basket, as was present in 68 percent of 2020 deals. In 2020, we have also seen a further increase in the number of deals allowing capacity under any permitted debt basket to be used for the incurrence of incremental debt from 6 percent of deals in the first half of 2019 to 32 percent of deals in the second half of 2020. This allows the borrower more flexibility to incur debt under the Senior Facilities Agreement or outside of it. However, it also increases the risk of security dilution on the basis that any incremental facility may be secured pari passu on the collateral, whereas the security which may be guaranteed for certain permitted debt baskets may be restricted.”

Majority lender threshold: Sponsor power underlined
“The majority lender threshold is yet another example of sponsors/borrowers trying to have the best of both worlds. Traditionally, matters requiring majority lender consent (including acceleration of the facilities) in European deals needed approval from at least 66.67 percent of lenders. In recent years, however, it has not been unusual to see the threshold being set at 50.1 percent or more which is the market standard in deals governed by the law of New York. The nuance comes when the threshold is bifurcated and 66.67 percent lender consent is required for acceleration, but 50.1 percent is required for all other majority lender matters and it is this position that is gaining traction in the market.”

Emerging markets are unpredictable

But even if the general picture is that documentation remains tight for most deals, tight documentation is not the only thing that matters. Byungkyu Cheon, chief investment officer at Korea’s DGB Life Insurance, says the problem in developed Asia-Pacific is not documentation but returns. The “very compressed liquidity premium”, compared with the US and Europe, makes private debt in Asia-Pacific unattractive for his firm.

As for emerging Asia, the returns are high, but the political and regulatory regimes make the process of debt recovery too unpredictable. “For so many defaults, the government or regulator jumps in, and the default takes on a different shape from what was anticipated,” he says. “That means a very unstable cashflow situation for us, so that’s why we’re still very reluctant to jump in.”

DGB Life Insurance has “several deals” in the US and western Europe but has never invested in Asia-Pacific private debt. He sees no signs of any improvement in this situation.

In Europe, meanwhile, last year was a “rollercoaster ride” in the relationship between borrowers and lenders, says Mikael Huldt, head of alternative investments at AFA, the Swedish insurer. “The first quarter was quite competitive for lenders. Leverage levels, spreads, fees, EBITDA definitions and covenants were all very much trending in borrowers’ favour. But after the pandemic struck in Q2, it reversed. There was very little deal activity but, if you needed a loan as a borrower, you pretty much had to take what you were given.”

“We’re very big on relationships and we learned a lot about which sponsors would be ready to step up and which would not”

Tom Aronson
Monroe Capital

The ride had another twist in store, however. “Since then, there has been a further gradual reverse with spreads slightly higher than a year ago and leverage levels in the core mid-market half a turn or so less,” says Huldt. “The documentation has slightly improved and there are generally better EBITDA definitions.”

But while gains made by lenders may have ultimately been modest, Huldt feels they have emerged from the pandemic with a better understanding of how loans behave in a crisis – and, therefore, with a better idea of how they should be drawn up in the first place. “Lenders will be even smarter in identifying and addressing risk in various loans,” says Huldt. “This type of company will behave in such and such a way and that’s why we need to focus on this particular covenant or piece of deal documentation. It will be more targeted and purposeful.”

As is invariably the case, it is the larger deal market that has the most borrower-friendly documentation. The mainstream private debt market tends to keep a nervous eye on what is going on in the high yield and leveraged loan markets, fearing that any egregious new deal term may eventually filter down to the smaller end. That fear is entirely justified at present, it seems.

“In the high yield market there has been a gradual erosion of creditor protection and we should expect more of it – uncapped baskets, super growers etc,” says Joseph Swanson, a senior managing director and co-head of the EMEA restructuring group at investment bank Houlihan Lokey. “The reality is that markets have melted up. Borrowers have more leverage because people are looking for yield and covenants are the victim.”

This has meant that borrowers and sponsors often find themselves in a stronger position than pre-pandemic. “Sponsors have realised they would have been better served if they had had even more flexibility in the documentation so they would have had more room for manoeuvre in the event of distress,” says Shweta Rao, a senior director and head of EMEA covenants at Reorg, a global provider of credit intelligence, data and analytics. “The covenants have shifted to be even more aggressive and pandemic-proof.”

This trend may indeed give the private debt market cause for concern. “The terms are getting pushed into the lower mid-market,” says Amy Kennedy, a leveraged finance partner at law firm Akin Gump Strauss Hauer & Feld in London. “They include grower baskets which are tied to performance – as the company grows, the borrower basket grows. You wouldn’t have seen that in the lower mid-market 18 months ago.”

Pushback on addbacks

Kennedy notes there has been some pushback from the lender side, for example on the knotty issue of addbacks including company performance that would have been delivered had it not been for covid-related disruption. “Some wanted to factor covid into the covenants, but most of the mid-market didn’t give that the wriggle room. In some respects, the documentation has been tighter, and that’s a

By and large, Kennedy acknowledges that the balance of power has stayed with the borrower. But there are still questions around whether this is simply because trading performance has been artificially supported by temporary liquidity measures. “Do things change in late 2021 and early 2022 with a wall of restructuring?” she ponders. “If so, the balance will likely have to shift back to the lender.”

“Mostly, lenders worked closely with borrowers to navigate the waters with struggling companies”

Lindsay Flora

In North America, as in Europe, a brief period of change in the early part of last year eventually reverted to something approaching the status quo. “My experience is that, as the pandemic started, we didn’t know how lenders would react with respect to a possible renegotiation of terms,” says Lindsay Flora, a partner in the global finance practice at law firm Dechert in New York. “Mostly, lenders worked closely with borrowers to navigate the waters with struggling companies. Things quickly scuttled back to the pre-pandemic ‘regular way’ as there were a lot of deals to be done.”

Flora reflects that, after the initial outbreak of the virus, there was not much time to engage in a wholesale renegotiation of deal terms before things picked up again.

“The mid-market is still quite collegiate,” says Flora. “The terms have not shifted in a large way to be any less borrower-favourable than they were a year ago. It depends on what the borrowers’ needs are. You negotiate around the edges but there’s not much pushback. We’re currently in a buy-and-build era where many private equity sponsors are targeting add-on acquisitions to portfolio companies and are asking for delayed draw facilities to finance this activity. They are continuing to build up their existing portfolio companies, especially in the healthcare sector.”

While many market sources say relationships between borrowers and sponsors stood firm against the strain of the health crisis, there is also a recognition that this was not universal.

“How collegiate things are really depends on the sponsor and opposing counsel,” says Flora’s colleague Jay Alicandri, co-head of Dechert’s global finance practice. “I’ve seen a sharp focus on areas where lenders have been jammed, such as the J Crew trapdoor, Serta Simmons or the Trimark up-tier exchanges. There is less empathy for credit leakage; and, in club deals, there is a hyper-sensitive focus on the lender knowing that its investment is in a senior loan and it does not wake up one day to find out its investment has turned into a junior loan.”

Carey Davidson, managing director and head of capital markets at Chicago-based fund manager Monroe Capital, says lenders did feel they regained some bargaining power throughout the covid period. “Liquidity concerns during the onset of the pandemic reminded the market how important it is to limit cash leakage. While I wouldn’t say all of the negotiating power has since gone right back to the borrower, I would say that lenders have tried to remain balanced. This wasn’t about completely rewriting documents, it was about tightening them in areas that help to preserve cash and collateral.”

Davidson’s colleague, Tom Aronson, a managing director and head of originations, says the crisis has provided useful insights into how different PE firms respond in challenging situations. “It gave us a glimpse into the value of a strong relationship and the need for ongoing transparency and open communication during uncertain times. We’re very big on relationships and we learned a lot about which sponsors would be ready to step up and which would not.”

This is something investors all over the world will be focused on at the current time. It is clear, however, that there is a fairly significant difference between East and West. In Asia-Pacific markets, lenders come to the table to discuss troubled deals in a position of negotiating strength. In Europe and North America, they may not get to the table at all.