Why scrutiny of deal contracts can turn into ‘Whac-A-Mole’

In a podcast published this week, a leading covenant expert and lender representative insisted private debt has no room for complacency when it comes to fair documentation.

“There must be a better way.” That’s the thought Sabrina Fox says she has harboured through a career that has put her in the middle of contracts drawn up between the buy and sell sides in the leveraged finance market.

Fox, who has for the past few years been chief executive officer of the European Leveraged Finance Association (having been with the organisation since January 2019), was the guest for the fifth episode of our Decade of Private Debt podcast mini-series. The “better way” refers to fairer treatment of lenders in deal documentation – with ELFA having been formed at a time when Fox sensed lenders “wanted to have a voice”. ELFA was designed to be that voice.

As discussed in the podcast, the leveraged finance market – including leveraged loans and high-yield bonds – developed a reputation for some egregious contractual terms in the cheap money era when financing was plentiful and borrowers in a strong position to drive hard bargains.

As one example, Fox cites a contract she scrutinised that allowed the borrower flexibility to pay dividends even during a period when it was in default. In that case, the wording was noted and ultimately revised, but Fox says picking up on such anomalies in the first instance is vital: miss the same thing a few times and it can become precedent. She also says scanning documentation for controversial terms can become like a game of “Whac-A-Mole” as your focus is quickly diverted from one issue of concern to another. There is a need, in other words, for constant vigilance.

For most of its history, this arguably had little to do with private debt. Offering strong covenant protection, it was widely perceived to be a disciplined and transparent market. But in recent years, as the larger end of the private debt market has increasingly “crossed the border” into broadly syndicated loans, there has been what many see as a shift towards more flexible documentation. Private debt is nowhere near at the point of the BSL’s “zero covenant” stance, but the two markets have more in common than they used to.

Fox is wary of even further blurring of the boundaries and suggests private debt lenders should take advantage of what is perceived to be a more lender-friendly environment in a market that has posed the kinds of challenges to sponsors and borrowers that they have not experienced for some time. The theory is that it’s a good time to draw a line in the sand.

The reality may be a little different. Fox points out that, given the various macroeconomic headwinds that companies have had to face, a higher premium than ever is placed on those businesses that have withstood the shocks. With competition for these assets as strong as ever, flexibility in the documentation can still be used as a negotiating tool in auction processes – and sponsors will naturally take the best deal for their clients.

That need for constant vigilance isn’t going away any time soon.

Write to the author andy.t@pei.group