By Hamlin Lovell, NordicInvestor
Generalisations are dangerous, but apply in some cases…
Direct lending is attracting billions of assets from investors. As an asset class it runs over one trillion dollars. Preqin’s Quarterly Private Debt Update finds that as of April 2019, there are now 407 funds raising assets, targeting USD 187 billion. This is up from 237 funds targeting USD 122 billion in April 2015.
With investment grade debt offering near zero yields, and high yield corporate debt paying around 3% in Europe (or hedged back to European currencies), it is no surprise that investors are seeking an illiquidity premium. Sweden’s AP funds are also increasing their allocation to illiquid assets, including direct lending. But returns are also coming down in private debt as the cycle matures: for one, three and five year periods ending in June 2018, the internal rate of return has been 5.3%, 6.3% and 7.7%, respectively, according to Preqin. And direct lending actually had lower returns, of 2.9%, 3.8% and 4.7% over these periods (Preqin’s private debt category also includes mezzanine and distressed debt, which had much higher returns).
It is possible that the volume of capital flowing into the space is not only compressing yields, leading some manager to reduce return targets, but also leading to lower standards in terms of covenants. An April 2018 report by KMPG Investment Advisory, Revisiting Direct Lending, argues that, “selecting the correct DL manager is more important than ever, particularly with pressure on risk protections for lenders (covenants)”.
In the world of listed loans and bonds, it is plain and clear to see that covenants are becoming an endangered species. Globally, central banks- the Federal Reserve, the International Monetary Fund and the Bank for International Settlements, as well as the Bank of England – have raised concerns. Sweden’s Riksbank also wrote a working paper number 325 – Covenant Lite Contracts and Creditor Coordination – on the topic as long ago as May 2016.
The credit ratings agencies regularly publish research that tracks the percentage of loans and bonds with and without covenants. For instance, at the end of 2018, a record proportion – 85% – of new issues of leveraged loans were covenant lite, according to S&P Global Market Intelligence Leveraged Data & Commentary, and in Europe 87% of issuance was covenant lite. It may be no coincidence that these percentages are so close. Law firm, Latham and Watkins, say that, “Associated provisions customary in US covenant-lite structures are regularly being adopted in Europe. For example, the US-style equity cure, with cure amounts being added to EBITDA and no requirement for debt pay-down, is now being accepted by many lenders in Europe on cov-lite deals”, in their report “The Continued Growth of European Covenant Lite”. Another trend is to only have “incurrence” covenants and no restrictive “maintenance” covenants. An incurrence covenant is only tested if a company proposes an action, such as more borrowing or paying a dividend to a private equity sponsor. In contrast a maintenance covenant is tested at regular intervals, so is more likely to be triggered.
The concern is that weaker covenants will result in investors making lower recoveries when companies default: “S&P’s LossStats, and LCD, conducted analysis on recoveries of cov-lite loans that defaulted before the 2008-09 financial crisis, versus those that were structured and defaulted after the crisis. The later-vintage group of cov-lite loans saw an average discounted recovery of 56%, compared to a 78% average recovery on the earlier deals”, the report states.
The ratings agencies will track nearly all deals because they provide a credit rating for most loans and bonds in the public markets. In the private lending markets, some issues may have a credit rating (particularly larger issues associated with private equity buyouts, and/or securitisations) but it is less often seen in the smaller deals. By its nature, direct lending is a fragmented market, with no centralized aggregated data available on loan terms. These are often bilateral contracts between lenders and borrowers and the details need not be publicly disclosed.
All of the managers I have interviewed are keen to stress that they continue to insist on strict, tight covenants for private lending deals, in contrast to the deterioration they see in public markets.
But some managers have been willing to speak about their concerns around what they have seen or heard other managers doing. BlueBay Asset Management’s Head of Private Debt, Anthony Fobel, told private equity wire in 2018 he is seeing some funds do covenant lite deals. Blackstone GSO has started making covenant lite direct loans, according to a Financial Times report in 2017. The KPMG report also states that some direct lending managers have begun to issue covenant lite or covenant loose loans (without naming any specific managers).
Covenants can also be “loose” rather than “lite”, so they may have only one or two covenants rather than none – or the covenants may be weak. For instance, it may take a big drop in corporate income to trigger them.
Proforma EBITDA Adjustments
The income itself can be measured in different ways. Covenants may be harder to enforce even where they exist, due to an important trend that is being seen in public and private debt markets: proforma EBITDA adjustments. The profit measure used to define leverage and coverage ratios, covenants and breaches thereof, is being increased by adjustments that might, for instance, anticipate future synergies from a merger. Of course, they may or may not materialize, so the forecast of cashflow could turn out to be too high. This also means that headline leverage multiples, which are already around record highs, may be understating true leverage based on current earnings. On this point, KPMG also find that leverage has increased by 0.5 times over the past 18 months, and purchase prices of companies as a multiple of EBITDA have increased.
Direct loans can be unitranche or may have levels of seniority: first lien, second lien, mezzanine and so on. One approach is to stay senior in the capital structure. KPMG recommend: “clients should look to invest in lower risk DL funds by avoiding investing with managers with large subordinated debt / equity allocations”.
As we only have rather patchy data on covenants in direct lending, we would welcome input from readers – both managers and allocators – who would like to share their experience and views.