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Keeping Covenants

An alarming statistic crossed our desks last month. Nearly 80% of U.S. leveraged loans, which can be loosely considered proxies for the private debt sector, made so far this year have been “covenant-light”, or lacking the strict requirements on financial metrics like cash flow and debt leverage that could protect lenders in the case of default. Booming cov-light loan issuance is undeniably a late-cycle signal; lenders required strong covenants following the 2009 financial crisis, but a tremendous demand for yield and an extraordinary amount of dry powder accumulated within direct lending funds has translated into a willingness to loosen those standards in order to put capital to work. In other words, it’s been a seller’s (i.e. borrower’s) market for at least the last few years.

Interestingly, the private equity market has been a primary driver behind the growth in private debt in general and, more recently, cov-light loans in particular. Why? Because the ability of traditional banks to underwrite the debt needs of PE-sponsored businesses became severely curtailed following the financial crisis, and private equity firms needed a reliable source of debt financing for those businesses. On the flip side, some private debt funds – brimming with cash to invest – were more than happy to lend to sponsor-backed businesses because they were a ready source of deal origination and the size of the transactions generally allowed for significant capital deployment (i.e. scale).  Additionally, not only does the involvement of a PE backer typically ensure borrowers come with better financial reporting, governance standards and operating structures, but a PE sponsor is more likely to step in to provide additional financial resources should a borrower experience financial difficulty.

However, as the private debt asset class has expanded rapidly in recent years, the private equity sponsor model has taken on a different hue. Because of the pressure to get capital to work, direct lending fund managers have been willing to compromise and do more aggressive deals, and private equity managers know it. It may be late-cycle, but the rise in covenant-light loans is no accident; PE sponsors are savvy financial operators, and they pit lenders against one another for the opportunity to lend to a portfolio company seeking financing. They have significant influence on the deal terms, pushing for looser criteria and weak covenants under which a default would be triggered, such as EBITDA coverage and leverage limits. This ultimately provides some operational flexibility to the borrower, but the real goal is better protection for the equity holders. All else being equal, it is a riskier proposition for the lender. 

At Old Hill Partners, we don’t do many sponsored deals. It’s not that we won’t do them, it’s just that the companies we work with are smaller and our loan balances are lower, which naturally means we have less interaction with the kind of companies supported by the private equity sector mentioned earlier. 

It’s just as well. We would have a hard time foregoing the protections we’ve established over the years. They’re critical to our underwriting discipline, and we do not like to compromise our standards just to get deals done. Part of our small-balance lending strategy is to purposely focus on these types of transactions, as we feel we have a better negotiating position to incorporate protections into our lending parameters, something our large-balance, private credit-focused competitors do not have.  Granted, our approach requires deep analysis and time-consuming due diligence on every transaction, but we are able to operate in an inherently less competitive space and can often create transaction structures and economics at very attractive risk-adjusted levels. Furthermore, we typically become close with our borrowers and require they also have substantial personal capital at risk in our deals. This aligns our interests more directly than may be the case with a professional private equity firm with a portfolio of companies to tend to. After all, a PE firm will care less about a particular borrower than the founders/owners running it.

Lastly, we’ve never depended on any single source for deal flow, and relying on private equity sponsors for deal origination strikes us a pretty symbiotic bargain given where we are in the credit cycle. We’re not sure where the covenant-light trend goes, but it’s intuitive that the push by private equity sponsors to get the easiest terms possible for their portfolio companies’ debt transactions could have damaging consequences for lenders should a more difficult economic environment arrive. 

As sponsor-backed, covenant-light loans skyrocket, we’re content to stay in our lane – the prudent generation of attractive, risk-adjusted returns through structured asset-based small balance debt transactions.