With financial markets undergoing a severe correction amid the COVID-19 crisis, Broadridge considers the impact on private debt managers.
Until recently, private debt – along with private equity in general – faced growing criticism. Institutional investors complained that managers were hoarding large amounts of uninvested capital (known as “dry powder”), yet still charging management fees on the back.
The underlying issue: With too much competition and excess capital in the marketplace, lending opportunities were relatively scarce. Private debt managers were hoarding cash in part because they could not find places to invest.
The COVID-19 crisis has now made large piles of cash an industry advantage. As of December 2019, private debt managers had accumulated around $261bn in dry powder.
While this represented a drop from the 2018 peak of $292bn, it meant there was still enormous capital available.
In the future, we expect private debt cash will be channeled towards financing for leveraged buyouts (LBOs), especially if banks continue to retreat away from lending [1].
Consequently, LBOs in the mid-market space that are not dependent on bank-arranged syndicated leveraged loans are likely to see minimal disruption.
Similarly, distressed debt and special situations investors are expected to use the crisis to grab cheaper but fundamentally strong assets.
The crisis could yield a number of opportunities for either newly launched private debt funds or those with dry powder to invest.
Tightening of covenants
The abundance of dry powder combined with pressure from investors encouraged some private debt managers to execute deals that involved significant risk pre-COVID 19.
Loans were issued to less creditworthy borrowers. In the US mid-market particularly, these deals included borrower-friendly loans with “covenant-lite” or “covenant-loose” [2] terms.
In fact, in 2019 only 60% of private credit transactions used traditional financial covenants [3]. What does this mean?
Traditionally, lenders insert maintenance covenants into loan documents to protect themselves against the risk of borrower default.
Typically, these covenants stipulate that borrowers must demonstrate sound financial health on a quarterly basis.
Among other things, borrowers must disclose details about their debt-to-EBITDA, interest-to-EBITDA and cash-to-debt financial ratios [4].
Lenders usually include up to 30% headroom as part of the covenant test [5]. If the borrower fails any tests, the loan is in default.
This testing mechanism enables lenders to identify struggling borrowers and then take corrective action.
Given the intense market competition over the last few years, borrowers were in a stronger position to negotiate terms.
The result: more covenant-lite and covenant-loose terms, which offer fewer protections than those granted by traditional maintenance covenants.
Added flexibility and headroom for borrowers means lenders assume much greater risk. Without maintenance covenants, lenders miss warning signs that borrowers are in jeopardy [6].
A COVID-19 Covenant reckoning
The global economic impact of the COVID-19 crisis is truly unprecedented in scale, and the private debt industry is unlikely to be spared.
Maintenance covenants provide lenders with a safety net during normal market conditions. However, the effectiveness of these covenants will be tested too.
Several global law firms have already warned lenders that borrowers will breach their financial covenants as cash flows evaporate and people turn to revolving credit facilities to meet liquidity requirements [7].
Arnold & Porter, for example, recently advised at-risk borrowers to reach out to their lenders and discuss covenant waivers or permanent amendments [8]. Such measures will help protect both borrowers and lenders.
Some maintenance covenants in the leveraged loan market already include clauses that safeguard borrowers against black swan events, including acts of God, natural disasters and pandemics [9].
The same is true for a small minority of private debt funds. The real concern is how the COVID-19 crisis will impact private debt funds with covenant-lite and loose structures.
Covenant-lite and loose structures give lenders recourse only in extreme trigger events (i.e., if the borrower incurs more debt, sells assets, pays junior debt, or announces a dividend) [10], allowing troubled borrowers to avoid lender retribution for longer.
This places private debt funds at greater risk of suffering heavy losses, especially where borrowers have high capex and weak balance sheets.
Mitigating risks
Operational excellence will be critical to weathering the ongoing volatility. At the very least, private debt funds need to intensify the operational due diligence they conduct on the creditworthiness of their borrowers.
Looser covenant structures are likely to come under serious scrutiny. Risk-conscious managers are already tightening borrower terms and conditions, often by reverting to maintenance covenants.
Again, this is a positive sign. By revisiting lending terms, private debt funds and their investors will be better protected against borrower credit risk.
Such safeguards will be pivotal over the coming months. In fact, clients are already looking to lend at more reasonable prices and with enhanced covenant protections as the dust continues to settle from the March volatility.
Eric Bernstein, head of asset management Solutions at Broadridge, is responsible for driving the firm’s global business growth in investment management solutions.
[1] Investment Europe (March 17, 2020) Pitchbook note: COVID-19, the ‘sell everything’ trade and their impact on private markets
[2] and [3] and [10] Proskauer (June 20, 2019) Will the next restructuring cycle be different?
[4] and [5] Hermes Investments (February 12, 2019) Cov-lite loans: the new normal, but what cost?
[6] Hermes Investments (February 12, 2019) Cov-lite loans: the new normal, but what cost?
[7] Shearman (March 11, 2020) Coronavirus implications in loan documents
[8] Arnold & Porter (March 23, 2020) Key issues in loan agreements relating the Covid-19 pandemic
[9] Baker McKenzie (February 2020) In the know: Novel coronavirus outbreak: don’t overlook these implications for your leveraged finance documentation
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