December 15, 2022 | 11 Minute Read
Global Head of Private Credit Client Solutions and Product Strategy
Debt financing in recent decades has grown cheaper and easier to procure, with fewer strings attached as lenders competed for financings. Now, the market is beginning to turn. Rates are rising, underwriting is tightening, and terms are shifting. Credit assets are often assessed at a headline level, only considering basic characteristics like the coupon, rating, and duration, but the underlying terms and structures are key to understanding how these assets might behave in a downturn. It’s important for credit investors to not only understand the terms of deals being done today, but also the terms of their existing portfolio and which ones may become more important when rates rise and growth slows.
Over the last decade, terms for leveraged loans have increasingly resembled high yield, but the borrowers tend to have lower ratings and the debt is floating rate, which has implications in today’s market. The vast majority of leveraged loans today are classified as covenant-lite—but that doesn’t mean borrowers are without protections or recourse. Private credit, for its part, is growing and in many ways filling a gap left as the leveraged loan market evolves; larger private credit fund sizes and new loan structures are enabling lending that was not feasible in the past. An added wrinkle is that the more structured credit investments utilized in private markets have a variety of embedded terms and features that complicate analysis, providing the potential for additional upside and—more importantly in the current environment—downside risk reduction.
When new loans are formed, originators set the initial terms and include standard features like voting rights and mandatory prepayment conditions. Lenders tend to require that proceeds from loans serve an express purpose, often related to a specific acquisition or capital expenditure. Separately, mandatory prepayment helps to ensure lenders are repaid in the event of asset sales and corporate events. Terms are necessarily more standardized for syndicated deals involving multiple lenders.
The bilateral nature of private lending allows for close alignment between borrowers and lenders. The documentation for private loans often stipulates that the borrower must provide monthly financial statements, whereas public market lenders are beholden to quarterly reporting cycles, which can be further delayed by audits. This allows both sides in private credit relationships to be proactive before potential issues arise. While the terms are more stringent, private lenders often work closely with borrowers to establish bespoke conditions and arrangements that not only provide an ex-ante playbook for distressed situations but can also help to course-correct before more severe action is needed.
The most fundamental protection for corporate lenders is collateral, which can include inventory, receivables, hard assets, and capital stock of operating units. While the concept of collateral is straightforward, there should be clear documentation about how collateral is protected (e.g., a negative pledge that prohibits assets as being pledged as collateral to different lenders).
Inadequate documentation and ambiguous language have led to disputes over collateral between borrowers and lenders in the leveraged loan and private credit spaces. These issues often surface when a borrower attempts to move assets outside of the legal entity with the obligation to the lender. In recent years, several private equity-backed companies have attempted—with varying degrees of success—to move business units, real estate, and other assets including intellectual property. The most infamous examples involved companies transferring intellectual property to an unrestricted subsidiary, in what is now often referred to as a “trap door.”
Prudent lenders have always addressed these issues, but market terms have broadly adjusted to address the risk of the “trap door” and similar efforts to shift collateral to enable further borrowing. Today, borrowers generally have few allowances for removing assets from the entity being lent against, but investors need to be aware of risk and ensure proper protections are in place. As with other terms, private creditors are generally better able to document collateral at the onset and track it over the course of the loan given the bilateral relationship and tighter reporting standards.
The heightened pricing uncertainty of syndication in today’s market is one reason why private lenders have grown more popular. For deal financing, which is a primary purpose of leveraged loans and private lending, there is typically a gap of several months between when the deal agreement is in place and the transaction actually closes. In public issuances, flex provisions allow lenders to change the spread or size of the tranches during syndication to reflect market pricing. This has become increasingly important in the current market environment, as rising rates have made it more difficult to syndicate loans that were underwritten in more favorable borrowing environments. The average bid for new issues is around 95 cents on the dollar, pushing the yield for newly issued B-rated paper to more than 11%.1
The freezing of the banking and syndicated loan markets through 2022 has made the certainty offered by private creditors increasingly attractive. Rather than syndicating loans, these lenders generally draw capital commitments from closed-end funds, assuming the risk of holding the paper. This structure also tends to lead to fewer lenders in each transaction, helping to streamline the process. Even before the current market disruptions, borrowers had been increasingly opting for the flexibility of private lending, with the shift towards private credit underway for some time. While difficult to quantify in its entirety, the private credit market can be examined through several proxies including business development companies, where the share of private lending versus syndicated loans has shifted from 50/50 in 2016 to about 75/25 in recent years.2
For loans that are already in place, covenants help to ensure the borrower maintains a sufficient operational trajectory to service the debt. Affirmative covenants are common and fairly standardized, requiring the borrower to take basic actions associated with the loan (e.g., pay interest). Even loans categorized as “cov-lite” will carry these terms. Negative covenants are more bespoke and tailored to the specific company’s situation, detailing restrictions on corporate activity (e.g., mergers & acquisitions, dividends, asset sales). Most covenants center on financial metrics, including balance sheet strength, cash flow coverage, and capital expenditure levels.
Negative covenants take two basic forms: maintenance and incurrence. As the name suggests, maintenance covenants require that a borrower “maintain” the ability to pass certain tests of financial performance on a periodic basis. While lenders technically have the right to accelerate a loan when a maintenance covenant is breached, the more common option (and typically more fruitful route for both parties) is to negotiate additional fees, a wider spread, more collateral, or similar concessions. Some loan agreements include provisions for “equity cures,” which allow the borrower to address a covenant breach by making an equity contribution. Incurrence covenants tend to cover similar aspects as maintenance covenants but only are tested if the borrower takes specified corporate actions, such as paying a dividend, issuing debt, or executing a transaction.
Over the last decade, the term “cov-lite” has become virtually synonymous with leveraged loans, commanding more than 90% of the market. The common assumption is that this shift reflects a widespread disregard for incorporating basic protections into underwriting. The reality, however, is that cov-lite simply means that the loan has incurrence covenants—historically associated with investment-grade paper—rather than the maintenance covenants that the leveraged loan market initially coalesced around. To that end, the near ubiquity of cov-lite loans is more a reflection of the institutionalization of the market than a complete disregard for underwriting standards. In fact, LCD—the preeminent provider of leveraged loans data—ceased reporting on many aggregate maintenance covenant statistics due to the market’s widespread adoption of incurrence covenants (i.e., cov-lite).3 4
Even with the prevalence of cov-lite loans today, covenant relief in the leverage loan market was needed en masse during the pandemic. Almost all this relief pertained to pro rata loans, which includes revolvers and amortizing debt that are required to have covenants, as opposed to tranches sold to institutional investors. During the initial months of the pandemic, leveraged lenders worked with borrowers to allow them to draw on revolvers despite many failing to meet their incurrence covenants due to operational disruptions caused by lockdowns.
In private credit, senior direct lending and unitranche deals at the top end of the market have gravitated in a similar cov-lite direction as leveraged loans. Most private loans to middle-market borrowers, however, still carry maintenance covenants, typically including one that is financial in nature. Many borrowers were at risk of triggering those financial maintenance covenants, leading lenders to provide liquidity relief via changes in amortization schedules, switching to payment-in-kind (PIK) rather than cash interest, and even direct capital infusions. These deals often carried liquidity covenants, while offering leeway on leverage and fixed-charge covenants that might otherwise have been tripped.5 While these measures proved effective, how the market will respond during a prolonged economic downturn has yet to be seen since private credit was relatively nascent during the global financial crisis. In many cases, private lenders tend to view themselves as partners of equity owners and would prefer to find amicable resolutions in distress situations rather than pursuing workouts.
Source: Leveraged Commentary & Data (LCD). As of October 31, 2022.
Another common remedy for borrowers in recent years, whether for reasons of stress or convenience, was to amend-and-extend their existing loans. Under these transactions, the maturity on existing liabilities is extended further into the future with the option for lenders to convert to longer-dated paper with a wider spread. The amendment portion of the transaction, which requires a majority vote of the borrower group, stipulates the amount of the extension and the new spread as well as any revised terms. Amend-and-extend activity for leveraged loans hit record levels in recent years amidst attractive financing conditions, pushing out the maturity wall for leverage loans; at year-end 2020, more than $350 billion of leveraged loans were set to mature in 2023 and 2024, compared to about $120 billion today.6
Hedging has not been a central topic recently due to the relatively benign rate environment, but risk reduction has come to the forefront given the inflationary backdrop and aggressive policy response. Due to the floating-rate nature of leverage loans and private market debt, many lenders require borrowers to have a certain amount of interest rate hedging in place. While some borrowers are already hedging their rates exposures, lenders may increasingly ask borrowers to implement interest rate hedges to ensure debt servicing is maintained. This often takes the form of interest rate caps, which act as an insurance policy against rising reference rates like SOFR. The need for hedging has increased in recent years as more financial sponsors are opting to exclusively use floating-rate structures to finance deals. While some borrowers will have termed out that exposure when markets were favorable, an analysis of the high-yield market suggests that many borrowers still have significant floating-rate liabilities.7 Prepayment is also typically easier for floating-rate instruments, presenting a risk to lenders, but in today’s market many have been able to better negotiate call protections.
Foreign exchange (FX) hedging, while not as frequently featured in loan agreements, is becoming an increasingly salient topic for both borrowers and lenders too. For many private market strategies, currency hedging is relatively less important due to the long investment horizons and focus on capital appreciation; but yield-oriented strategies, such as private credit, are more exposed to fluctuations in FX markets due to the more consistent cash flow.
Credit investors are inherently focused on downside risk reduction, particularly in tumultuous and volatile markets, with little additional upside potential beyond recouping the par value of the bond. In today’s tight lending market, borrowers may need to include additional upside opportunity through warrants or other incentives to entice lenders. Certain strategies, such as mezzanine, have always included warrants and equity features as standard operating practice, but the terms for more general direct lending strategies shift over time with market conditions. To that end, so-called “structured equity” investments, which include components of both debt and equity, have gained traction recently as a viable middle ground for companies in need of capital but unwilling to take on pure debt and reluctant to raise equity at depressed valuations.
Many credit investors have yet to experience a full market cycle, and for those who have, markets look fundamentally different today than they have in the past. The leveraged loan market has risen in prominence and shifted to look more like high yield. Private credit has also gained traction, with an increasing spectrum of sub-strategies and underwriting features and provisions. As evolution in the space continues, investors need to understand the underlying positions of their credit portfolio. Particularly in private markets, where the terms can vary greatly from deal to deal, broad strategy labels may not accurately reflect the holdings within. As covered in a prior Perspectives article, the interest coverage ratio is a simple metric that can be used to judge a company’s ability to repay debt. Aggregate stats suggest general health in the market, but coverage ratios are significantly different across sectors and between companies—underscoring the need to understand idiosyncratic holdings.
For new debt issuances, lenders have already seen their negotiating positions improve in credit agreement structuring. Lower-quality companies are seeing the most significant tightening, but terms are also shifting for high-quality borrowers. Going forward, the shift to cov-lite debt—with incurrence rather than maintenances covenants—is unlikely to reverse in the leveraged loan market. Instead, we expect to see increased nuance in the structuring of incurrence covenants and more stringent restrictions on how borrowed cash can be used. Private creditors are likely to be able to command the most stringent terms, as the borrower base tends to be riskier; however, higher-quality companies are increasingly showing a willingness to engage with private credit and forge a closer relationship with a lender.
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1 LCD. As of November 2022.
2 LCD. As of November 2022
3 LCD, Leveraged Commentary & Data (LCD): Leveraged Loan Primer. As of 2022
4 LCD, High Yield Bond Primer. As of 2022.
5 S&P Global, Private Debt: A Lesser-Known Corner Of Finance Finds The Spotlight. As of October 12, 2021
6 LCD, Amend-and-extend activity remains focused on pro rata loans. As of September 22, 2022
7 Goldman Sachs Global Investment Research, High Yield Credit Notes. As of July 8, 2022
Middle-market borrowers generally include businesses with revenues of $25 million to $250 million.
Revolver refers to a borrower—either an individual or a company—who carries a balance from month to month, via a revolving credit line.
SOFR is secured overnight financing rate.
Tranches are pieces of a pooled collection of securities, usually debt instruments, that are split up by risk or other characteristics in order to be marketable to different investors.
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Date of First Use: December 15, 2022 299523-OTU-1707673