Yuen-Yee Cho, Will Stawell and Dan Flanagan give a short primer on the different approaches being taken with financial covenants in levfin deals.
When we talk to people[1] about our Year In Review articles the common feedback is “why can’t there be more of them?”.
So in the interests of ensuring that our Linkedin engagement remains high, what follows is a short primer on one of the topics du jour on cov-lite financing.
1. The other great W.S. was onto something ‘What’s in a name?’
Without Jargon we’d have no Golden Age of Private Credit and AI would have taken our jobs years ago.
Our taxonomy:
- Covenanted – a deal with at least one maintenance financial covenant (usually a net leverage ratio but sometimes also an interest cover ratio or fixed charge cover ratio) – historically set with headroom to the lender financial model and stepping down (or up) to enforce some deleveraging over the life of the loan
- Cov-Loose – tongue in cheek – a Covenanted deal with way more headroom than normal (whether because of day 1 headroom, lack of stepdowns or the ability to adjust EBITDA up the wazoo) – we often hear the complaint that a deal is covenant loose because if EBITDA has declined to the point where the leverage ratio is tripped (remembering there is no amortisation in these deals) the Borrower has long ceased to be able to service cash interest.
- Cov-Lite – a deal with a ‘springing’ financial covenant if certain conditions are met – eg the revolver on a TLB deal – see below
- No-Covenant – c.f. a Cov Loose deal – a deal with no maintenance financial covenant at all (not even a spring) – eg a 2L TLB.
Incurrence covenants (ie you can incur additional indebtedness so long as, pro forma for that incurrence and the use of such proceeds, your leverage ratio does not exceed XX) are a topic for another day.
2. History, a lesson
Back in the ‘good old days’ when a firm handshake and an old school tie were the only necessary pre-conditions to being a leveraged finance banker, deals, had covenants and:
- there were at least 2;
- they were tested at all times (although query how that worked practically)
- if breaches were going to be cured, it was done by paying down debt
For a brief period prior to the GFC, these rules were relaxed in the Australian market and the number of covenants were reduced and EBITDA cures were fairly common for top tier sponsor deals.
According to those previously referred to old school bankers – this relaxation directly resulted in the GFC, Kanye West and the downfall of Western Civilisation, so terms were wound back in lenders’ favour post GFC.
3. Where are we now
In leveraged finance land:
- Covenanted deals are found in the mid-market
- Competitive bank processes, non ‘mega’ unitranches are trending towards Cov-Loose (ish)
- RCFs in TLBs and some very bespoke ‘Aus Style’ TLBs are Cov-Lite
- ‘Mega’ unitranches and the term loan tranches of TLBs are No-Covenant.
4. Cov-Lite
What are the key features of a cov-lite deal?
- The covenant ‘springs’ – this means that it only tested on a calculation date if the testing condition is satisfied at that time.
- The testing condition is a matter for negotiation – the general principle is that your working capital facility is drawn above an agreed metric (the thinking is the borrower is experiencing a level of financial distress if it can’t manage its working capital to get below this level).
- And yes, for Sponsor deals, there are various business levers which can be pulled to make sure the testing condition is never met. – There are also documentation points around components of the test and when you test (ie can you retest post calculation date and pre compliance certificate delivery?)
- Only a sub-set of lenders have the benefit of the covenant – those lenders (in a TLB, the revolving capital facility lenders) are the only ones who can (i) agree amendments/waivers to the financial covenant and (ii) call an event of default for breach. Even if the covenant has sprung and the compliance certificate shows a breach of the required level, if the RCF lenders do not elect to accelerate, then then the term lenders have no rights. All the more reason for Sponsors to stay close to their RCF Lenders!
5. What’s next
Our overseas friends have observed that the better credit borrowers have access to cov-lite loans, meaning those borrowers only able to access covenanted loans are generally worse performing credits –so counterintuitively lenders with a mandate for covenanted deals only can end up with relatively worse book – Australia is a different market (with different competing products) so interesting to see if this will apply here.
The ability to agree to a No Covenant deal (even if reluctantly) remains a competitive advantage for the large cap Private Credit houses in Sponsor led deals where they are competing against other products (or smaller private credit houses).
Sponsors will continue to weigh up flexibility versus price and Lenders need to be eyes open on understanding the runway that the covenant choice provides the Sponsor
As we have always said – breadth of product choice is an attractive feature of the market that we don’t see going away any time soon.
[1] Don’t ask us for names