A rash of covenant violations due to government-mandated shutdowns has forced lenders to reevaluate portfolio companies and rewrite covenants. As a result, new trends have taken shape in private credit during the pandemic era, according to Lincoln International, which provides mergers and acquisitions, capital advisory, restructuring, and valuation services.
These trends are as follows:
- Restructuring experts are in. Takeovers by lenders are not.
- Minimum liquidity covenants are in. Leverage and fixed-charge covenants are out.
- Smaller revolvers and hold sizes are in. Unfunded DDTLs are out.
On the topic of liquidity covenants, private debt providers have begun temporarily installing minimum liquidity requirements to replace leverage tests, typically for 6–9 months, as part of amendments after borrowers break covenants.
“Liquidity covenants were far more exceptional pre-COVID. Now they’re much more mainstream,” said Ronald Kahn, co-head of Lincoln’s U.S. Debt Advisory and Valuations and Opinions groups.
Liquidity covenants are typically calculated as cash on hand plus revolver availability, measured monthly or quarterly. Amounts vary, depending on company size, profile, and capital needs.
“Most of these companies will go back to a leverage test in Q4 2020 or Q1 2021. It buys everybody time to get some perspective on what the new normal is for a business,” said Christine Tiseo, co-head of Lincoln International’s Debt Advisory Group.
Instead of modifications, recent amendments typically offer a reprieve for near-term quarters from performance metrics linked to earnings, such as leverage and fixed-charge covenants.
“Many lenders are saying it doesn’t matter what companies are earning, so leverage doesn’t matter. What matters is how much liquidity a company has, so the lender knows how much runway a company has before there’s a problem,” Kahn said.
What has not become a trend is EBITDAC, or Earnings Before Interest, Taxes, Depreciation, Amortization and Coronavirus, Kahn said. Talk of EBITDAC emerged in recent months as a potential metric of COVID-era company performance.
The “Bells and whistles” are gone
More recently, new loan agreements have closed with covenant packages more or less in line with pre-COVID parameters, Tiseo said. Features such as a single leverage test, an EBITDA projection cushion of 30–35%, and the ability to use cash netting to calculate leverage are comparable to terms a borrower could get prior to the coronavirus outbreak, Tiseo said.
“While we’ve seen pricing change, and maybe leverage that’s more conservative than it used to be, other deal terms have been fairly consistent,” Tiseo said.
The difference between pre- and post-pandemic loan agreements lies in the “bells and whistles,” which are now harder for a borrower to come by, Tiseo said.
These include large unfunded DDTL (delayed-draw term loan) commitments with a broad list of preapproved uses, and wide open free-and-clear baskets. Uncapped incrementals, permitted acquisitions, and EBITDA addbacks are now capped.
Call protection has become more customary to incentivize lenders for taking on risk, yet it is not egregious compared to pre-COVID levels. Depending on borrower and sector, features that would not be unusual in the market today are a call at 101 for one year for a senior or senior stretch loan, and a call at 102 in the first year, dropping to 101 in the second year, for a fully levered unitranche financing.
Pre-COVID, a borrower could set up a DDTL in significant size for a range of purposes. Today, the use of proceeds would be far more restrictive, and the facility size would be significantly smaller than before.
Revolvers are harder to come by, and many private lenders won’t provide them at all, sending borrowers to banks for these credit facilities. Some private credit lenders will still provide them to avoid bringing another senior lender into the capital structure. But revolvers, too, are smaller.
Less agreement on pricing
Another change is recent months has been increased volume of M&A financing versus refinancings. At Lincoln, the balance between acquisition financing and refinancing is usually split evenly.
“We seem to be more heavily weighted in acquisition financing, which is not what we were expecting,” Tiseo said.
The deals that are closing in the private market now involve high-quality businesses that are what the firm identifies as “pandemic-protected” or “pandemic-proof.” These new terms are stronger than “recession-proof” and “recession-resistant” buzzwords of recent years.
“Pandemic-protected” companies may have shown real earnings growth during COVID-induced shutdowns. Interest in them is strong: As many as 20–25 lenders typically vie to participate in these deals. What’s different in the current market is that the dispersion of proposals is wider, with pricing ranging by as much as 200 bps, and by 100 bps for closing fees (calculated as OID, or original-issue discount).
“It used to be that lenders would be very tightly clustered around a level. But the dynamic now, when you get 12 to 20 bids, is that they are widely dispersed. And lenders are comfortable putting healthy multiples against these companies.”
Generally, pricing on recent deals has averaged L+600–700, ranging from L+500 for cash-flow senior loans to L+800 for highly leveraged unitranches. That said, unitranche loans are averaging L+650–750.
No takeover rush
Another trend among private credit providers is hiring restructuring experts to negotiate and run amendments and forbearance agreements. But taking over ownership of companies has not happened in significant numbers.
“At least for right now, sponsors and lenders are working collaboratively to keep these companies going,” Kahn said. “We always thought private debt lenders would act differently than banks. They don’t have the regulation. They don’t have the bureaucracy. The mentality is similar to private equity, so they have a longer outlook.”
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