For as long as there have been loans, lenders have sought to establish protection for their money. If I lend you money, what guarantee do I have that you will repay me?
Increasingly, the concept of lender protection rights is being undermined in private debt markets. The growth and evolution of the asset class, which didn't exist in Europe in nearly the same capacity pre-financial crisis, has fundamentally altered the level of security within debt.
Prior to the crisis, more than 80% of large-cap lending was originated by banks — and mostly retained on balance sheet. Since then, new capital adequacy regulations have forced a significant reduction in the quantum of bank lending as traditional debt providers scaled back balance sheets, reduced risk and moved to comply with the more stringent regulatory environment.
This scale-back left a gap in the market and an opportunity for custodians of global capital. This gap has now been filled by a wave of institutional investors directing significant allocations to private debt funds as they look to take advantage of the yields on offer. While still lagging behind their American peers, direct lending funds are now a mainstay of institutional allocations in Europe.
The maturation of the private debt market and the megafunds that have been raised in the past 10 years meant that there was a natural focus on the large-cap sector, as funds had to find big-ticket credits to deploy the reams of dry powder. That focus left an opportunity for new entrants to tackle midmarket lending — an area that remained dominated by traditional banks. Institutions began taking notice of the growing opportunities, which drove greater transparency and diversification, but equally it increased the levels of competition.
Fast forward to 2019 and the level of private debt assets under management have reached new levels — hitting $769 billion as of June, according to Preqin. In Europe alone, direct lending now accounts for 10% of the business loan market. The volume of money entering the asset class and the resulting competition means that funds are finding new ways to compete to deploy capital. Primarily, competing involves accepting increasingly weak protections on the loans.
The presence of covenant-light loans, which have minimal, or no, covenants, first appeared in the large-cap leveraged loan market. While at first these type of deals were reserved for only the best-performing companies, covenant-light loans now make up 86% of the large-cap market. The reduction in these protections, which provide lenders with the safety of recurring maintenance covenant tests, has spread to small- and medium-size enterprises in some cases. For those loans that have maintenance covenants, the level of headroom that they provide has also increased. An even more concerning development is the inclusion of increasingly flexible add-backs to EBITDA — used to calculate leverage ratios — which adjust the figures to include future earnings, providing a more flattering profile of a company's finances and potentially does not reflect its real ability to cover its liabilities.
One would naturally think that a reduction in the robustness of loan terms would result in some premium to account for the increased risk and reduced protection. However, the prevalence of these loans means that the usual 75-basis-point premium attached to this type of covenant-light loan has evaporated since 2015.
Prospective investors in the asset class are now faced with a dilemma: how do you access the favorable risk-return profile compared to other debt investments that the market can offer without sacrificing nearly all protection usually found in these products?
First and foremost, investors need to be aware of the difference in downside risk between covenant-light, covenant-loose — in which the threshold on the covenants is very low — and covenanted senior loans. While all three types of loans provide lenders with first-lien security over the borrower's assets and operations, the time at which that action, such as a capital call, can be taken to rectify the underperformance of a borrower can be materially different and hence impact expected recoveries in a default scenario.
In addition, investors must question direct lenders about the underlying lender protection rights in the documentation of the loans, including getting a better understanding of how covenants are set. This will not only increase their understanding of the risk-reward profile different lenders offer, but it will also force direct lenders to achieve better terms, which in turn could boost lending protection rights.
Despite the proliferation of covenant-light loans, there is still a significant amount of loans, primarily found in the midmarket, which are governed by meaningful covenants and where EBITDA add backs are more effectively controlled. This segment of the European market can still deliver the attractive returns that led to the growth of private debt, without sacrificing protections.
The dangers of this market are enough that the most influential financial institutions in the world, including the Bank of England, Bank of International Settlements and Federal Reserve, have issued warnings. However, value is there to be found, but it requires a disciplined approach and an acute understanding of the risks the current market structure presents.
