Covenants: translating jargon of private credit

Key Takeaways:

1. An important feature for investors when participating in private credit is the availability of legal downside protections on deals in the form of covenants – contractual promises in a loan agreement laying out the conditions that borrowers must adhere to.
2. In a time of heightened market volatility and increased uncertainty for companies, covenants allow lenders greater visibility into the financial health of companies, and limit borrower action without lender approval, ultimately allowing lenders to act early in complex situations and potentially preserve value before issues become payment defaults.
3. Since private credit deals are directly negotiated between lender and borrower it allows for these customized terms that address specific risks and situations. In contrast, 93% of the syndicated loan market does not contain covenants.

What are covenants?

One of the key features for investors when participating in private credit is the availability of covenants as a form of risk mitigation.

Covenants are contractual promises in a loan agreement laying out the set of conditions that the borrower must adhere to, serving as legal protections for lenders. Covenants help lenders catch problems early and address financial concerns before a challenging situation escalates. In essence, covenants are meant to serve as guardrails, making sure borrowers stay and play within the original terms of the loan.

In periods of heightened market volatility and operational uncertainty, covenants are a particularly important tool that private credit lenders can use to 1) keep a close eye on borrower financial performance and 2) proactively protect investors by working directly with company management through complex market scenarios.

If a borrower breaches a covenant, for example by taking on too much debt or not having enough liquidity, the lender can take action to protect the loan position, up to and including a forced repayment, as set forth in the loan agreement. Without covenants, lenders have limited recourse or warning if a borrower’s risk profile deteriorates, which could significantly increase the chance of losses.

Since private credit deals are directly negotiated between lenders and borrowers, they allow for these customized terms that address specific risks and situations. In contrast, most of the public broadly syndicated loan (BSL) market lacks stringent downside protections, with 93% of the BSL market containing no covenants ¹.

Benefits of covenants and why they matter?

1. Early Warning Signals - Covenants require borrowers to meet regular financial targets, allowing lenders to monitor company health and spot issues before they become payment problems. If a borrower does breach a covenant, this allows lenders to step in early and act quickly by working with management teams, demanding repayment, renegotiating terms, or restructuring the loan – ultimately promoting the preservation of value
2. Stronger borrower guidelines - Strong covenants limit what borrowers can do without lender approval — like taking on extra debt or selling assets. This helps keep companies in line per expectations and financially disciplined.
3. Greater Transparency - Private credit deals with covenants help increase the visibility of financial status and any financial changes made by borrowers due to the requirements to comply with covenant terms. Privately originated loans can also improve connectivity and transparency to company management, typically offering more visibility than public high-yield bonds or syndicated loans.

Types of covenants:

Maintenance and incurrence covenants are two categories of financial covenants that work together as a ‘system of safeguards’ to help ensure that a borrower and their business are performing and operating within expectations:

Not all defaults are created equal

The term “default” has increasingly been used as a catch-all to refer to both covenant and payment defaults, however in practice, the type of default is critical in understanding the current state of the loan.

A covenant default occurs when a borrower violates one of the requirements (covenants) agreed to in the loan contract — even if they are still making their loan payments on time.

For example, if a company’s debt-to-earnings ratio gets too high (breaking a maintenance covenant), or if they sell a major asset without permission (breaking an incurrence covenant), that's a covenant default.

As discussed, covenant defaults are often early warning signs of financial stress, but they allow lenders to step in early and legally work with management, renegotiate loan terms or require corrective actions before payment problems, or losses for investors, arise.

A payment default occurs when a borrower misses a scheduled payment on the loan — either interest or principal. By the time a payment default occurs, the borrower's financial circumstances are to the point where current cashflows and available liquidity are unable to cover borrowing costs, and subsequent recovery rates for investors are often lower.

A payment default is more serious and typically triggers immediate legal rights for lenders, like moving to seize collateral.

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