The Case for Covenants (Part Three)

At a recent debt conference we did what most of our direct lending colleagues are doing these days: complain. Speaking with one long-time practitioner, we mentioned a middle market transaction which was both cov-lite and ebitda adjustment-heavy. “Yeah, it’s ridiculous,” he said. “But it’ll get done.”

Therein lies the problem. As we discussed last week, loan arrangers are pushing cov-lite for middle market loans because they can. Insatiable investor appetite and less-than-robust buyout flow have combined to produce issuer-friendly conditions. “Getting it done” refers not to winning a great asset, but getting it off your books.

Direct lenders have built sizeable war chests to accommodate larger holds. But as competition has heated up and deal terms have become increasingly aggressive, arrangers have pivoted from holding loans to distributing them.

At the same time, investors are eager for the premium yield middle market loans enjoy relative to their broadly syndicated cousins. Agents are accordingly betting that any deterioration of terms will be offset by the thirst for assets. So far, it’s worked.

In the case of cov-lite, investors say they’re willing to accept debt incurrence-only tests on a “case-by-case” basis. Those cases appear to have three common denominators. First, borrowers have demonstrated solid free cash flow characteristics through a cycle. Second,