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Nobody likes reading the small print. Research suggests that nearly no one bothers to read every word of the terms and conditions before signing a contract. But the devil, as they say, is in the detail, and in the direct lending market there is such a wide disparity between the different terms and conditions provided on deals that a read is usually worthwhile. 

The disparity is becoming more pronounced too, particularly as the larger deals get larger and their terms move closer to those in the broadly syndicated loan market. There’s been a marked uptick in the proportion of bigger direct lending deals completed on a covenant-lite basis in recent years, without any of the typical lender protections that traditionally have been available on these sorts of loans. 

At the other, smaller end of the direct lending market, deals usually still carry at least one maintenance covenant – a clause that requires a regular review of a company’s financial health to give early warning signals of potential default. 

The prevalent maintenance covenant on these smaller deals is a leverage ratio covenant. This test monitors the level of indebtedness a borrowing company has against its current ebitda, enabling a lender to push for action in the event of underperformance. Companies may also be limited from taking on too much additional debt, with a covenant that requires its leverage ratio (net debt to ebitda) to stay below the level it was at when the loan was originally agreed. While these covenants do typically offer a company headroom of around 30 per cent more borrowing on top of their existing leverage levels, they can signal to investors when a business is taking on too much debt or facing a fall in earnings. 

The art of the covenant

Investors’ expectations about what they will see in a covenant package have shifted. Before the global financial crisis, both broadly syndicated and direct loans (then typically provided by banks) carried robust covenants, including debt coverage ratios, interest coverage ratios, and capex limits. These guardrails would limit how much a borrower could spend on the day-to-day running of their business as standard. 

As the banks stepped back from direct lending in the years following the crisis, and as the institutional market grew, reduced covenant packages became commonplace for larger deals. Typically, this included the one maintenance covenant, reflecting what was on offer in the much larger US market. 

In contrast, smaller deals are likely to have tighter restrictions on ebitda adjustments (changes borrowers can make to their reported ebitda figures based on their own expectations about future cost savings). They are also likely to limit the forward-looking period for which borrowers can project such adjustments. 

Such controls are important to investors because more generous adjustments allowances mean companies can potentially distort the financial picture, eroding the protections against default offered by a covenant.

Tailored terms

Effective documentation is not just about protecting investors from the worst-case scenario of a credit default, but rather about laying out guidelines for the relationship between lender and borrower for the duration of the loan. For example, a deal’s documentation may stipulate what sort of acquisitions a company can make and whether they’ll need a lender to approve any M&A proposals. Investors can specify what countries a company can expand into, or what sort of synergies they would be looking for in a takeover. 

Documentation also allows lenders to outline their expectations about a company’s ESG profile, and how they expect it to improve as a result of the loan. Targets can be set for a company – reducing its carbon footprint, increasing the waste it recycles, or boosting the diversity of its management team – with a margin ratchet inserted that flexes the cost of borrowing depending on whether or not the company hits those targets. 

Because deals are negotiated one-on-one between borrower and lender at the smaller end of direct lending, every set of conditions put in place is bespoke to that company and that loan. This allows lenders to track the metrics that are most important to that company’s business priorities, and develop a robust understanding of its particular risks, as well as its progress. 

On larger transactions, where a club of lenders are more likely to have banded together to provide a loan, terms are typically more standardised and individual investors may only have access to the borrower via a sponsor or arranger. 

In some senses, this can be an easier process for an investor. After all, negotiating a deal’s terms and conditions with a borrower is often tricky. It can be a difficult, delicate conversation that requires expertise and diplomacy, but it ensures lent capital is well-protected, and that it’s being used in the most effective and responsible way. 

Wading through the minutiae of a deal’s documentation is never going to be the most thrilling of jobs, but with such wide disparity emerging, and with investor protections becoming ever more important as the credit outlook weakens, it could perhaps be one of the most important. It’s time to sweat the small stuff.

Raphael Charon

Raphael Charon

Head of Direct Lending Origination

Nina Flitman

Nina Flitman

Senior Writer