COVID-Era Private Credit Trends: Liquidity Covenants In, DDTLs Out

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 delayed-draw term loans, or 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 six to nine 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’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.

“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.

The Bells and Whistles Are Gone

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 commitments with a broad list of preapproved uses, and wide open free-and-clear baskets. Today, the use of proceeds would be far more restrictive, and the facility size would be significantly smaller than before.

Another change in recent months has been increased volume of M&A financing versus refinancing. 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- proof.” These new terms are stronger than “recession-proof” and “recession-resistant” buzzwords of recent years.

No Takeover Rush

Another trend among private credit providers is hiring restructuring experts to negotiate and run amendments and forbearance agreements. But taking ownership of companies has not happened in significant numbers.

“We always thought private debt lenders would act differently than banks,” said Kahn. “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.”