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Alternative debt needs alternative covenants

GC1727 Leader cartoon covenants.jpg

Direct lenders are shedding mainstream protections but they should look at other options

Cov-light deals are making their way into the direct lending market, according to several market sources. This is an important moment for the market in charting its future.

Direct lenders need protection more than most other investors. Their market caters for small and mid-sized companies, which are

typically more vulnerable to falling into difficulty than larger borrowers. Plus there is no active secondary market in which to dump bad deals, so if one turns sour then an investor can be left with a very bitter taste.

However, mainstream covenants, participants say, have proven pretty useless. Typical protections in direct lending include restrictions on capital expenditure, interest coverage and most commonly net leverage. Covenants are there to act as an early warning that a company may be getting into difficulty, but often are set so loosely that defaults occur before the covenants are even triggered.

This makes the case for cov-light deals that much stronger and is perhaps why some in the market, like Blackstone Credit and Goldman Sachs Asset Management, are heading towards terms more like those on leveraged loans.

But while traditional protections may not be of much use, more bespoke terms could keep the market safe and save lenders difficulty down the line.

Covenants are there to protect a lender's investment, so introducing a blocker to dividend payments or restrictions on asset sales for the life of the loan would help. If they are there to support a lender in difficult situations, junior lenders could have buyout rights over the senior debt in a default.

If mainstream protections are not working, then the market should do what it does best and be creative. Light documentation may be easier to read, but in the next downturn lenders may wish that they had drafted something lengthier.