Covenants Make Credit More Interesting
Carson Block, the famed short-seller, noted to 9fin in an interview last week: “If you can find that level of delta between reality and perception in the market, then it makes sense for us to do something on the credit side, even if it’s purely credit.”
Finding delta between reality and perception can happen in two ways in credit – either based on the company’s performance and prospects, or based on the borrower’s ability to take actions under the covenants.
I wrote previously about how modern covenant packages offer maximum flexibility to borrower and their owners [Do covenants really matter?]. If the latest creditor-on-creditor trends from the U.S. make their way to Europe (and let’s face it, they often do), then other lenders might seek to utilise this flexibility. (This is an especially complex question in Europe as some U.S. transactions might not be permitted under local law.)
This begs the question: you know what the company does, but do you really know what the company (or its owners) can do?
In a market rife with covenant flexibility, where market participants must understand legalese to decipher covenant terms, understanding how to analyse covenants is more important than ever.
Why?
Borrowers are not required to report covenant capacity.
Reporting covenants have also undergone significant erosion during the last decade of easy money, but this has always been the case. Lenders can ask about covenant capacity (and I always recommend that they do),but borrowers are under no contractual obligation to tell them. (Indeed, some lenders are wary of even asking lest they receive a less favourable allocation on the next deal.)
By educating market participants on covenant analysis, we are upskilling leveraged finance market participants to identify potential downside risk in the covenant package without having to ask.
Covenants are complicated, but they’re not rocket science. When combined with credit analysis, documentary flexibility can be viewed through the eyes of the borrower, its owners, or indeed, other lenders, to determine what could happen.
To Carson Block, finding any delta between what the market expects and what the company can actually do is an opportunity.
To lenders, it is a necessity.
Sabrina Fox - FLT Founder