Do covenants really matter?
As we enter a new year, I have been reflecting on a question I’m sometimes asked: if wide covenant flexibility is now the norm in the leveraged finance market, does understanding them really matter?
My answer: Absolutely – and now more than ever.
Investment decisions are no longer just about what the business does or the industry it operates in or who owns it. In a time when maximum flexibility has resulted in maximum complexity, it is also critical to know how to find key provisions and understand how they work.
I wrote in a previous blog post (which you can read here) that high yield bond and leveraged loan covenants once worked in more or less the same way, providing only necessary flexibility for borrowers to operate and modestly grow the business.
Modern covenant packages also work in more or less the same way, due to the precedent-driven nature of the markets, but now they offer maximum flexibility to borrowers and their owners, which can be (and has been) used to the detriment of lenders.
Indeed, covenant flexibility, and as a result, complexity, has increased to such a degree that most market participants now engage one of several specialist covenant analysis services to provide summaries of legal documentation, and many will also engage legal counsel to do a deep dive on the docs on top of this if the borrower becomes stressed.
These are legal documents, so these summaries must be precise and as a result use applicable legal vernacular. The reports and analyses are not written in plain English – they are written in legalese.
Terms like “structural subordination”, “right and priority in payment”, and “liens on the collateral” are just a few examples of words with potentially dire consequences to any lender caught unawares on the wrong side of the concept.
In context of the current market volatility, lenders must become well-versed on how to decipher legalese.
That’s exactly what our Leveraged Finance Covenant Training course achieves – and we can say that with confidence.
Our first cohort of students took an entrance exam at the start of the course to test their covenant knowledge and scored an average of 42%. After completing the course, their scores increased to an average of 84%.
The knowledge reflected in those scores – the ability to manage risk and identify opportunities derived from the docs – is not just valuable to leveraged finance market participants as we enter 2023.
It is essential.
Author: Sabrina Fox - January 2023