Aviva Investors: Don't forget your covenants

The rapid growth of private credit markets has been a distinctive trend since the turn of the millennium. From that point, the volume of privately-originated debt placed with large institutions and traded privately on secondary markets has grown at almost 20 per cent a year.¹ The level of interest reflects the advantages to be had from an asset class that can help investors enhance yield and diversify their credit exposure.

With banks constrained by the tighter regulatory environment following the financial crisis, non-bank lenders have stepped into the breach and stepped up their activity. As Basel IV has encouraged banks to trim holdings of large debt transactions, asset managers, insurers, private equity companies and hedge funds have all been actively scouring for private market opportunities.

One key benefit of private debt has traditionally been the extra security they provide in the form of covenants. The precise details are unique to each deal, but covenants often include financial maintenance clauses covering the volume of debt and the borrower’s ability to service it. (See box  for the range of measures borrowers may be subject to.) By flagging when a company’s financial strength might be deteriorating, the covenants are an important form of investor protection.

However, with growing amounts of capital seeking a home, rival lenders are increasingly looking to win deals through flexible lending structures or less onerous covenants. One specific outcome of the competitive marketplace has been the return of ‘covenant-lite’ loans, a phrase synonymous with loose credit conditions in the years leading up to the global financial crisis of 2007-2009.

Initially prevalent in the US among larger companies, lax lending terms have spread to Europe as well (although to a lesser extent in the small and mid-cap sectors). In fact, around 80 per cent of the senior loans extended to large European companies were reported to be covenant-lite by 2017.²

This has important implications for investors. Until recently, the existence of maintenance covenants differentiated private debt from publicly-listed high yield bonds. Certain private borrowers have had the opportunity to increase leverage, but this needn’t have serious implications immediately in a period of global recovery. Nevertheless, fewer flags will be raised if and when financial metrics start to deteriorate, preventing lenders stepping in early to stop future defaults.

Mind your head(room)

Taking a role as a lead lender or sole lender in a private, direct transaction makes it possible to have much greater control over structuring and negotiating terms in a way that might protect investors in all market conditions. “It allows a more rigorous approach to risk, as appropriate lending criteria can be embedded within the loan documentation,” according to John Dewey, head of investment strategy in Aviva Investors’ solutions function.

To do this effectively requires a detailed understanding of the nature of the borrower, as well as the dynamics of the sector it occupies. For instance, a metric like debt-to-EBITDA – measuring debt to cash flow – will clearly be more volatile in cyclical industries. “A covenant of three times EBITDA might be aggressive in some industries – like retail – yet it would be conservative in other industries that offer more visibility and stability in terms of cash flow generation,” says Antoine Maspétiol, head of private corporate debt at Aviva Investors.

So the issue is not just if covenants exist, but how they are structured and how much protection they really provide. For instance, there has recently been an expansion of headroom in the real estate finance market. “There was a recent commercial-mortgage backed security issue which, at first glance, appeared to have a covenant for both interest costs and loan-to-value,” explains Gregor Bamert, head of Real Estate Finance at Aviva Investors. “But closer examination showed plenty of headroom for both covenants, and default would only be triggered if both measures were tripped. A more prudent approach might have been to have less headroom and default triggered by a single covenant breach.”

The return on the deal, after adjusting for anticipated losses, should be the final consideration. Riskier assets with higher yields should only be considered if the investor is willing and able to sacrifice some certainty over cash flows. Some private assets might offer lower returns, but also tangible benefits in that they can be held to maturity and relied upon to pay out as expected.

Default position

For those prioritising certainty, it is worth drilling down into recovery rates. The theoretical recovery rate is only useful if the manager has the skills to deliver when the borrower defaults. For example, the security a commercial property provides in a real estate debt transaction is only helpful if the manager can ensure a smooth transition if a default event actually occurs. “The manager needs to demonstrate it can find new tenants, sell the property at a fair value or achieve favourable re-financing terms,” says Bamert.

By focusing on the risks first and then the returns, a private credit manager will not be overly swayed by a seemingly attractive return at the outset.

Reviewing the insurance formula

While these considerations have implications for all long-term credit investors, insurance companies have additional features to bear in mind, which add to the complexity.

For instance, the Prudent Person Principle (PPP) governs investment for European insurers. One element of the PPP is that insurers should “only invest in assets and instruments whose risks the [insurer] can properly identify, measure, monitor, manage, control and report”.³

To address this concern, insurers have been seeking to increase their in-house expertise. Some have developed internal credit rating models for private debt assets, often leveraging the credit assessment process used by their asset managers.

This assessment includes consideration of the covenant protection within the deals, with some insurers using rating methodologies based on assessing expected losses rather than the likelihood of default. This issue is exacerbated by the overly-simplistic treatment of private loans within the Solvency II Standard Formula. For example, the same capital charge applies to a private loan to a large, defensive corporate entity with covenant protection as a private loan to a small, highly-cyclical business with limited covenants.

The European Insurance and Occupational Pensions Authority has recently issued its advice to the European Commission on the treatment of private debt as part of the 2018 review of the Standard Formula.⁴ The proposed approach would reduce the capital charges for private loans issued to non-financial corporates that are deemed to be equivalent to ‘A’ and ‘BBB’ publicly-rated entities, subject to the asset, the borrower, and the insurer satisfying a number of criteria.

For UK-based insurers, the Prudential Regulation Authority is closely monitoring the use of private debt assets to match liabilities arising from annuity products. UK firms typically use the Matching Adjustment (MA) framework under Solvency II to manage and value their annuity business. This enables the investor to value the liabilities at a higher discount rate, derived from the yield on their assets, minus defined haircuts for credit risk. There is clear regulatory benefit to using higher-yielding assets with a strong credit rating.

As the volume of private debt issuance has increased, competition has eroded some of the features that offer investors a level of comfort. Understanding the idiosyncratic elements of private markets transactions – where the risks lie and what controls are in place to mitigate them – will be key to meeting regulatory hurdles and deciding long-term investment success.

1. ’Financing the economy 2017: The role of private credit managers in supporting economic growth,‘ Alternative Credit Council, October 2017.
2. Directive 2009/138/EC of the European Parliament and of the Council, as at November 25, 2009.
3. EIOPA’s second set of advice to the European Commission on specific items in the Solvency II Delegated Regulation, as at February 28, 2018.