According to Proskauer’s latest trends in private credit report, just 3% of surveyed US lenders would consider a covenant-lite transactions for borrowers with under $30m of EBITDA; for companies with more than $50m of EBITDA, that figure rises to 30%. 

In 2022, 7% of deals with EBITDA less than $50m were considered cov-lite, while that number increased to 51% of deals for companies with EBITDA greater than $50m, Proskauer data shows.

Nowadays, those large deals are few and far between. Private equity-backed buyouts, which sometimes use direct loans to finance deals, have stalled due to the higher cost of debt financing and widespread economic uncertainty.

As of the first quarter of this year, PE firms brought in an estimated 2,177 deals in the US, of which LBOs represented less than 20% by volume, according to Pitchbook. That’s compared to the 9,286 deals made during the 2021 boom, nearly 30% of which were LBOs, the data shows. 

Thinning pipelines

Borrowers are also showing signs of distress as they contend with higher interest rates and compressing margins. That has both sponsors and lenders increasingly wary of seven-year commitments to debt-laden companies, some of which are already struggling under the weight of now double-digit coupon payments. 

This means there are fewer LBOs for private credit firms to finance, and the deals that are available are less enticing, according to several industry sources we spoke to for this article. 

“What I hear from a lot of lenders is that their pipelines are light or that more of what's coming through are weaker assets,” said one lawyer who spoke to 9fin. 

So when something does come along that piques lender interest, there’s more hands itching to grab a piece of the pie, the lawyer added: “Lenders are feeling that they really have to compete and get aggressive for better assets.”

This is despite what was an inflection point in the early part of 2022 in the private credit market, where lenders were able to secure better terms, whether it was higher pricing, lower leverage or the inclusion of a whole host of covenants that in previous years (like in the frothy market of 2021) fell by the wayside.

But it still remains an industry where winning the favor of sponsors’ is key as this often carries with it access to larger deals. Lenders in certain circumstances are more willing to be flexible on terms in the hope of cultivating a longer-term relationship. 

“Lenders work very hard in building these relationships, and they work even harder to maintain those relationships,” You told 9fin. “If lenders are underwriting a deal and they really like it, they remain willing to do it largely on sponsor’s terms.” 

Despite the worsening economic outlook over recent months, that dynamic still exists, said You.

Bend the knee

There are strong incentives for sponsors to push for weaker documentation in private credit deals. For one thing, weaker docs may enable companies to raise new debt at significantly cheaper rates — an important consideration at a time of high borrowing costs. 

Some sponsors are already taking an aggressive stance on existing documentation. Just last month, Galway Insurance, backed by Harvest Partners, irked lenders by offering a new incremental loan at off-market pricing in order to avoid triggering MFN protection and keep its overall interest costs down. 

When it comes to hashing out new deals, lenders are often willing to bend on headline terms such as total leverage, amortization, operational covenants and loan tenor. But in highly competitive scenarios, they may also give concessions in other areas such as prepayment premiums and incurrence tests, David Hayes of Reed Smith told 9fin.

Occasionally, such agreements may not be part of the final credit agreement but in side-letters instead — confidential side-deals with specific lenders can give certain private credit firms preferential terms. Lenders may use side-letters to gain an edge over other lenders in a club. 

This can add complexity to deal terms, and has the potential to lead to a race to the bottom in terms of documentation quality. And yet, lenders may be more willing to tolerate this kind of cut-and-thrust dealmaking when the borrower is large and attractive. 

“The larger the deal and more attractive the asset, the more likely that lenders are to maybe live with something that's less than perfect,” said the lawyer. “No lender wants to go completely naked in that arena, but they might be more willing to take a step back.”

Plugging a leak

Still, as economic conditions tighten, lenders are starting to draw a line in the sand about what they won’t tolerate. 

Now, lenders are beginning to push back on terms that would have flown under the radar in the high opportunity and capital fueled mania in years past. Some of that hard lining comes in the form of limiting EBITDA adjustments, as Craig Packer of Blue Owl told us in the latest episode of Cloud 9fin. 

This showed up in negotiations around the private credit financing for Carlyle’s would-be acquisition of Cotiviti earlier this year — even as they offered borrower-friendly features like a hefty PIK component, lenders were able to impose a limit on EBITDA add-backs within the credit agreement. 

As in the broadly syndicated markets, private credit firms are also extremely focused on documentation points that could lead to collateral leakage, such as the now infamous “J.Screwed” trap door mechanism. 

“We simply do not allow for assets to get stripped out or big dividends to get paid or collateral to be moved around,” Packer said. “We can’t afford to live with that risk, and we don’t.”