Looking Through a Lender’s Lens at Debt Covenants Post-COVID-19

As COVID-19 continues to interrupt everyday life across the globe, lenders have been feeling the impact on their borrowers. After a long benign credit cycle, many lenders saw a significant uptick in covenant breaches, waiver requests, and defaults on deals originated pre-COVID.

Pre-COVID, default rates were relatively low, and the economy was on a decades-long bull run. The macro-economic environment looked far different than it does today. At the end of 2019, corporate debt reached a record percentage of GDP as companies took advantage of interest rates falling to an all-time low. The world was ten years past the last economic downturn—the Great Recession a distant memory—and lenders were willing to forego tight covenant structures owing to a highly competitive marketplace.

COVID-19 was arguably the most abrupt, acute shock the global economy has ever experienced. Everything changed dramatically, and in only a few weeks.  

Covenants in the Middle Market

Although covenant-lite structures have been common in recent years, most loans in the middle market include at least one financial covenant, which have become particularly relevant in the context of COVID-19. Previously profitable companies have experienced sharp declines in earnings due to government-mandated shut-downs, supply chain challenges, and fundamental changes in consumer behavior. Through no fault of their own, many portfolio companies breached financial covenants at some point in 2020.

A Lender’s Response to Covenant Breaches

Covenant breaches are not uncommon post-COVID. Most companies subject to covenants, particularly those based on a cash flow metric, including leverage, interest coverage, and fixed charge coverage ratios, experienced covenant issues. That said, lenders have thus far been patient with their borrowers, particularly where the private equity sponsor has been willing to provide incremental support.

We have seen a few different reactions to covenant issues thus far in the post-COVID recovery.  

Waive the covenant without a fee. If the lender believes the default is a one-off occurrence and performance will return to compliance with the existing covenant suite, some have elected to waive the fee (at the lender’s discretion) to avoid further deterioration in the company’s liquidity position. Of course, the borrower is responsible for the legal and financial advisory fees of the lender. Most waivers have been effective for one or two quarters.

Waive the covenant with a fee. Historically, most lenders will charge a fee, which can be an agreed lump sum documented in the loan wavier or a percentage of the loan, in exchange for agreeing to waive covenants. Some lenders have been steadfast in insisting on an amendment/waiver fee post-COVID. Often, these lenders cite “policy” or institutional precedent when insisting on a fee. 

Reset the covenants. If the borrower’s downturn in performance is likely to persist beyond a few quarters, a temporary waiver is probably not a solution. If the lender still views the company as creditworthy, they may opt to reset covenants to a more realistic level to reflect projected performance going forward. Resetting covenants post-COVID has been challenging since many borrowers and sponsors cannot reliably provide forecasts around which to reset covenants. That said, as confidence has increased, more covenant packages are being reset. A covenant reset is almost always accompanied by a lender fee and is often part of a more global “restructuring” whereby the private equity sponsor injects more capital – either in the form of a debt instrument or as equity (the latter may be less advisable).

Two other approaches that have been less commonly deployed post-COVID are 1) raising the interest rate and insisting on default rate interest, and 2) calling the loan. In the former, raising interest expense on a borrower that has experienced a sharp drop in revenue and liquidity is not constructive and only exacerbates the issue. As it relates to the latter, lenders have been loath to call the loan or force bankruptcy due to the same uncertainty and inability to adequately forecast the future – without a reasonable view of the prospects of the borrower, exiting bankruptcy is challenging and may very well harm the lender’s collateral.

What We Have Seen in the Market

The response to covenant breaches has varied across lenders. Early in the pandemic, when there was little clarity around the gravity or duration of the “new normal,” some waivers suspended leverage tests altogether. In some circumstances, lenders allowed companies to substitute their previous year’s results in place of current earnings for covenant calculations. These lenders are holding back on more draconian measures to give companies time to recover from events outside of their control.

At the other end of the spectrum, some secured lenders have begun to take a more proactive approach to obtain greater control or returns. In the case of significant and ongoing covenant defaults, some lenders have been more willing to step into the equity position through an out of court restructuring or through a bankruptcy process. 

Looking Forward

1Q 2021 is likely to be similar to what we saw in the market in 2020. However, later in the year, that could change as the COVID vaccine is distributed and confidence returns. In a somewhat perverse way, the return of that confidence may lead lenders to push sponsors for resolution of their out-of-covenant portfolio companies. Emboldened by more opportunity to exit underperforming loans (through M&A, for example), lenders are increasingly likely to insist that the incumbent private equity sponsor support the company with additional equity or a paydown of secured debt. The most successful negotiations will result in a solution that appropriately shares the risk of recovery across the incumbent lenders, the incumbent equity, and any newly invested capital, be it debt or equity.

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