The upper end of the private credit market has converged with the broadly syndicated loan market in the last two years or so. Many companies in this space transitioned to the private credit market to refinance their capital needs while the institutional loan market was largely dormant from early 2022 through late 2023.

However, the trend reversed somewhat this year with the syndicated loan market reclaiming some lost ground.

In such crossovers, a question emerges as to whether loan documentation has changed for issuers that refinanced out of the broadly syndicated loan (BSL) markets into private credit markets. Given the relative opacity of the latter, it is a challenge to make definitive observations on specific covenant trends. Moreover, market dynamics of demand and supply of loans at the time of a transaction also drive documentation quality. However, based on our review of credit agreements of 22 such companies that refinanced out of BSL into private credit, private credit markets tend to tighten agreements.

Another question raised is whether private credit agreements for the core and upper middle markets do away with financial maintenance covenants. We reviewed more than 1,000 credit agreements in the private credit universe and found most include at least one financial maintenance covenant, except for loans to larger entities (debt size of $1 billion and above). Most of those larger entities are without financial maintenance covenants.

We also note that borrowers in the private credit market utilize payment-in-kind (PIK) provisions to address their liquidity and refinancing needs. We looked at the phenomena and motivation issuers have in opting for a PIK structure.

Financial Maintenance Covenants

Bank lending and BSL markets

The syndicated leveraged loan market of today has roots in traditional bank lending, albeit with some features significantly altered as the investor base has changed and broadened dramatically. Instead of holding loans on their balance sheets, banks leveraged their relationships with sponsors and issuers to originate and distribute term loans predominantly to collateralized loan obligations (CLO) and other institutional investors. This has allowed banks to reduce their capital reserve requirements and increase fee income. When banks held the loans on their books, they relied on financial maintenance covenants to monitor issuer health and intervene if performance deviated from agreed credit metrics.

In the early years of the institutional loan market, covenant-lite term loan structures (without financial maintenance covenants) were granted only to select borrowers deemed worthy of this accommodation. However, with the evolution of a secondary loan market, which emerged sharply and provided institutional investors an option to exit their loan positions, covenant-lite term loans gained broad market acceptance after the global financial downturn.

Moreover, issuers and sponsors became concerned about their ability to renegotiate financial maintenance covenant thresholds with a large base of lenders whenever they ran into operational issues. This is unlike the quick and efficient process of dealing with a small base of bank lenders traditionally. The covenant-lite loan structure became the BSL standard and today represents almost 90% of loans in the LSTA LCD Index. Banks still preserve maintenance covenants for the pro rata revolving and term loans they issue and hold, although revolver covenants are typically in the form of springing covenants tested only if revolver borrowings exceed a preset threshold (typically 25%-40% of the commitment).

As the syndicated loan market expanded, fueled by the CLO market, power dynamics shifted to issuers and sponsors. This led to more flexibility in documentation, including wider definitions of EBITDA, larger incremental loan buckets, flexible language around restricted payments, investment baskets, and an umbrella of hidden flexibilities to be tapped for a rainy day.

Bank lending and private credit markets

Banks shied away from lending to middle market entities given the consolidation and growth of banks and the focus on generating financing, syndication, and advisory fees from larger issuers. Further, regulatory considerations such as interagency guidelines on leveraged lending also discouraged banks from making loans to leveraged entities.

As banks retracted from such lending, private credit managers moved in and focused on middle market entities, often holding the loans in the fund complex they managed or in their books, generally through maturity. Given the buy-and-hold to maturity nature of these loans, private credit lenders instituted financial maintenance covenants in their loan agreements, keeping the option to intervene early to course-correct and protect their position and interest. Most lending in the middle market is done through small groups of private credit lenders (club lending).

Overlap Of Private And Syndicated Loan Markets

The BSL and private credit markets, for the most part, addressed the needs of different sizes and profiles of borrowers until around the time of the COVID-19 pandemic. In 2022 and 2023, the rise in inflation and general uncertainty in capital markets stalled bank syndication of loans and brought institutional loan issuance to a 12-year low of $225.3 billion in 2022, which only increased marginally to $234.2 billion in 2023 (based on Pitchbook LCD data). The near freeze in bank lending and syndication meant several issuers looked for alternative options to refinance, and private credit markets stayed open to provide financing and liquidity to issuers traditionally from the BSL market.

BSLs have since come back strongly this year and reclaimed some ground. However, we expect issuers and sponsors to continue to tap both markets, depending on their circumstances and motivations, including pricing and deal economics, flexibility of structure, and time to execution. (See "Credit Trends: Public-To-Private Borrowing Is A Two-Way Street", published May 7, 2024.)

Financial Covenants And Impact On Recoveries

In S&P Global Ratings' view, loans structured with financial maintenance covenants recover higher than those without, given similar capital structure and business prospects. In the former, lenders can intervene to tighten loan terms or technically trigger a default before operating performance deteriorates more substantially. In our recovery ratings methodology, we assume borrowers with maintenance covenants breach them on their path to default and must pay a higher spread or fee to compensate lenders for increased credit risk. The incremental borrowing costs lead to an earlier assumed default at higher EBITDA and enterprise value, which prevents further leakage of enterprise value and helps preserve lender recovery prospects.

This hypothesis is borne out in two empirical studies we did of companies that emerged from bankruptcy. We found that covenant-lite loans had an average recovery rate 11 percentage points below that on covenanted loans and a median recovery rate 34 percentage points below. (See "Settling For Less: Covenant-Lite Loans Have Lower Recoveries, Higher Event And Pricing Risks", published Oct. 13, 2020, and "Lenders Blinded By Cov-Lite? Highlighting Data On Loan Covenants And Ultimate Recovery Rates", published April 12, 2018.)

We also reflect higher recoveries for loans with financial maintenance covenants in our CLO rating methodology. If a loan has a recovery rating from S&P Global Ratings (which most do in the BSL universe), the recovery rating takes into account financial maintenance covenants and may be lower for covenant-lite loans. For loans that don't have an S&P Global Ratings recovery rating, which describes most of the loans in middle-market CLOs, recovery assumptions used in the CLO analysis are lower for covenant-lite loans.

Maintenance covenants in loan structures

We reviewed a vast majority of the credit agreements for which we provided credit estimates last year. More than 90% had some form of financial maintenance covenant, the most common being leverage-based. When a second financial maintenance covenant was present, it was a fixed-charge coverage ratio. Lenders likely want to keep a pulse on a company's ability to service fixed costs, especially when benchmark rates are at a 15-year high.

For many distressed issuers, lenders also want to keep track of cash balances and ensure issuers proactively address liquidity concerns. Consequently, liquidity covenants were tested monthly or bi-weekly. These lenders typically require the submission of 13-week cash flow projections.

We observed a negative relation between the size of the companies and the prevalence of maintenance covenants. We broke out the presence of maintenance covenants by debt size (Chart 1). The inclusion of maintenance covenants remains strong (more than 95%) until debt reaches about $350 million, then starts to decline gradually. For the largest deals in our study (more than $1 billion), only 39% still had a maintenance covenant. Overall, the percentage of entities without a maintenance covenant across the credit-estimated companies is less than 10%.

Chart 1

Comparison Of Select Provisions In Private Credit And BSL Documentation

For 22 entities that moved from BSL to private credit, we reviewed select provisions from their respective credit agreements from the two markets. These loans are now held in middle market CLOs that private credit managers issue and we rate.

In addition to the financial maintenance covenants, the other provisions we reviewed included EBITDA definitions and guardrails around asset transfer.

We noted that of the 17 syndicated loan market credit agreements, which were covenant-lite previously, eight required a financial maintenance covenant on moving to the private credit market, indicating the relative negotiating strength of private lenders. The covenant was for the most part leverage (debt to EBITDA) and, in the remaining cases, fixed-charge coverage.

EBITDA Addbacks In Loan Agreements

The typical EBITDA definition in credit agreements includes an array of addbacks, including restructuring charges, acquisition costs, transaction expenses, stock compensation expenses, severance costs, earn-outs, losses from discontinued operations, and a broad definition of nonrecurring expenses. EBITDA definitions in most credit agreements also allow for cost savings and synergies that an issuer can expect to realize coming out of mergers and acquisitions, buyouts, etc. Credit agreements generally cap the amount that can be added under this bucket. More aggressive credit agreements don't cap the addbacks, providing borrowers with unbounded flexibility to add back anticipated synergies and cost savings. Over and above calculation for financial maintenance purposes, EBITDA is also used in the calculation of incurrence ratios and to set capacities under various other negative covenants.

EBITDA calculations for S&P Global Ratings

To be clear, EBITDA used in our ratings and credit estimates analysis is based on our view of a company's EBITDA regardless of how they are defined in credit agreements. In our reviews, we determined that issuers/sponsors are a lot more aspirational in their forecast of synergies and cost savings. (See "Adding Up: EBITDA Addback Study Shows Moderate Improvement In Earnings Projection Accuracy", published March 27, 2024.) However, EBITDA, as defined in loan credit agreements, is applied in the calculation and sizing of various baskets. Hence, an open and broad definition of EBITDA poses more potential risks, given the flexibility for issuers and sponsors for additional borrowings, payment to subordinate debt, and other applications that dilute recovery prospects for senior lenders.

For these 22 companies before transitioning to private credit, eight of their syndicated loan credit agreements did not cap anticipated cost savings that could be added back to agreement-defined EBITDA. Seven of them were also covenant-lite and did not issue covenant compliance certificates. This makes it that much more challenging for BSL investors to know the likely magnitude of EBITDA addbacks and the potential flexibility it provides under other baskets or when an issuer effects a transaction. When the entities transitioned to private credit, synergy and cost saving was capped in all but one case. In that instance, the deal dispensed with the EBITDA-based covenant and switched to a liquidity covenant when it moved to the private credit market. There was one deal that did have a cap for cost saving but got rid of it when it moved to private credit.

The median cap for the loans that transitioned was 30%, and the range of addbacks was between 10% and 35% for private credit. However, among BSL credit agreements, which had a percentage cap for addbacks, the overall median EBITDA addback percentage was 25%.

Asset transfers to unrestricted subsidiaries and other non-guarantor subsidiaries

In the syndicated loan market, some distressed issuers have utilized unrestricted subsidiaries to transfer or "drop down" assets from their loan groups. Unrestricted subsidiaries are generally not required to comply with the covenants of the credit agreement and do not provide guarantees and security. Consequently, the assets transferred to unrestricted subsidiaries are removed from the collateral package backing existing loans. These assets are then pledged as collateral for new funding incurred by the unrestricted subsidiary to address the company's liquidity needs.

Most commonly, the transferred assets are intellectual property, which lends itself to flexibility in valuation. The transfer of assets out of the existing loan group to the unrestricted subsidiary can be accomplished either by an actual transfer or by designating a restricted subsidiary that owns such assets as an unrestricted subsidiary (in either case, using flexibility under the credit agreement allowing such an action).

Historically, such financings have mostly been in the BSL universe. Recently, however, a high-profile drop-down financing involving a transfer of intellectual property occurred in the private credit market. Our understanding is that this transaction also involved a variation sometimes seen in such financings. The assets were transferred not to an unrestricted subsidiary but instead to a non-guarantor restricted subsidiary--a subsidiary not required to provide a guarantee or security but otherwise generally bound by the covenants of the credit agreement. As in the case of an unrestricted subsidiary, the new debt raised by the non-guarantor restricted subsidiary (and backed by the newly transferred assets plus any of its existing assets) will be structurally senior to the existing debt.

A drop-down to a non-guarantor restricted subsidiary might be the lesser of two evils compared to a drop-down to an unrestricted subsidiary, but such transactions could nevertheless impair the recovery prospects of existing claims.

Before and after the J. Crew deal

Following the much-discussed J. Crew Group Inc. drop-down financing in late 2016, some lenders began including in their credit agreements "J. Crew blocker" provisions that restrict the ability of borrowers to remove material intellectual property from the loan group using unrestricted subsidiaries and, in some cases, other non-guarantor subsidiaries. We reviewed the 22 credit agreements in our samples from the BSL and private credit markets for such blockers and certain common components of those blockers. (The strength of such blockers ultimately varies from agreement to agreement based on other factors as well, such as how they are drafted and any exceptions.)

Among the 22 BSL credit agreements, 10 were executed before 2018 and the heightened market awareness of drop-downs following the J. Crew financing, so it is likely that none considered such a transaction. Six of the 12 agreements executed after the J. Crew financing included a blocker. One of the six had a restriction on transfers of material intellectual property to an unrestricted subsidiary. Four restricted such transfers as well as the ability of the borrower to designate a subsidiary that owns material intellectual property as an unrestricted subsidiary or the ability of an unrestricted subsidiary to own such intellectual property. Of these four, one also incorporated restrictions on the transfer of material intellectual property to a non-guarantor restricted subsidiary. One agreement formulated the blocker as restricting ownership of material intellectual property by an unrestricted subsidiary.

For the six borrowers under post-2017 BSL credit agreements that did not include a J. Crew blocker and then transitioned to refinance in the private credit market, the private market credit agreements of five added a blocker. The sixth removed the concept of unrestricted subsidiaries. Overall, 18 private market credit agreements include a blocker, and 17 include an unrestricted subsidiary concept. Of the latter, 14 include a blocker, and seven of the 14 restrict the transfer of material intellectual property to unrestricted subsidiaries and also restrict the ability of the borrower to designate a subsidiary that owns such intellectual property as an unrestricted subsidiary or the ability of an unrestricted subsidiary to own such intellectual property. The other seven of these agreements also include restrictions applicable to non-guarantor restricted subsidiaries.

Of the remaining five agreements without an unrestricted subsidiary concept, one includes a restriction on transfers of material intellectual property to a non-guarantor subsidiary, and two include both such a restriction and a restriction on the ability of a non-guarantor subsidiary to own material intellectual property. One of the five agreements formulates the blocker as restricting ownership of such intellectual property by a non-guarantor subsidiary.

Private Credit: PIK And Extension To Address Liquidity Challenges

The taxonomy of defaults for credit-estimated private credit entities borrows from our rated universe. A credit estimate of 'd' corresponds to a general payment default such as bankruptcy or missed payment across the capital structure. An 'sd' (selective default), on the other hand, is at the issue level and where there is a breach of the original promise of payment. The issuer executes a distressed exchange to avoid a traditional default. There is no adequate and offsetting compensation for the lender for such a breach. Examples of 'sd' are a below-par exchange or amend-to-extend transaction, deferral of interest, or postponement of scheduled principal payments.

As of the end of June 2024, the private credit-derived default rate, which is based on the 'd' and 'sd' credit estimates, stood at 4.57%. This may be different from other default rate citations because of different methodologies and sample considerations adopted by other institutions that provide this metric.

Last year, selective defaults ticked up significantly. Instances of selective default rose from 83 in the last 12 months ended in June 2023 to over 100 in the same period ended in June 2024. The uncertainty around the direction of the interest rate environment and the divergence in valuations reduced asset sales and, therefore, sponsor exits. Issuers thus executed amendments to push back their near-term maturities.

Further, high debt servicing costs put significant pressure on the liquidity of companies leading several of the challenged ones to get a reprieve via conversion of their cash interest payments to a partial or full PIK. Unsurprisingly, the two primary drivers of selective defaults were cash interest conversion to PIK (69%) and maturity extensions (41%), with some transactions doing both.

Issuers and lenders have different motivations for negotiating a particular PIK structure: one that suits an issuer's business model, accommodates a transaction or waiver, supports during a macroeconomic environment, or typically one that helps through a distress situation. Depending on the motivation and circumstances of the issuer, we classify PIK payments into four categories:

The structure allows PIK from the onset, which gets exercised (typically recurring revenue deals).  In these agreements, especially those drafted for middle market companies with a recurring revenue-based business model and maintenance covenant, the business thesis is predicated on high upfront investments toward customer acquisitions, growth, and business development to scale to a critical mass of customers. As a result, in most cases, such interest deferral is permitted until a "conversion date" (the "pre-conversion" period wherein a company is anticipated to scale up)--i.e., when the maintenance covenant test flips from leverage based on recurring revenue to EBITDA.

The structure provides an option to PIK (but may not get exercised).  Since 2023, we have seen a pick-up in deals that provide the option to PIK a portion or the entire applicable margin. The interest is deferred for a limited duration (usually the first two years) as issuers see some benefits to the buffer this optionality will provide with the current high interest rate environment. Despite the availability of this option, several credits haven't exercised it mainly due to sufficient operating cash flow or available on-balance-sheet liquidity. In contrast to the broader credit estimated universe with a median EBITDA of $35 million, these credits have median EBITDA of $78 million, pointing to the relatively larger entities offered this option. We also note limited sectoral themes and believe it is issuer-specific.

PIK over and above cash pay.  In a limited number of agreements, PIK interest is in addition to cash interest. In a couple of them, the additional PIK was either used to sweeten a highly leveraged buyout, to deter against higher leverage (where PIK is added only to the highest pricing slab by leverage tier), or as increased economics in exchange for a covenant reset. Further, because these are either a part of the original terms or added over and above the cash pay rate, the issuer with such loans is not considered to be in selective default.

Instances recently also include a delayed-draw term loan facility to fund interest payments on the funded term loans and revolver draws for a limited duration. None of the above are categorized as a selective default because the issuer's option to PIK the entire interest, or a portion of it, is part of the original terms.

PIK to address distress.  Among all the types of PIK structures we reviewed in the last few years, the most common address liquidity stress arising from operational underperformance coupled with rising benchmark rates. These are typically distressed entities that execute amendments to defer interest payments either partially or in full. These generally constitute a selective default because these terms are granted to help avoid a near-term default and because there is a breach in the original terms of payment and, in our view, an absence of adequate and offsetting compensation.

We reviewed nearly 100 entities that executed amendments to convert their cash pay to partial or full PIK payments within our credit estimates from the start of 2022. (Some of these issuers paid in kind multiple times.) The duration of the PIK period varied. The median duration of PIK was four quarters, with the average slightly higher at five quarters. Instances where companies could PIK until maturity drove up the median and average.

In some instances, the company was allowed to PIK not for a specific time but until a particular condition, typically a liquidity threshold, was met. Full cash interest pay resumed at a minimum dollar value of liquidity or other credit performance metric. The primary difference between these distressed PIKs and the third category of PIK (over and above cash pay) is that in these cases, cash interest paid is being reduced, which is a breach of the original promise.

In several instances, sponsors contributed equity financing to address liquidity issues, including guaranteeing liquidity if it drops below a minimum certain threshold. In some instances, the sponsors suspended their management fees.

A handful of the companies utilized PIK as a form of bridge. They would PIK multiple times consecutively to bridge the time gap until it executed a broader and more fulsome amendment. In others, there was recidivism in which the companies would PIK for a short time, resume full cash pay, and then return, typically a year later, to PIK.

The median EBITDA of all credit estimates updated in 2023 was approximately $35 million. In contrast, the median EBITDA for the companies that used PIK out of necessity was close to $17 million, underscoring the financial distress these companies face. That said, we don't find a strong relationship between entity size and its performance, reflected by a downgrade of credit estimates.

Flexibility In Market Dynamics

Given the buy-and-hold nature of private credit deals, it is only logical that lenders will want better protections in their lending documents. Further, given the relatively small base of lenders and the relationship-based nature of the market, private credit deals may be unlikely to engage in some forms of liability management transactions such as priming, impairing a select subset of senior lenders.

This market is constantly evolving with more opportunities for private credit lenders as banks continue to retract from lending. Market dynamics have already resulted in some flexibility that private credit lenders provide, such as a higher prevalence of larger entities without financial maintenance covenants and the ability to reclassify incremental loans. (See "Common Themes In Middle-Market Credit Agreements", published July 6, 2022). As the asset allocation for private credit widens, more private credit lenders will likely compete for deals. This could shift the dynamics of power and negotiating leverage to the borrower's side, which in turn could have the effect of eroding some document provisions.

While documentation in certain portions of the private credit market may begin to resemble those of BSL markets, for broader private credit market loan documentation to shift to BSL-type credit agreements, the structure of the market needs to change significantly, the least of which would be the availability of a dynamic secondary market as an exit option for lenders.

Related Research

• Credit Trends: Public-To-Private Borrowing Is A Two-Way Street, May 7, 2024
• Adding Up: EBITDA Addback Study Shows Moderate Improvement In Earnings Projection Accuracy, March 27, 2024
• Common Themes In Middle-Market Credit Agreements, July 6, 2022
• Settling For Less: Covenant-Lite Loans Have Lower Recoveries, Higher Event And Pricing Risks, Oct. 13, 2020
• Lenders Blinded By Cov-Lite? Highlighting Data On Loan Covenants And Ultimate Recovery Rates, April 12, 2018