The critical role of covenants in Private Credit

While breaching a covenant can have serious consequences, they are designed primarily to be deterrents to certain types of risk taking by borrowers and as tools for risk management.

The primary function of covenants is to protect lenders by ensuring borrowers adhere to agreed parameters. When a borrower diverges from these terms, lenders can intervene to renegotiate and restore compliance. This process is crucial for maintaining the stability and performance of the underlying asset or business.

The effectiveness of covenants as relevant and actionable risk management tools depends on how well they are tailored to the specific industry and financial conditions of the borrower. Different industries require different approaches to covenant customization. For example, the financial metrics used to monitor a borrower in the industrial sector should differ from those in the real estate or technology sectors. Moreover, the regular, detailed financial reporting that monitors sector-specific KPIs – typically on a monthly or quarterly basis – associated with tailored covenants allows lenders to track compliance and to respond quickly to any potential issues.

Covenants often come into play well before any formal breach occurs. Lenders use them to initiate discussions with borrowers about potential issues, allowing for early interventions that may prevent small problems from becoming larger ones. This proactive approach is especially valuable in a market where trading loans is not a tool that lenders can use to mitigate risk.

In the private credit market, where trading out of a loan is difficult, covenants are an essential risk management tool that allow lenders to recalibrate if things go off track. At O'Connor Capital Solutions (“OCS”), we emphasize the importance of covenants for effective risk management.

Another way to look at the importance of covenants is to see what happens to the severity of defaults (i.e., recovery rates) as covenants go away.

The charts below look at defaults and recoveries in the High Yield/Broadly Syndicated Loan markets, comparing annual and 25-year annual average metrics. Despite recent default rates remaining stable relative to historical averages, the severity of defaults has increased significantly with recovery rates plummeting in recent years. We believe the lack of covenants in these markets (where >90% of the deals are "covenant lite") is the primary driver of these materially lower recovery rates.

High yield bond default and recovery rates

Leveraged loan default and recovery rates

There is no one-size-fits-all approach to private credit covenants. However, lenders who implement covenants that are closely tailored to the borrower’s base case gain more effective tools for monitoring and managing risk. By customizing covenants to fit each borrower’s unique situation, lenders can better adapt to changes with the goal of ensuring the long-term success of their investment portfolio. As market conditions evolve, so too should the covenants that protect lenders’ interests.