Why covenants matter: Safeguarding investor interests in private credit
Matthew Darrah, Head of Underwriting, Principal Alternative Credit, defines the role of covenants in direct lending, including how they provide early warning signals, drive sponsor support, and enhance outcomes compared to covenant-lite structures.
- Covenants give lenders the right to engage with a borrower before problems reach the point of a payment default.
- When a borrower breaches a covenant, lenders can use the intervening period to understand the business, develop a recovery plan, and prepare for a restructuring if necessary. Without covenants, that window does not exist.
- Multiple maintenance covenants provide a more complete early warning system than a single covenant, capturing different forms of stress.
- Covenant breaches often act as a catalyst for private equity sponsors to inject additional equity or liquidity support, strengthening the borrower’s position and protecting lender capital.
- Covenants enhance lender oversight by enabling access to more frequent reporting, operational insights, and direct engagement with management, supporting more informed decision-making during periods of stress.
Covenant-lite structures can leave lenders reactive rather than proactive, as they typically provide no mechanism for engaging with a borrower until a payment default occurs, often when financial deterioration is already severe, and recovery options are limited.
Financial maintenance covenants, such as leverage and fixed charge coverage ratios, serve as structured, recurring health checks on a borrower’s performance, giving lenders defined triggers to step in early and actively work with ownership to stabilize the business.
Although covenant-lite lending has become more common in larger transactions due to competitive pressures, borrower size does not eliminate risk, and covenants remain a critical tool for consistently protecting investor interests across market segments.
To learn more about how covenants can drive sponsor support, improve recovery outcomes, and create opportunities for enhanced lender economics and oversight during stressed situations, download Why covenants matter: Safeguarding investor interests in private credit
If you have questions about how Direct Lending investment solutions can fit into your clients’ investment approach, ask an expert on our team.
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When evaluating private credit, advisors should look carefully at the composition of their portfolio and consistency of their approach through market cycles, especially in periods when pressure to accept weaker terms is acute.
Four questions are worth asking:
- Does the manager require financial maintenance covenants on every deal? If not, what share of their portfolio is covenant-lite?
- Diversification objectives: Does the manager typically require two covenants rather than one?
- Has that approach been maintained through periods of intense competition?
- What does the manager’s track record look like when covenants have been breached?
Risk considerations
Past performance is no guarantee of future results and should not be relied upon to make an investment decision. Investing involves risk, including possible loss of principal. Private market investments, unlike publicly traded stocks, involve various risks due to illiquidity, lack of transparency, and higher minimum investment requirements. These risks include liquidity risk, market risk, capital risk, and regulatory risk. Additionally, private market investments often involve higher fees and expenses and may have longer investment horizons. Infrastructure investments are long-dated, illiquid investments that are subject to operational and regulatory risks. Infrastructure companies are subject to risk factors including high interest costs, regulation costs, economic slowdown, and energy conservation policies. Asset allocation and diversification do not ensure a profit or protect against a loss. The risk management techniques discussed seek to mitigate or reduce risk but cannot remove it.
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