Covenant breaches trend upward as GPs navigate uncertainty – Lincoln report

Financial covenant breaches are an area of concern for private equity firms and their portfolio companies as they face continued market disruption and volatility this year, a report from investment bank Lincoln International has found.

Of the 719 PE-backed companies in its database in Q4 2022, 4.2 percent are dealing with covenant breaches, rising from 3.7 percent in Q3 and 2.5 percent at the beginning of 2022. However, these figures remain below peak levels seen during the pandemic.

“It’s a steady progression and I would expect Q1 2023 to tick upwards as well because changes in EBITDA due to inflation would be cumulative over four quarters,” Richard Olson, a managing director in Lincoln’s valuations division, told Private Equity International. “We’re still not at the level [we saw] during the pandemic. It’s still a comparatively low number, but it is creeping up.”

Olson added that debt maturity is another concern for sponsors. “Given that 2021 was such an extraordinary year for M&A volumes, the bulk of these new deals will mature five to seven years in the future.”

The deals Olson was most concerned about would be those with debt maturing in the next year or two. Factors that GPs need to think about include the interest expense they are currently paying, the leverage multiple available when those deals were originally struck, and what those companies can support now.

Data from Lincoln’s European Private Markets Insight: Q4 2022 shows that interest expense is increasing. As an illustrative example, a standard €50 million EBITDA business that closed on 31 December 2021 – all things being equal – would see its interest expenses for the same amount of debt rise by two-thirds in December 2022.

“[That means] a company that started off paying 5.5 percent interest is now paying over 9 percent interest. As a result, companies are getting very creative about deal structuring to conserve cash while delivering adequate returns to PE sponsors,” Olson added.

As near-term deployment moves slower this year than in prior years, there appears to be growing creativity among advisers and sponsors in terms of cash conservation and deferred pay-outs to sellers, Olson said.

“You’re seeing some creativity in terms of the structuring on the debt side to conserve cash – for example, holdco/opco structures with more non-cash payment-in-kind interest… You’re seeing more flexibility on the part of funds to facilitate NAV lending, which can enable follow-on investment into portfolio companies or distributions to limited partners, without selling companies in a slower M&A market.”

Deal processes are taking longer, but advisers are coming at them with all of their tools and most creative solutions, noted Olson. “It’s going to look different this year in terms of how deals get done, but we’re certainly seeing dealflow opportunities.”