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The significance of covenants in turbulent market conditions

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Christopher Godfrey - featureWhat is the significance of covenants and how should we be monitoring them? How could they be affected by the volatile market and geopolitical conditions? Christopher Godfrey, President of CEPRES Corp, join us for an exclusive interview and puts covenants under the spotlight.

Given your nearly two decades in private markets, you are no doubt well versed in covenants. While loan to value ratio is an effective measurement tool, what other ways do you believe LPs and GPs should be measuring covenants?

The fundamentals of the market have been moving in a positive direction on loan to value. In today’s market, investors should focus on the fundamentals of the companies in which they invest around revenue growth, profitability and cash. A covenant based on debt to EBITDA ratio, which dictates how much coverage there is to pay the debt from the income of the company, is far more relevant today. If a company is not realising sufficient profit to cover the debt, then of course they will eventually default. Worryingly, over the past decade the debt to EBITDA ratio has been going up, which is a negative. The median ratio has increased 30 percent or more over the last 10 years, which is quite troubling.

What ways do you believe GPs can best communicate the need for a covenant to their LPs?

In 2007, the year before the global financial crisis, private debt deals had the lowest pooled returns ever. Immediately following the onset of the GFC, transactions were sparse across the board, but deals got done in private credit. Because the rest of the credit markets had dried up, the private credit providers, the GPs, were able to negotiate deals with strict lending criteria and strong covenants combined with good pricing and equity kickers. As a result, 2009 realised the highest-ever returns for private credit. Investors are worried about the same pattern occurring and will be open to ways to mitigate any downside risk and be ready for the upside.

While it has been a very positive environment recently for private equity and for private debt, LPs are telling us they are concerned about liquidity risk with the uncertainty in the current market. Given private credit is an income generating strategy, this uncertainty provides an opportunity for GPs to showcase how covenants help reduce the risk profile of investments, resulting in lower losses and better risk management. That is a powerful combination. In the event of a market slump, provided they are able to maintain their discipline, private debt GPs would be in a very strong position. I think the opposite is true for any GP promoting more relaxed credit criteria and covenants. LPs are going to be concerned with such an approach, and rightly so.

We have been hearing for some time that we are in the seventh or eighth inning of the current cycle. How does this level of uncertainty impact covenants?

This certainly is a time for maintaining robust credit criteria and covenants, and carefully monitoring the companies being financed. Of course, there are cases of disruptive businesses that are to some degree immune to downturns or otherwise countercyclical. For these companies, given their positive growth prospects, a GP could perhaps have a more relaxed lending approach. But when it comes to financing most assets today, it is important to maintain strict adherence to covenants, to credit criteria, to exercise even more caution than you might otherwise. Discipline is key. I think this should be viewed as a positive, not a negative.

You are responsible for serving CEPRES’ North American clients. With the approaching U.S. presidential election, what are your clients’ concerns, if any, and what advice are you providing to help them prepare for a potential change in administration? How does this impact covenants?

For me personally, as 'an Englishman in New York', who made his own 'Brexit' some years ago, it offers an interesting perspective on both sides of the Atlantic. As we know, the U.S. and the U.K. (and many other countries) are in the midst of some social and political turbulence. I think for professionals in our market, including institutional investors and fund managers, the raw politics is mostly noise and unfortunately entertainment. The real concern is the economic and trade policies of administrations on both sides of the Atlantic. Nationalist tendencies, trade wars and tariffs, and of course Brexit, are fostering significant uncertainty and volatility in the stock markets, in the credit markets, in inter-bank lending and elsewhere. This uncertainty is impacting institutional investors of all types including pension plans, insurers, endowments, etc., and the individuals they serve. I think politicians in the United States and elsewhere are playing a very high stakes game that will have potentially massive consequences around world.

Regarding covenants, I think it is important to determine whether, or to what extent, a company is going to be influenced by the international situation and by market turbulence. For example, it used to be a positive for businesses to sell their products into other countries, to have a global footprint. Today, exposure to international markets could prove to be a negative caused by political interference. We've definitely seen that in the U.S. and in the U.K. In the latter, for example, the exchange rate has made it very expensive to buy parts from abroad. In the U.S., the administration’s tariffs have led to business closings. These are issues of which GPs financing companies need to be aware. They need to be making sure that the businesses in which they’re investing can maintain their growth, their cash flow, their EBITDA, to support the debt they’re taking on. These fundamentals are going to be key over the next few years.


Under the spotlight: Christopher Godfrey

Chris is a President at CEPRES, heads the New York office and is responsible for North American clients. Prior to CEPRES, Chris worked with Secondcap, Burgiss and Investran and has a long career driving transformational technology in finance working with JPMorgan Chase, Hewlett Packard, Amercian Honda Finance and The Wellcome Trust. Chris graduated from the Russell Group, University of Leeds with a BSc honours degree in Physics & Astrophysics. 

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