The loan market continues to evolve, and recent trends in loan covenants reveal significant shifts in how lenders and borrowers navigate risk and protection. According to the LSTA’s report on Loan Market Covenant Trends for the third quarter of 2024, several changes in covenant structures are making headlines, particularly in the private credit markets. Here’s what you need to know. Preferred Equity Financing: A Growing Trend One of the notable developments discussed in the report is the increased use of preferred equity financing as part of Liability Management Transactions (LMTs). This financing approach allows borrowers to raise priming debt through preferred equity at restricted subsidiaries, which traditionally have been seen as non-threatening to senior lenders. This tactic provides borrowers with more flexibility, but it also raises concerns for lenders, as it can sideline senior debt holders and create added risk. With more money chasing limited deal opportunities, the use of such instruments could become a more common trend in future LMTs. The High Water Mark Feature Another significant covenant feature making its way into loan agreements is the high water mark construct. This allows borrowers to use their highest historical EBITDA to determine basket capacities, rather than basing these calculations on current earnings. While this can provide borrowers with more borrowing capacity and flexibility, it poses substantial risks to lenders by disconnecting basket sizes from the borrower’s actual current financial health. Such provisions can give a false impression of a borrower’s ability to repay, potentially leading to higher exposure for lenders. Payment-in-Kind (PIK) Optionality The Payment-in-Kind (PIK) feature is also becoming more prevalent. PIK allows borrowers to capitalize interest payments, meaning instead of paying in cash, they add the interest to the principal. This option provides financial relief for borrowers during times of financial distress, allowing them to preserve cash flow. However, this comes at a cost to lenders, who receive deferred payment and face an increased risk if the borrower’s financial health does not improve. What These Trends Mean for Lenders and Borrowers The emerging covenant trends reflect a market where borrowers have greater leverage, often at the expense of traditional lender protections. The move towards more flexible and borrower-friendly covenants, such as preferred equity financing and high water mark provisions, represents a shift in the balance of power. For borrowers, this is positive news as it provides more breathing room and financing options. For lenders, however, these trends increase the need for diligent risk assessment and negotiation to ensure adequate protections remain in place. As we move forward, lenders and borrowers alike must be vigilant. Borrowers should explore the opportunities these flexible structures provide, while lenders need to carefully assess the long-term implications of loosening traditional covenant protections. For a more in-depth analysis of loan covenant trends in Q3 2024, you can visit the LSTA website.