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When assessing direct lending strategies, investors should not neglect the investment risks particularly toward the end of an economic cycle.

During the last 10 years, valuation multiples gradually increased with the expansion of the economic cycle. In turn, sponsors steadily pushed leverage levels up in line with pre-GFC peaks to compete in sales processes and meet valuation expectations. Even though leverage levels were steadily increasing in line with valuation multiples, sponsors increased their equity cheque at a faster rate over the period. Hence, the cash equity cushion below the debt in the capital structure typically remained in excess of 45%, in line with post-GFC figures.

Key terms such as “covenant headroom” and “EBITDA adjustments” are gaining importance in borrower-friendly environments. The importance of data as well as deeper analysis of direct lenders’ term sheets and financing structures is critical to understanding the genuine risk profile investors are taking. Covenant headroom can be compared to a margin for error granted to borrowers when defining the covenant level. It is formally the relative difference between the level of a financial metric at origination and the agreed covenant level.

In most cases, covenant headroom decreases over time, as covenants tend to be stricter over the life of the loan. EBITDA adjustments, or the practice of taking credit for cost savings and other pro forma adjustments, became popular in the past few years. By overestimating a company’s profitability, these adjustments skew the valuation calculus, making companies seem less expensive than they really are. In turn, it becomes much easier for a sponsor to lever up the company. While private equity sponsors have become more creative in how they define EBITDA, direct lending GPs (and co-investors) must rely on a quality of earnings report. Published by reputable accounting firms, these reports help the sponsor and lender determine which adjustments should be added back to EBITDA and which should be excluded.