Private Equity Report 2008 — The Covenants That Weren't There

The buyout industry entered 2008 having just completed the most aggressive lending cycle in its history, and the terms are worth stating because they explain the outcome:

• Leverage multiples had risen to levels well above prior cycles.
• Purchase price multiples had risen with them, since cheap debt is capitalised into the price paid.
• Covenants had been substantially weakened — the "covenant-lite" structure, where maintenance tests requiring ongoing compliance were removed or loosened.
• And maturities had been extended, with much of the debt not due for six or seven years.

The consensus view at the time was that this was reckless and would produce a wave of defaults when the cycle turned. The cycle turned violently. The default wave was far smaller than predicted.

The reason is the report's central and slightly uncomfortable finding.

A covenant is a trigger. A maintenance covenant requires a company to meet financial tests quarterly — a leverage ratio, an interest coverage ratio. Breaching one is an event of default, which gives lenders the right to demand repayment, renegotiate, or take control.

In a sharp downturn, earnings fall and those tests are breached mechanically — not because the business is failing but because the ratio's denominator moved. A company with tight covenants therefore defaults early in a downturn, while it is still solvent and still generating cash.

A covenant-lite structure has no such test. The obligation is to pay interest and to repay principal at maturity. A company that can pay its interest does not default, however bad its ratios look.

So the loose terms that appeared to increase risk at signing reduced the incidence of default in the downturn. They transferred control from lenders to borrowers, which is bad for lenders and good for the survival statistics.

The second finding is the archive's most repeated one: what determined survival was when the debt came due. Debt maturing in 2009 was a crisis; debt maturing in 2015 was a problem for a recovered economy.

What a covenant is actually for

The mechanism deserves precise treatment, because "covenant-lite is riskier" is true for lenders and misleading about outcomes.

Two kinds of covenant do different jobs:

Incurrence covenants restrict specific actions — taking on more debt, paying a dividend, selling assets. They are tested only when the company attempts the action. A company that does nothing never trips one.

Maintenance covenants require ongoing compliance with financial ratios, tested quarterly regardless of what the company does. They fire automatically when performance deteriorates.

What a maintenance covenant provides the lender:

• Early warning, before the company runs out of cash.
• Negotiating leverage at that early point, when the business is still worth saving and the lender can extract fees, higher margins, more security or equity.
• And control, including the ability to force asset sales or replace management.

Its cost to the borrower is precisely that it hands over control at the worst moment — during a downturn, when refinancing is unavailable and negotiating position is weakest.

Covenant-lite removes the maintenance test. The consequences follow directly:

	Tight covenants	Covenant-lite
Default trigger	Ratio breach, quarterly	Missed payment or maturity
Timing of trouble	Early in the downturn	Only if cash actually runs out
Who holds control	Lender, on breach	Borrower, until payment fails
Recovery when default happens	Higher, acted on early	Lower, more value already lost

Covenant-lite does not make a company safer. It makes default later and rarer, and — when it finally arrives — worse for the lender. The default statistics improved and the recoveries deteriorated.

Both effects were observed. Default rates on covenant-lite loans were lower through the downturn, and loss given default was higher, because by the time a payment is missed, far more value has been consumed.

The allocation implication is that these two statistics must be read together. A low default rate is not evidence of credit quality when the trigger has been removed — it is evidence that the trigger has been removed.

Maturity was the variable that mattered

The survival pattern followed maturity structure closely, and the mechanism is now familiar from four other reports in this archive.

Why leverage level is less decisive than it appears:

• A highly levered company with no near-term maturity and enough cash flow to service interest can operate indefinitely. It is uncomfortable, constrained and fragile — but it does not default.
• A modestly levered company with debt maturing into a closed credit market defaults, because it cannot refinance and cannot repay.

The distinguishing question is not "how much debt" but "when is it due, and will the market be open then."

The 2006–2007 vintage happened to be structured favourably on this measure. Long maturities were a term borrowers negotiated because credit was abundant. When the market closed, those long maturities meant refinancing was not required for years — by which time credit markets had reopened.

This was luck rather than foresight. The maturities were long because borrowers had negotiating power, not because anyone anticipated a closed market.

The "wall of maturities" that dominated commentary from 2009 onward — the large volume of buyout debt coming due in 2013–2015 — was widely expected to produce a default wave. It largely did not, for reasons covered in the Private Equity Report 2012: credit markets reopened, and refinancing at lower rates was available before the wall arrived.

The generalisable principle:

Leverage determines how uncomfortable a company is. Maturity determines whether it survives. The archive documents this in banks, in shadow credit vehicles, in venture-backed companies and here — the same finding each time.

The screening application is direct and uses public information: for any levered borrower, the debt maturity schedule matters more than the leverage ratio, and it is disclosed in credit agreements and financial statements.

The loans that could not be sold

The banking side of the buyout boom produced its own failure, and it is a clean illustration of what happens when a distribution business retains inventory.

How the model worked: a bank underwrites financing for a buyout — committing to provide the debt — then syndicates it, selling participations to other lenders and to institutional investors. The bank earns fees and holds little or nothing.

Two features made it fragile:

• The commitment is firm and made in advance. A bank agreeing to finance a deal is obliged to fund it even if market conditions change between signing and closing.
• The syndication is not guaranteed. It depends on buyers existing at an acceptable price when the time comes.

When credit markets closed in 2007–2008:

• Signed commitments still had to be honoured, so the banks funded the loans.
• The buyers had disappeared, so the loans could not be syndicated.
• The banks held them — a "hung" position, often very large.
• And they had to be marked down, since the market price for such paper had collapsed.

The consequences:

• Banks took substantial losses on assets they never intended to own, in a business they had thought was fee-based.
• They stopped underwriting new commitments, which shut the buyout market more effectively than any decline in equity appetite.
• And the hung loans were eventually sold at steep discounts, frequently to credit funds — which was the origin of a great deal of subsequent distressed and private credit fundraising, covered in the Private Credit Report 2009.

A distribution business becomes a balance sheet business the moment distribution fails. The risk was not in the assets but in the gap between committing and selling — which is a warehousing risk that the fee-based framing conceals.

The structural response was to reduce commitment sizes, add market flex provisions allowing terms to be adjusted before syndication, and shorten the window between commitment and distribution. These are direct mitigations of the warehousing exposure.

Valuations that fell less, and why

Private equity marks fell far less than public equity in 2008, and the reasons are worth separating because they were widely misread as evidence of resilience.

The genuine reasons:

• Portfolio companies were often different businesses from the public index — different sectors, different sizes, in some cases genuinely more stable.
• The valuation methodology looks through short-term dislocation, using multiples of earnings that a manager judges normalised.

The measurement reasons, which did most of the work:

• Valuation is quarterly and lagged, so a fall shows up months later, per the mark-versus-price analysis in the US Venture Capital Report 2013.
• It is performed by the manager, who has a natural preference against writing down, and is validated rather than determined by auditors.
• Comparable multiples are selected, which permits judgment about whether a distressed public multiple represents fair value or a temporary dislocation.
• And no transaction forces the issue. A public price is set by trades; a private mark is set by an opinion.

The consequence for reported statistics:

• Private portfolio volatility was understated, which fed into asset allocation models as genuine low volatility.
• Reported correlation with public markets was understated, partly because of the lag.
• And both effects made private assets look better on a risk-adjusted basis than a like-for-like comparison would support.

The honest position is that some of the smoothing is real and some is measurement, and separating them requires looking through to underlying exposures rather than relying on reported series.

The practical test is what positions actually transact at. The secondary market for fund interests provides that test, and in 2008–2009 it priced portfolios at very substantial discounts to reported net asset value — which is the market's opinion of the marks. The Secondaries Market Report 2010 covers this directly.

Where the damage actually landed

The industry's outcome from the crisis was uneven in a specific and predictable way.

Funds that had already deployed at 2006–2007 prices were damaged:

• They had bought at peak multiples, with peak leverage, into an economy that then contracted.
• Their entry price was fixed, and no subsequent skill recovers a purchase price.
• And they had limited capital left to support portfolio companies or take advantage of lower prices.

Funds that still held capital were positioned well:

• They could deploy into much lower valuations, per the vintage analysis in the US Venture Capital Report 2009.
• Competition for assets had collapsed.
• And debt, when it returned, was available on better terms relative to the price paid.

The distinguishing variable was pacing — how quickly a manager had deployed. A fund that had invested its capital rapidly in 2006–2007 was fully exposed to the worst entry point; one that had deployed slowly had capital available at the best one.

This has an uncomfortable implication for how managers are assessed:

Rapid deployment looks like conviction in a rising market and looks like recklessness afterwards. The same behaviour, evaluated at two points in the cycle, produces opposite judgments — and neither judgment is about skill.

The structural response across the industry was to formalise pacing discipline — investment period limits, deployment guidelines, and greater attention to vintage diversification by investors. The Private Markets Outlook 2016 covers how this became standard.

The additional effect on limited partners was the denominator and commitment problem described in the US Venture Capital Report 2008, which hit at the same moment and from a different direction — so the funds best positioned to invest faced investors least able to fund them.

What an allocator could act on

Read default rates and recovery rates together. A falling default rate alongside rising loss given default indicates a removed trigger, not improved credit quality.

Screen maturity schedules before leverage ratios. A highly levered borrower with no near-term maturity survives; a modestly levered one refinancing into a closed market does not.

Identify warehousing risk in fee-based businesses. An underwriting commitment that cannot be distributed becomes a balance sheet position, and the fee framing conceals the exposure entirely.

Treat private marks as opinions and secondary prices as evidence. The discount at which fund interests actually transact is the market's assessment of the marks, and it is observable.

Adjust reported private volatility and correlation upward. Quarterly, manager-determined, lagged valuation understates both, and asset allocation models that take them at face value overweight the asset class systematically.

Assess managers on deployment pacing, not just selection. Entry price is fixed at purchase and cannot be recovered by later skill, so how fast capital went out determines much of a vintage's outcome.

What 2008 established

• Covenant-lite reduced defaults and worsened recoveries, because a covenant is a trigger and removing it delays the event.
• Maturity structure, not leverage level, determined survival — the archive's most repeated finding, in a new setting.
• Underwriting commitments became balance sheet positions when syndication failed, shutting the market from the debt side.
• Private marks fell less than public prices for reasons that were substantially measurement rather than resilience.
• The damage concentrated in already-deployed vintages, making pacing the decisive variable.