Private credit is often described in terms of yield and spread. Those numbers matter, but they describe what a lender expects to earn when things go well. What protects a lender when things go less well is written in the loan documentation: the covenants, reporting requirements, collateral package and remedies agreed before the first dollar is advanced.
One of the advantages of direct lending over broadly syndicated markets is the ability to negotiate those terms directly with the borrower. That advantage only exists if the lender uses it. Documentation negotiated in a hurry, or copied from a template that does not fit the business, can leave a lender with less protection than it believes it has.
What good documentation does
- Requires timely, accurate financial reporting, so problems are visible early.
- Sets covenants that fit the borrower's business and give the lender a seat at the table before a crisis.
- Defines the collateral clearly and perfects the lender's security interest in it.
- Limits the ways value can move away from the lender, through additional debt, asset transfers or distributions.
- Provides clear remedies and decision rights if the borrower defaults.
Each of these protections is easier to secure at the start of a relationship than later. A borrower that needs capital will accept reasonable terms. A borrower in difficulty has little reason to grant new ones.
“The time to protect a loan is before it needs protecting.”
Reading for what is missing
Experienced credit teams read documents for what they leave out as carefully as for what they include. Gaps that allow a borrower to move assets beyond the lender's reach, incur debt ahead of existing lenders or weaken reporting at the worst moment have become a familiar feature of credit markets. Slate Blue Harbor's credit memorandum standard asks the team to identify these gaps explicitly and to explain, for the credit committee, why each remaining risk is acceptable.
Documentation and judgment work together
Strong documents do not replace credit judgment. A well-structured loan to a weak business is still a weak loan. But good judgment without good documentation leaves a lender relying on goodwill when it may most need rights. The combination, a borrower worth lending to and an agreement worth relying on, is what makes private credit durable through a cycle.
For the investors who provide the capital, the quality of documentation is one of the clearest signs of a manager's discipline. It is worth asking about directly.
Perspectives are general information and reflect the views of Slate Blue Capital at the time of writing, which may change without notice. They are not investment, legal or tax advice, do not describe or offer any security, fund or service, and should not be relied on in making an investment decision. See Important information.