Direct lenders are starting to ask for “Pluralsight Protection” when negotiating new deals to head off a repeat of the standoff this summer between private credit firms and financial sponsor Vista Equity Partners over ailing portfolio company Pluralsight.

The request comes even as the private credit market moves towards more looser covenant packages and pricing reminiscent of the broadly syndicated lending market amid intense competition by direct lenders to win business, according to direct lending executives and attorneys who advise on deals.

Pluralsight made headlines when Vista threatened a liability management exercise that would have impacted Ares Management, Blue Owl Capital, Goldman Sachs, Golub and other direct lenders that funded the buyout of the technology learning platform.

Vista injected preferred equity into the company through a drop-down transaction that moved the company’s intellectual property to a restricted subsidiary, a negative move for the lending group that iterated off an infamous IP transfer executed by retailer J. Crew eight years ago.

While the group of Pluralsight lenders ultimately took the keys to the company and Vista never moved the assets out of creditors’ reach, the aggressive drop down has some private credit lenders asking whether other sponsors will follow Vista’s lead and attempt more liability management exercises in the future.

Saving the crown jewels

“Direct lenders are focused on the issue of collateral leakage–they want to ensure borrowers cannot bypass existing J. Crew blockers by moving important assets to a non-guarantor restricted subsidiary and then using preferred equity to avoid the debt caps,” said Paul Hastings partner Jennifer Daly.

In the wake of the 2016 J. Crew deal, lenders started insisting on so-called J. Crew blockers to prevent companies from moving IP and other crown jewel assets out of the reach of creditors into unrestricted subsidiaries. New blockers named after companies like PetSmart/Chewy and Serta Simmons Bedding soon emerged to stop other creditor negative events.

Pluralsight shows that under some debt documents, a company can transfer assets to a non-guarantor restricted subsidiary, raise preferred equity from the sponsor (rather than debt) and dividend proceeds back to the company, Daly said.

“Some lenders now are saying let’s see if we can prevent that from happening in our deals,” Daly said.

Another attorney who works on private credit deals cautioned that while lenders are asking about Pluralsight protection, there are still questions about what exactly this would entail and whether it should be an expansion of the J. Crew blocker.

“People are always trying to circumvent the other precedent – in J. Crew they moved the IP, so in the next deal if you can’t move the IP because of the blocker you will move the headquarters,” he said.

Though not everyone in the market is colloquially referring to additional protection around the use of preferred equity and the moving of assets as a “Pluralsight Protection,” conversations about how to prevent similar scenarios are taking place as it represents another form of credit leakage, said Damian Ridealgh, head of US private credit and capital solutions at Freshfields.

The market is still figuring out what the protections should look like and how to balance what the lenders want against any flexibility the borrower needs to operate effectively, Ridealgh said. He noted talks are focused on what counts as a material or key asset and putting limitations and caps on moving assets into non-guarantors. For example, while IP is often key for technology and retail companies, for other businesses, IP may not be that valuable compared to other assets.

“Whether you can get the sponsor to agree to protections against a Pluralsight-like scenario is really a question of A- how much investment capacity the borrower has to transfer assets to non-guarantors, combined with the aggregate amount of structurally senior debt that non-guarantors are permitted to incur and B- what flexibility does the company really need, what assets are critical to the business,” Ridealgh said.

In a competitive market, sometimes private credit firms that want the best airtight credit agreement and documents are left with no deal flow, said the second attorney, who asked to speak not for attribution.  “You have the best document with all the protections but nowhere to deploy your money,” he said.

Blocked blockers

With a lull in the number of M&A transactions and a reopened broadly syndicated loan market, direct lenders are competing with each other and the BSL market over the few deals available, said Stephanie McCann, a partner at law firm McDermott Will & Emery focused on corporate finance.

While lenders may want tighter documentation and the inclusion of something like a Pluralsight blocker, market dynamics are preventing private credit firms from upholding the standards they like.

An executive at a large direct lender said they had seen peers give up protections like the J. Crew blocker to win a deal. If a lender refuses to give up a blocker, they essentially commit to not doing deals with certain sponsors, noted a second direct lending executive.

These days, it is more common to only get one covenant on a direct lending deal because competition has swung power back to the borrowers, the second direct lender said. Especially on a large deal with at least USD 100m in EBITDA, lenders will take a cov-lite deal and make additional concessions to the sponsor. The second direct lender said he has seen deals without a J Crew or Petsmart blocker in the documentation.

Some direct lenders give up what were once standard protections, believing that it is better to lend to larger, healthier companies with fewer protections than to lend to smaller, riskier companies that are willing to agree to tighter documentation and desired protections, the first lender explained.

The number of financial covenants for middle market deals involving companies with an EBITDA range of around USD 10m to USD 60m, has also declined, according to a Private Credit 2Q report from investment bank Configure. The bank, which looked at its own deal data, noticed the percentage of deals with just one covenant rise increase from 6.7% for the first quarter to 33.3% for the second quarter.

Deals with three covenants and four covenants–accounting for a third and 6.7% of deals in the first quarter, respectively—disappeared entirely in the second quarter. Configure also noted in its report that the percentage of one-covenant deals in the second quarter surpassed the high of 25% seen in full-year 2022 data.

Even if the documents are tight, it is difficult for lenders to eliminate the ability for the sponsor to pull a liability management transaction, which may leak value from the senior lender, said Michael Handler, a partner in law firm King and Spalding’s restructuring practice.

Ultimately, Handler said the relationship between the sponsor and the lenders—the fact that the lenders know each other and often have relationships prior to the deal—remains one of the greatest protections from liability management transactions spreading to the private credit space beyond one off deals.