Covenant-invisible priming in leveraged finance: The hidden risk of monetisation structures

This article examines covenant-invisible priming where groups generate immediate liquidity by converting future economic value into present cash, either through asset transfers or by delaying payment obligations, without triggering traditional covenant protections.  It identifies key risks, flags practical considerations and offers potential solutions for creditors and practitioners.

This article was first publish in the June issue of Butterworths Journal of International Banking and Financial Law.

Key Points

• Although monetisation structures may resemble asset disposals or borrowing in economic substance, they frequently escape the covenant protections that would otherwise apply.
• Covenant regimes reflect an assumption that standard liquidity tools such as receivables financings, leasing arrangements and factoring programs will not materially reallocate assets or cash flows or create priming risk for existing creditors.
• The authors propose three potential solutions some of which are already beginning to be reflected in market practice.

Introduction

Priming transactions as part of liability management exercises have increased in frequency and become a central focus of market commentary, deal structuring and litigation.  Yet the discussion has largely overlooked a form of priming that operates outside the perimeter of existing covenant frameworks.

This article examines how groups generate immediate liquidity by converting future economic value into present cash, either through asset transfers or by delaying payment obligations, without triggering traditional covenant protections, including debt incurrence, asset sale restrictions or restricted payments.  In these monetisation transactions, existing creditors are effectively primed, as either value is removed from their credit group or additional liabilities are added to the credit group, with little to no covenant protection.  The common feature across both categories is not their legal or accounting form, but their ability to alter creditor economics while remaining permitted or effectively invisible under existing covenant frameworks.  These structures often serve legitimate commercial purposes, including working capital management, supply chain financing and operational liquidity.  However, they can surprise creditors in a distressed environment meaning a company may be in more dire circumstances than previously anticipated.

In this article, we highlight this covenant invisible priming, identify the key risks, flag practical considerations and offer potential solutions for creditors and practitioners navigating these structures, reflecting a broader shift in which priming risk increasingly arises through permitted transactions rather than formal priority changes.

Pathways to Creditor Priming

In practice, five distinct pathways arise within a standard leveraged finance incurrence-based covenant package, each capable of producing a priming effect, usually without amending the existing documentation.  Each of the first four pathways has been a core focus of the liability management transactions referred to above and has been well scrutinised by the market.  The fifth, monetisation structure, has had less attention and is subject to more recent market focus.  It is essential to understand the first four to understand how the fifth differs.

• The first is contractual priming, which occurs where creditor priority is established by agreement within the credit documents, most commonly through intercreditor agreements or similar arrangements.  Priority may take several forms, including payment priority, lien priority, or priority in the application of enforcement proceeds and insolvency or liquidation distributions, a ranking commonly referred to as "super senior" debt.
• The second is effective priming (collateral scope), which arises where creditors achieve superior recovery prospects not through contractual ranking but through differences in collateral scope.  Where assets fall outside the collateral package, any creditor holding security over those assets will have priority over the general creditor group in respect of those assets, effectively achieving seniority without express contractual subordination.  This can result from negotiated collateral definitions, excluded assets or unencumbered property sitting outside the shared security package.
• The third is structural priming (entity-level priority), which operates through corporate structure rather than contractual ranking or collateral scope.  It arises where debt is incurred by a non-guarantor subsidiary, whose creditors hold direct claims against that entity's assets.  Such claims structurally outrank other creditors regardless of the priority they enjoy within their own debt structure.  Even super senior secured creditors are thereby reduced to a residual equity claim from nonguarantor entities, placing them in the same economic position as shareholders with respect to those entities.
• The fourth is transfer priming (asset migration "drop-downs"), which occurs where value is moved outside the restricted group through unrestricted subsidiary designations or investments in unrestricted subsidiaries.  The group will typically rely on available investment and restricted payment capacity, including builder baskets and related carve-outs, to transfer assets beyond the reach of existing creditors and covenant limitations.  The asset pool that previously supported the restricted group is thereby reduced, with transferred assets removed from the security and covenant perimeter and made available to support new financing or restructuring transactions, reducing the collateral and economic value available to existing creditors.
• The fifth mechanism, and the primary focus of this article, is covenant invisible priming through monetisation structures.  These are arrangements that generate immediate liquidity by converting future cash flows, assets or payment capacity into present cash.  This often results in short term liquidity at the cost of longer-term value, either through asset transfers or by delaying payment obligations.  This happens without engaging the covenant protections typically associated with asset sales, indebtedness or restricted payments, and in some cases without recognition of such obligations as financial debt under applicable accounting standards.

Such arrangements may take different forms, but in their essential structure, each involves:  (i) the creation of immediate liquidity, whether through the realisation of future value today or the deferral of obligations that would otherwise fall due; (ii) increased future payment obligations or the loss of future value, with (i) and (ii) resulting in a reduction of future economic capacity, which may be significant.

Monetisation Structures:  Present Liquidity and The Erosion of Future Value

These monetisation techniques take many forms, ranging from simple invoice factoring arrangements to more complex receivables securitisations.  Historically, they focused on receivables financing, where companies generated liquidity by selling or pledging identified payment claims arising from completed transactions.  Over time, these structures have expanded beyond traditional receivables to additional asset classes, including inventory financings, intellectual property monetisation and governmental receivables.  More recently, the market has developed tax credit monetisation and similar asset-based liquidity transactions.  The evolution is illustrated by renewable energy tax credit financings, where liquidity is raised against projected statutory credits (companies can sell or transfer unused tax credits) rather than receivables generated from completed commercial activity.  Together, these developments reflect a broader shift toward financing diversified and/or recurring sources of cash flow that can produce similar economic outcomes despite differing legal structures.

A growing range of financing techniques can be classified collectively as monetisation structures.  These transactions fall broadly into two functional categories:

1. Value-transfer monetisation structures – such as receivables financings, tax credit monetisation, and intellectual property securitisations, generate liquidity through the sale or isolation of assets or cash flow rights, thereby reducing the future asset base or cash flow available to the group and/or reallocating it outside the reach of existing creditors.
2. Obligation-based monetisation structures – such as reverse factoring (lender lends to buyer to pay supplier invoices) and other supply chain financing arrangements, sale-leasebacks, and other leasing structures, generate liquidity by replacing payment timing flexibility or asset ownership with forward contractual commitments, leaving the group with debt-like obligations that may not be reflected as financial indebtedness on the balance sheet.

While accounting treatment is beyond the scope of this article, obligations falling under certain of the categories above are not always presented as financial indebtedness, meaning leverage effects may arise without corresponding balance-sheet debt recognition.  For example, reverse factoring may increase reported cash while related obligations are recorded as trade payables rather than financial debt.  While structurally distinct, both value-transfer and obligation based monetisation structures substitute future economic value for present liquidity and therefore may raise similar covenant and creditor-protection considerations.

Covenant Treatment of Monetisation Structures

Incurrence based covenants in leveraged finance documentation protect creditors through restrictions on value transfers, controls on incremental obligations and protections governing asset dispositions, alongside related safeguards such as affiliate transaction, merger and change-of-control provisions.  These protections operate on the premise that material value extraction or leverage expansion will ordinarily engage at least one covenant constraint.

Although monetisation structures may resemble asset disposals or borrowing in economic substance, they frequently escape the covenant protections that would otherwise apply.  Value-transfer monetisation structures often fall outside "Asset Sale" covenants because they are structured as receivables financings or other working capital arrangements rather than disposals of operating assets and are typically either excluded from the definition of "Asset Sale" or permitted under ordinary course or receivables financing carve-outs.  As a result, the Asset Sale covenant and its associated fair market value, minimum cash consideration and proceeds application requirements are not engaged.  Obligation based monetisation structures, meanwhile, frequently fall outside covenant definitions of "Indebtedness" because the resulting obligations are characterised as trade payables or operating lease commitments rather than financial debt, or are otherwise permitted under uncapped or broadly available baskets.  As a result, these structures often do not trigger the covenant creditor protections that would otherwise constrain comparable transactions.

Even with covenant protection, this can typically be amended by less than a unanimous vote of creditors, thus allowing for potential transactions to be consummated with a sub-set of creditors who may benefit from such transactions, potentially to the detriment of other creditors.

What is the risk?

Both categories share a common feature:  their capacity to alter creditor economics while remaining permitted or invisible under existing covenant frameworks – a feature that distinguishes them from the four priming pathways described above.  These monetisation structures generate indirect economic seniority by diverting future cash flows or accumulating debt-like future payment obligations outside the perimeter of covenant protections ordinarily applicable to asset dispositions or increased leverage.

Although value-transfer monetisation transactions may generate liquidity today, that liquidity is typically not subject to the safeguards that ordinarily govern asset disposals:  there is no requirement to receive fair market value, no minimum cash consideration threshold, and no obligation to apply proceeds for the benefit of the restricted group or its creditors.  Similarly, although obligation-based monetisation transactions may increase liabilities, they usually fall outside covenant definitions of "Indebtedness" or are permitted under uncapped or broadly available baskets.

The resulting risk mirrors the outcomes covenant frameworks were designed to address, yet may fall outside their operative scope in practice.

Monetisation structures present two distinct risk profiles for existing creditors, depending on their form.  Value-transfer monetisation erodes the asset base and revenue streams underpinning existing creditors' recovery, redirecting future economic capacity without triggering asset sale covenant protections.  Obligation-based monetisation accumulates future payment obligations outside conventional debt metrics, distorting the true leverage profile of the group in ways that existing financial covenants are not designed to capture.

In both cases, the resulting weakening of enterprise value may not become apparent until the group is already in financial distress.  The complexity of these structures, combined with their treatment under existing accounting and legal frameworks, means that deterioration in creditor economics will typically not be visible from covenant compliance certificates, financial statements or traditional credit analysis.  Thus, the risk surfaces only once liquidity stress or a restructuring process reveals the true economic position of the group.

A further risk is certain creditors agreeing monetisation transactions with the group that position them in a more favourable position than other creditors.  These financings can typically be structured in a relatively safe manner, and the returns recovered on these transactions may cover losses suffered on the original debt in the group.  This can typically be undertaken with a sub-set of consenting creditors, which may bind all creditors into a consent to allow for such transaction, but only a smaller sub-set of creditors may benefit from this (and future related transactions).

Market examples of these risks have manifested themselves in recent distressed cases and creditors are now alert to some of these risks.  In terms of receivables financings, risks involved can relate to mismanagement of the relevant invoices (which may be deliberate), whereby invoices are classified in the wrong categories or are double pledged or sold.  These issues will immediately turn off the availability for receivables financing which may very quickly cause a liquidity issue, requiring emergency financing to fund the business from other sources.

Alternatively, delaying payments may increase funding requirements of the business on a longer-term basis.  While leases are often treated in different ways depending on categorisation (operating or finance lease, and pre- or post-IFRS 16 accounting treatment), the payment obligations associated with such leases must be serviced.  These potentially longer-term liabilities remain in the business and may require emergency financing to ensure such leases can be serviced so that the group can continue to use vital property, plant and equipment to operate and ensure it continues to provide longer term revenues.

Perspective on Risks and Proposed Solutions

Incurrence based covenant frameworks were designed around distinctions between debt, asset sales, and restricted payments, grounded in legal form, accounting classification, and disclosure assumptions, on the expectation that these categories would broadly reflect underlying economic substance.  At the same time, incurrence based covenant regimes were intentionally structured not to regulate ordinary-course of business activity, preserving operational flexibility unless specified thresholds were exceeded.  Covenant regimes therefore distinguish transactions largely by legal and accounting characterisation, reflecting an assumption that standard liquidity tools such as receivables financings, leasing arrangements, and factoring programmes would not materially reallocate assets or cash flows or create priming risk for existing creditors.  As a result, these arrangements were frequently permitted or left uncapped, with creditors expected to rely on financial reporting and disclosure rather than covenant limitations to assess their economic impact.  Recent distressed scenarios have exposed the limits of this approach:  monetisation structures may reallocate future assets or cash flows or accumulate obligations that operate as a form of indirect priming, without engaging any of the protections that covenant frameworks were designed to provide and, more importantly, in ways that may come as a surprise to creditors.

Depending on perspective, the objective of potential solutions may well not be to prohibit monetisation structures, which may serve legitimate liquidity and capital management purposes, but to adapt covenant, diligence, and disclosure frameworks so that contractual protections more closely reflect economic substance.  Potential solutions, some of which are already beginning to be reflected in market practice, include the following:

• First, covenant frameworks could align certain monetisation transactions more closely with asset sale protections where material assets or cash flows are transferred.  Applying concepts such as fair market value requirements or reinvestment and deleveraging obligations may partially restore creditor safeguards, although such mechanisms are less effective where value erosion occurs gradually through future cash flow extraction rather than through discrete asset dispositions.  A further limitation of relying on the asset sale covenant is that asset sale covenant mechanics, even where applicable, do not require that proceeds derived from a specific monetisation be applied in a manner that necessarily preserves the creditor value previously supported by the transferred asset or cash flow.  Because cash is fungible, issuers may satisfy reinvestment conditions through capital expenditure or investments that would have occurred irrespective of the transaction, achieving technical compliance without offsetting the underlying reduction in future economic capacity.
• Second, documentation may introduce targeted quantitative limits on tax credit monetisation, reverse factoring, and similar arrangements.  Covenant frameworks have historically treated -both value-transfer and obligation based monetisation structures as operational liquidity tools, permitting them on an effectively uncapped basis.  More recent drafting has begun to impose caps or narrower eligibility criteria where large-scale monetisation materially erodes the future assets and cash flows supporting the group and its creditors.  This approach is not without its own limitations.  Incurrence covenants typically operate only outside the ordinary course of business, reflecting the recognition that operational flexibility must be preserved.  Striking the right balance between restricting monetisation activity that warrants limitation and preserving ordinary course liquidity management that should remain uncapped is inherently difficult, and rigid drafting risks impairing legitimate business operations without meaningfully reducing priming risk.
• Third, and potentially the most durable response is enhanced transparency, achieved not only through disclosure requirements but equally through creditor diligence and ongoing reporting mechanisms.  Transparency operates across three distinct informational dimensions:

i. existing exposures, including monetisation programmes and associated payment obligations;

ii. forward-looking permissions, reflecting what transactions are contractually permitted under the existing covenant framework; and

iii. ongoing visibility through reporting obligations following material transactions.

Disclosure and creditor diligence together address the first two dimensions.  Creditors therefore need sufficient visibility into both the obligations currently in place and the latitude afforded by covenant structures for future monetisation activity.  The importance of diligence around (i) and (ii) becomes particularly acute where formal disclosure is limited or absent, including distressed situations, private placements, or other transactions not accompanied by offering documentation, in which informational asymmetries are most pronounced.

The third dimension (iii) is addressed through reporting covenants that provide continuing visibility into monetised assets, outstanding programmes, and related payment obligations as they evolve over time.  Because monetisation obligations are not always reflected as financial indebtedness in financial statements, related exposures may appear only indirectly through disclosures or narrative reporting, reinforcing the need for standardised reporting expectations.

Conclusion

In this article, we highlighted the rise and risks of complex monetisation structures that have the potential to prime creditors yet remain permitted or effectively invisible under existing covenant frameworks.

While covenant-based responses offer partial relief, the most durable solution lies in enhanced transparency:  ensuring that creditors have sufficient visibility into existing monetisation exposures, the contractual permissions available for future activity, and the ongoing reporting needed to track those obligations as they evolve.  Where that transparency is achieved, whether through robust diligence at origination, disclosure requirements, or standardised reporting covenants, creditors are better placed to assess and price the risk before it surfaces only in distress.

The central question that remains is what will incentivise issuers to embrace greater transparency voluntarily.  Whether the answer lies in pricing pressure from creditors, reputational discipline in the primary market, or the lessons of recent distressed precedents, the informational gap between what monetisation structures create economically and what covenant frameworks capture must ultimately be closed.

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