Covenant-Lite Loans

Covenant-Lite Loans: Cov-Lite Definition

Covenant-lite loans, as implied by the name, are loans that come with less restrictive debt covenants – in particular, the lack of strict covenants.

Historically, traditional loans were known for their restrictive covenants, or more specifically, “maintenance” covenants.

Covenants are added to lending agreements to protect the lender’s interests, but in return, borrowers receive more favorable terms.

However, the recent emergence of different types of private lenders has caused competition within the credit markets to increase, thereby creating a more borrower-friendly environment.

For their financing packages to be competitive, traditional lenders are forced to offer more flexible terms – hence, the surge in lower-cost debt capital in the past decade.

The standard covenant-lite loan is structured with the following terms:

• Senior Secured Term Loan – Placed at Top of Capital Structure with Seniority Over Subordinated Debt and Equity
• Non-Amortizing (or Minimal) Amortization – No or Limited Mandatory Amortization of Principal in Borrowing Term
• No Financial Maintenance Covenants – Consists of Incurrence Covenants Similar to High-Yield Bonds

Covenant-Lite Loan Issuances Trends

S&P Cov-Lite Issuance Volume

“More than 90% of U.S. leveraged loans issued this year have been covenant-lite, a new record, further marking a two-decade-long transformation of the asset class in which nearly all newly issued loans have shed lender protections that once had been standard.”

^{Covenant-Lite Deals Exceed 90% of Leveraged Loan Issuances (Source: S&P Global)}

Maintenance Covenants in Cov-Lite Loans

Oftentimes, stringent maintenance covenants deterred many companies from utilizing debt financing in the past.

Maintenance covenants consist of credit ratios and/or operating metrics that must be maintained throughout the lending term.

Further, pressuring the borrower to perform, compliance with maintenance covenants are typically tested for on a quarterly basis.

For example, a maintenance covenant could require the borrower to maintain a 5.0x or lower debt-to-EBITDA ratio.

If the borrower’s debt-to-EBITDA ratio were to exceed 5.0x from underperformance, the borrower is not in compliance with the lending agreement and would be in technical default.

Incurrence Covenants in Cov-Lite Loans

Ordinarily, maintenance covenants were affiliated with senior credit facilities, whereas incurrence covenants were more associated with high-yield bonds (HYBs).

But the trend of cov-lite debt has caused the lines between the two to blur, as nowadays, term loans are structured more similarly to a bond than traditional senior debt.

Covenant-lite loans are still secured (i.e. 1^st lien) but contain incurrence covenants, a feature traditionally more common with bond issuances.

Unlike maintenance covenants where testing is scheduled in advance to ensure compliance with specified credit ratios, incurrence covenants are tests that occur only when specific actions are taken such as:

• Mergers and Acquisitions (M&A)
• New Debt Issuances
• Dividends Payouts
• Sale of Assets (Divestitures)

The rise of cov-lite financing has been particularly advantageous for companies with extensive opportunities to put the capital to use – which is why such financing is common in leveraged buyouts (LBOs).

Pros/Cons of Covenant-Lite Loan Environment

From the perspective of lenders, covenant-lite loans are mostly a reaction to the sudden entry of private lenders into the credit markets.

Nevertheless, besides negotiating and finalizing the loan agreement in the current borrower-friendly environment, there are other side benefits.

For instance, incurrence covenants can provide earlier warnings that a borrower is at risk of default.

Following an acquisition, even if the company remains in compliance with the incurrence covenants, the lender gets alerted of any potentially concerning financial issues (e.g. deterioration in credit ratios).

As for the downsides, the lack of restrictive covenants can mean higher-risk decisions that prioritize the returns to equity holders over that of creditors.

Since the emergence of covenant-lite debt, corporate default rates have increased over time.

Despite the covenant-lite loan being secured and of higher priority than junior debt, covenant-lite loans result in lower recoveries in comparison to traditional term loans.

Debt covenants are often criticized as being too restrictive on borrowers while limiting their potential to achieve growth, yet covenants can actually have a net positive impact on the decision-making of management (i.e. “forced discipline”) from a risk management standpoint.