Covenant Lite: Everything You Need to Know
A covenant lite loan is special financing that is given along with relatively limited restrictions in regards to the borrower's debt-service capabilities.3 min read
A covenant lite loan is special financing that is given along with relatively limited restrictions in regards to the borrower's debt-service capabilities.
Covenant Lite Loans Overview
When a covenant lite loan is granted, it means that debt is going to be issued on both a commercial and personal financial basis to the borrower. This type of loan has fewer restrictions on things like:
- Income levels
- Terms of payment
The evolution of covenant lite loans can be traced back to the historic buying power enjoyed by private equity corporate groups, particularly when they perform high-leverage buyout options. The power that these groups have at their disposal ultimately led to more relaxed loan restrictions. This provided an increase in the flexibility of available repayment terms.
The main feature associated with most covenant lite loans is the lack of required financial maintenance tests that are normally imposed as covenants in a particular loan agreement. These covenants can require borrowers to meet specific standards in terms of performance on either a monthly or quarterly basis.
Additionally, covenant lite loans can sometimes allow borrowers to perform certain actions that might be otherwise restricted or entirely prohibited in more standard financial arrangements. Covenant lite loans are sometimes viewed as riskier than traditional loan options due to the fact that they overlook many of the early warnings that lenders might be able to identify under a standard loan agreement. This means that a lender's ability to take steps to avoid potential default scenarios might be negatively impacted in some scenarios.
Add to that the fact that greater flexibility on the borrower's side, such as their ability to pay out dividends in some situations, may lead to lenders having less control concerning what activities the borrower may be authorized to engage in compared to standard financing terms. This concern aside, though, many people have come to the conclusion that an increase in the frequency at which these loans are beginning to appear may reflect a change in the bargaining power between lenders and borrowers. This may be due, in part, to an increase in the competition traditional lenders are facing from private equity groups and other potential capital sources.
Covenant Lite Loans Dominate the U.S. Leveraged Loan Market
Covenant lite loans are considered to be rather issuer-friendly financial terms that offer lower levels of protection for the lender and associated investors than traditional credit lines. According to LCD, this type of loan currently accounts for 75 percent of the approximately $970 billion leveraged loans that are currently outstanding in the United States today. In fact, January 2018 marked the tenth month in a row for record-setting covenant lite market shares. This is due to the fact that covenant lite credit lines have remained the standard in certain lending segments that have recently experienced an unprecedented year in terms of credit line issuance.
Covenant lite shares comprised approximately 60 percent of the market as recently as 2015. In some ways, a covenant lite deal is structured in a way that can be considered similar to the structure of a high-yield bond. This type of loan features what is commonly known as an incurrence covenant. In simple terms, this means that issuers are only required to meet certain financial tests if they wish to carry out certain actions, such as paying dividends to private equity owners. In contrast, more traditional loan structures have many more restrictions associated with them.
Covenant lite loans incorporate maintenance covenants, which require the issuer to meet financial tests on a quarterly basis, even if they don't intend to carry out any action on their line of credit. Of course, covenant lite loans do have some negative aspects. Some might argue that the large amount of covenant lite debt that is currently outstanding may have an impact regarding recoveries associated with leveraged loans, particularly when the current cycle of credit, which is now approaching 10 years, makes a turn.
Historically speaking, covenant lite loans have a similar or somewhat lower rate of default than traditional loans. However, toward the end of the previous cycle of credit, which coincided with the 2007 through 2008 financial crisis, there was slightly less outstanding debt related to covenant lite loans than today.
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