What are Covenant-Lite Loans?
Covenant-Lite Loans, or “cov-lite” for short, are debt financing arrangements in which there are fewer restrictions placed on the borrower and less lender protection as a result.
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.