Covenant-lite loans: an overview
October 2015 | EXPERT BRIEFING | BANKING & FINANCE
Generally speaking, a covenant-lite or ‘cov-lite’ loan is a type of borrower-friendly secured loan facility that lacks the usual protective covenants typically found in more traditional loan facilities, with limited restrictions on the debt-service capabilities of the borrower. The core feature of most cov-lite loans is the absence of financial maintenance tests, usually imposed in the form of covenants (i.e., ongoing obligations on the part of the borrower) in a loan agreement, which require the borrower to meet certain performance standards on a monthly or quarterly basis. In addition, these types of facilities may at times allow a borrower to undertake certain actions that are generally prohibited or restricted in most standard financing arrangements.
Cov-lite facilities are at times viewed as potentially riskier than customary loan facilities because they remove the early warning signs lenders would otherwise receive through traditional covenants and thus impact the ability of lenders to take steps to mitigate a possible default. In addition, the added flexibility provided to borrowers in terms of their ability to, for example, under certain circumstances, pay dividends, means that lenders have less control over the activities in which borrowers may engage as compared to more standard financing.
Notwithstanding the above, however, many contend that the increase in frequency of these loans simply reflect changes in bargaining power between borrowers and lenders as a result of the increased competition faced by traditional bank lenders from private equity sponsors and other potential sources of capital. In addition, it is often noted that lenders today are able to benefit from the increased sophistication in the loan market whereby risk is dispersed through syndication or credit derivatives. Moreover, the growth of the secondary market for loans has provided another form of creditor protection in that, to the extent a given lender feels negatively about a facility or borrower, it will usually be able to trade out of its position as a result of the increased depth and diversity of the players in the market with differing appetites for risk.
In terms of removing financial maintenance tests, cov-lite loan facilities have been seen to remove reporting or maintenance requirements related to, among other items: (i) loan to value and EBITDA ratios; (ii) events constituting a ‘material adverse change’ in the financial or legal circumstances of the borrower; and (iii) changes in the borrower’s core line of business.
In addition, cov-lite loans at times contain other provisions not commonly found in traditional loan transactions with full covenant packages. For example, cov-lite loans may have looser negative covenants or ‘incurrence-style’ negative covenants, whereby, so long as it satisfies certain tests, the borrower may incur additional debt (both secured and unsecured), pay dividends to shareholders, make acquisitions or repay junior debt.
Cov-lite deals first became popular in 2006 by requiring less onerous covenants for borrowers than those that had previously been available in the standard bank lending market. Although the terms for these loans varied, many cov-lite agreements either eliminated financial maintenance covenants altogether, made them springing or so generous that they were virtually meaningless. For example, if the agreement included financial maintenance covenants, it might also provide for the right of the equity holder to prevent a default by injecting additional capital to count as EBITDA. Moreover, cov-lite deals often contained very limited restrictions on third-party debt or negative pledges, or used debt incurrence tests.
However, as the credit crisis unfolded in 2007 and credit policies tightened, the issuance of new cov-lite deals stopped due to the inability of lenders to monitor investments because of the lack of (or meaningless) financial maintenance covenants.
In recent years, however, the upswing in business activity, continuing low interest rates and ever increasing competition in the lending market, have resulted in a resurgence of cov-lite loans. In 2012, cov-lite loan issuances constituted approximately 30 percent of all outstanding loan issuances; by the end of 2014 that number had increased to around 60 percent. This means that by the end of 2014, only one-third of all loans were not covenant lite.
This increase in the overall volume of cov-lite facilities has been coupled with a continued increase in the number of potential capital sources, with the results being that high-grade borrowers are able to obtain even greater flexibility than in past years in terms of broader latitude with respect to business operations and more freedom to engage in activities with fewer restrictions. For example, recent years have seen the emergence of ‘baskets’ (these include, among others, so called ‘builder baskets’ and ‘grower baskets’) in many facilities, which provide for exceptions to specific negative covenants up to an agreed upon threshold. In the case of builder baskets specifically, these are baskets that ‘build’ throughout the life of a facility based on the performance of the borrower as measured through its retained earnings or other similar metric. The basket may then, depending on terms of the agreement, be used for actions such as paying down subordinated debt, making distributions to equity holders, or other actions that would otherwise be prohibited by the negative covenants present in the facility. This stands in contrast to older facilities where such actions would have required the approval of the lender on a case by case basis.
These developments, coupled with the fact that most cov-lite loans have not been tested by a major default cycle (recall that they appeared in 2006 so only a relatively small amount were impacted by the 2008 crisis) have led US regulators to take notice of the situation and, in certain cases, take action. For example, in late 2013 the Federal Reserve and the Office of the Comptroller of the Currency sent letters to some of the biggest US banks urging them to avoid arranging debt that may be classified by regulators as having some deficiency that may result in a loss.
However, while regulators seek to mitigate potential risks, recent data suggest that cov-lite loans may in fact be no riskier than traditional loan facilities. This was the case in a 2014 study by Moody’s Investors Services, which looked at 26 defaults by issuers with covenant lite facilities and compared recovery rates with 1000 other defaults. The study found that first-lien covenant lite debt had a recovery rate of 85 percent, a number equal to other first-lien debt regardless of covenants. These results did, however, point to possible changes in the market in that an earlier 2011 study by Moody’s Investors Services had found the default rate for companies with cov-lite loans to actually be lower than for comparable borrowers with more standard financing.
It is also useful to note that the percentage of cov-lite loans differs by credit quality. At the higher end of the credit quality spectrum, the percentage of covenant-lite loans has tended to be lower than in the lower and middle tiers; while middle-tier companies have 68 percent covenant-lite issuances, cove-lite issuances for upper-tier companies hover around 46 percent.
While regulators continue to remain wary, the oversupply of capital due to competition between banks and non-traditional lenders, coupled with the search for yield in the face of low interest rates, means that, notwithstanding recent market fluctuations, it remains to be seen whether a decrease in cov-lite facilities occurs in the near term.
Marco Ferri and Manuel Rodriguez are partners at Avila Rodriguez Hernandez Mena & Ferri LLP. Mr Ferri can be contacted on +1 (305) 779 3579 or by email: firstname.lastname@example.org. Mr Rodriguez can be contacted on +1 (305) 779 3574 or by email: email@example.com.
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Marco Ferri and Manuel Rodriguez
Avila Rodriguez Hernandez Mena & Ferri LLP