What is a Covenant-Lite Loan?

Covenant-lite loans are a type of financing that is issued with fewer restrictions on the borrower and fewer protections for the lender. By contrast, traditional loans generally have protective covenants built into the contract for the safety of the lender, including financial maintenance tests that measure the debt-service capabilities of the borrower. Covenant-lite loans, on the other hand, are more flexible with regard to the borrower's collateral, level of income and the loan's payment terms. Covenant-lite loans are also popularly referred to as "cov-lite" loans.

How a Covenant-Lite Loan Works

Covenant-lite loans provide borrowers with a higher level of financing than they would likely be able to access through a traditional loan, while also offering more borrower-friendly terms. Covenant-lite loans also carry more risk to the lender than traditional loans and allow individuals and corporations to engage in activities that would be difficult or impossible under a traditional loan agreement, such as paying out dividends to investors while deferring scheduled loan payments. Covenant-lite loans are generally granted only to investment firms, corporations and high-net-worth individuals.

The origin of covenant-lite loans is generally traced back to the emergence of private equity groups that used highly leveraged buyouts (LBOs) to acquire other companies. Leveraged buyouts require a high level of financing versus equity, but they can have enormous returns for the private equity firm and its investors if they result in a leaner, more profitable company with a focus on returning value to the shareholders. Because of the large levels of debt required for such deals and the equally large potential for profit, the buyout groups were able to begin dictating terms to their banks and other lenders.

Covenant-lite loans are riskier for lenders but also offer a larger potential for profit.

Pros and Cons of a Covenant-Lite Loan

Once private equity firms won a relaxation of typical loan restrictions and more favorable terms as to how and when their loans had to be repaid, they were able to go bigger and broader in their deal making. Consequently, the leveraged buyout concept was taken too far, according to many observers, and, in the 1980s, some companies started going belly-up post-LBO due to the crushing debt load they were suddenly carrying. No matter how covenant-lite the loans were, the companies were still on the wrong side of the balance sheet when it came to their ability to repay the money they owed.  

Although leveraged buyout deals arguably got out of control in the 1980s, and highly leveraged companies and their employees often paid the price, later analysis showed that many LBOs were successful in financial terms, and the overall performance of covenant-lite loans was in line with traditional loans provided to deal makers. In fact, the expectation has shifted so far that some investors and financial pundits now worry when a deal does not receive the kind of favorable financing terms that would fit the definition of a covenant-lite loan. Their assumption is that the inclusion of traditional loan covenants is a sign that the deal is bad, rather than a prudent step that any lender might want to take to protect itself.