What are 'Covenant-Lite Loans'

Covenant-lite loans are a type of financing that is granted with limited restrictions. Traditional loans generally have protective covenants built into the contract to protect the lender, including financial maintenance tests that measure the debt-service capabilities of the borrower. The issuance of covenant-lite loans means that debt is being issued to borrowers with fewer restrictions on collateral, payment terms and level of income. Covenant-lite loans are also referred to as "cov-lite loans."

BREAKING DOWN 'Covenant-Lite Loans'

Covenant-lite loans are borrower-friendly loans that allow for payment flexibility and provide the borrower with a higher level of financing than they would be able to access through a traditional loan facility. Covenant-lite loans carry more risk 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 only granted to financiers, corporations and high-net-worth individuals.

Covenant-Lite Loans and Leveraged Buyouts

The evolution of covenant-lite loans is generally traced back to private equity groups performing highly leveraged buyouts (LBO). Leveraged buyouts require a high level of financing versus equity, but they can have enormous returns for the private equity firm and their investors if they result in a leaner, meaner company with a focus on returning value to the shareholders. Because of the large levels of debt required and the equally large opportunity for profit, the buyout groups were able to begin dictating terms to banks and financiers.

The private equity firms were able to get a relaxation of loan restrictions and favorable terms on how and when loans were repaid. This flexibility allowed the groups to go bigger and broader in terms of deal-making. Consequently, the leveraged buyout concept was taken too far, and, in the 1980s, companies started going belly-up post-LBO due to the crushing debt load. No matter how covenant-lite the loans were, the firms were still on the wrong side of the balance sheet when it came to the ability to make any progress on repayment.   

Performance of Covenant-Lite Loans

Although LBOs arguably got out of control in the 1980s, later analysis showed that many LBOs were successful, 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 investors and pundits worry when a deal does not receive favorable financing terms that would fit the definition of covenant-lite loans. The assumption is that the inclusion of traditional covenants is a sign that the deal is bad rather than an indication of a prudent action any lender would take.

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