What is a Covenant-Lite loan?
A covenant-lite loan is a type of financing that is issued with fewer restrictions for the borrower and less protections for the lender. In contrast, traditional loans typically have protective clauses built into the contract for the lender’s safety, including financial sustainability tests that measure the borrower’s debt service capabilities. Covenant-lite loans, on the other hand, are more flexible when it comes to the borrower’s collateral, income level, and loan payment terms. Covenant-lite loans are also commonly referred to as “cov-lite” loans.
Understanding a Covenant-Lite loan
Covenant-lite loans provide borrowers with a higher level of financing than they could possibly access through a traditional loan, while providing more favorable terms for borrowers. Covenant-lite loans also carry more risk to the lender than traditional loans and allow individuals and businesses to engage in activities that would be difficult or impossible under a traditional loan agreement, such as paying down. dividends to investors while deferring scheduled loan payments. Covenant-lite loans are generally only granted to investment firms, corporations and high net worth individuals.
Key points to remember
- Covenant-lite loans are different from traditional loans because they offer less protection for the lender and more favorable terms for the borrower.
- The loans are favorable in terms of the borrower’s income level, collateral and loan payment terms.
- Also called “cov-lite” loans, covenant-lite loans are generally riskier for the lender, but with the potential for greater profits.
- The origins of covenant-lite loans can be traced back to debt buyouts by private equity firms.
The origin of covenant-lite loans generally dates back to the emergence of private equity groups that used LBOs to acquire other companies. Debt buyouts require a high level of funding relative to equity, but they can have huge returns for the private equity firm and its investors if they result in a leaner, more profitable business with an emphasis. on returning value to shareholders. Due to the high levels of leverage required for such transactions and the equally large profit potential, buyout groups were able to begin dictating terms to their banks and other lenders.
Advantages and disadvantages of a Covenant-Lite loan
Once the private equity firms obtained an easing of typical lending restrictions and more favorable terms as to how and when their loans were to be repaid, they were able to proceed further in their transactions. As a result, the concept of LBO was taken too far, according to many observers, and in the 1980s some companies began to go bankrupt after LBOs due to the overwhelming debt they suddenly carried. No matter how well the loans complied with the covenants, businesses were always on the wrong side of the balance sheet when it came to their ability to repay the money they owed.
Covenant-lite loans are riskier for lenders, but also offer greater profit potential.
While LBO operations arguably got out of hand in the 1980s, and highly leveraged companies and their employees often pay the price, subsequent analysis has shown that many LBOs have been successful in terms of financial and that the overall performance of covenant-lite loans was in line with traditional loans to negotiators.
In fact, expectations have changed so much that some investors and financial experts are now concerned when a deal does not receive the kind of favorable financing terms that would meet 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 cautious step any lender might want to take to protect themselves.