A Covenant-Lite Refresher
Covenant-lite loans have surged in the last couple of years. In 2018, cov-lite loan volume in the US reached $911 billion, an approximate 26% increase over 2017, and accounting for 85% of leveraged loans in the U.S., the highest percentage on record.
Through August 2019, cov-lite loan volume in the US soared to approximately $940 billion, about 3% more than the total for 2018. As of August 31, 2019, close to 80% of all outstanding par leveraged loans were covenant lite.
In terms of market provisions, certain borrower-friendly provisions became even more borrower-favorable in 2018. Despite some pullback in the fourth quarter of last year, the prevalence of this borrower-friendly environment is continuing into 2019.
Our Finance partner, Eric Goodison, and practice management counsel, Margot Wagner, review below some of the most common cov-lite provisions and pros and cons for lenders and borrowers.1 In our view, the current market remains favorable to PE sponsors borrowing under cov-lite terms.
Common Cov-Lite Features and Developments in 2018 - Early 2019
The absence of a financial maintenance covenant for the benefit of the lenders is the core feature of a cov-lite loan. Often there are other borrower-favorable terms that make the restrictions on the borrower more like high-yield bonds than traditional loan transactions with full covenant packages. In particular, cov-lite loans have looser negative covenants. Many cov-lite loans allow the borrower to take one or more of the following actions, subject to certain restrictions:
- Incur additional debt. Rather than having a hard dollar cap on the amount of additional debt a borrower can incur, many cov-lite loans allow an unlimited amount of debt above an untested cap if the borrower meets an incurrence test after giving effect to the incurrence of the new debt. Often the incurrence test is a maximum leverage or net leverage ratio or a minimum interest coverage ratio. Additionally, in most cov-lite transactions, if a borrower incurs debt under its fixed incremental basket and its ratio basket at the same time, it can exclude the fixed amount from the ratio calculation.
- Incur additional secured debt. Even if a borrower can incur additional debt, additional liens on the collateral may not be permitted by initial lenders. However, cov-lite loans typically allow the borrower to grant additional liens to secure newly-incurred debt (thereby diluting the security of the initial lenders), if the borrower meets an incurrence test. Often this test is a maximum leverage or net leverage ratio that applies to secured debt or first liendebt.