What Is a Covenant-Lite Loan?
A covenant-lite loan is a form of financing that imposes fewer restrictions on the borrower and provides fewer safeguards for the lender. Traditional loans, on the other hand, often have protective covenants inserted into the contract for the lender’s protection, such as financial maintenance tests that monitor the borrower’s debt-service capacities. Covenant-lite loans, on the other hand, are more flexible in terms of the borrower’s collateral, income level, and loan payment conditions. Covenant-lite loans are often known colloquially as “cov-lite” loans.
Defining a Covenant-Lite Loan
Covenant-lite loans provide borrowers a greater amount of funding than they would likely be able to get via a conventional loan, while simultaneously providing more borrowers-friendly conditions. Covenant-lite loans also involve greater risk for the lender than regular loans and enable people and organizations to do things that would be difficult or impossible to do under a typical loan arrangement, such as paying out dividends to investors while postponing scheduled loan payments. Covenant-lite loans are often exclusively made available to investment organizations, businesses, and high-net-worth people.
- Covenant-lite loans vary from regular loans in that they provide less protection to the lender while providing more favorable conditions to the borrower.
- The loans are advantageous in terms of the borrower’s degree of income, collateral, and loan payment conditions.
- Covenant-lite loans, often known as “cov-lite” loans, are usually riskier for the lender but have the potential for higher earnings.
- The roots of covenant-lite loans may be traced back to private equity companies’ leveraged buyouts.
Covenant-lite loans may often be traced back to the formation of private equity organizations that employed highly leveraged buyouts (LBOs) to purchase other businesses. Leveraged buyouts need a high amount of financing versus equity, but they may result in large profits for the private equity firm and its investors if they result in a leaner, more successful business that focuses on delivering value to shareholders. Because of the high amounts of debt necessary for such transactions, as well as the high potential for profit, the buyout groups were able to begin demanding conditions to their banks and other lenders.
The Benefits and Drawbacks of a Covenant-Lite Loan
Private equity companies were allowed to go larger and wider in their deal-making after winning a relaxation of normal borrowing limitations and more advantageous conditions about how and when their loans were to be repaid. As a result, many analysts believe that the leveraged buyout idea was carried too far and that in the 1980s, several firms began to go belly-up as a result of the heavy debt burden they were now bearing. Even if the loans were covenant-lite, the firms were still on the wrong side of the balance sheet when it came to their capacity to repay the money they owed.
Significant: Covenant-lite loans are riskier for lenders, but they also have a higher potential for profit.
Although leveraged buyout deals were arguably out of control in the 1980s, and highly leveraged companies and their employees often paid the price, later analysis revealed that many LBOs were financially successful, and the overall performance of covenant-lite loans was comparable to traditional loans provided to deal makers.
Indeed, the expectation has evolved so far that some investors and financial commentators are now concerned when a transaction does not obtain the type of attractive financing conditions that would qualify for a covenant-lite loan. Their belief is that the presence of typical loan covenants is a clue that the transaction is poor, rather than a normal precaution that any lender would take to protect itself.
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