Alternate name: Cov-lite
Although covenant-lite loan lenders disregard financial maintenance covenants, they do consider incurrence covenants. These must be met if the borrower wants to take a certain action, such as incurring more debt. Let’s say you’re a business owner who wants to take out a traditional loan. The lender will check your finances to make sure you’re able to repay them and are unlikely to default. If your finances aren’t in the best shape, the lender might not extend you the loan. Say you apply for a covenant-lite loan because you hope to acquire another company. There’s a good chance you’ll get approved, no matter where you stand financially. You won’t have to meet strict requirements, and you may receive the funds you need even if you’re a risky borrower.
How a Covenant-Lite Loan Works
Even though all covenant-lite loans are different, most of them are structured in the same way. They are widely seen in cash-flow financing and asset-backed lending. A typical cov-lite loan will have a loan agreement with a funded term loan or a series of term loans. In some cases, there may be a smaller revolving credit facility. If there is not, there may be a separate asset-backed lender. Cov-lite loans will also have credit facilities with most of the same covenants and that are backed by the same collateral. And, generally speaking, cov-lite loans won’t have any financial maintenance covenants.
Notable Happenings
Back in the 2000s, private equity groups used covenant-lite loans and leveraged buyouts (LBOs) to acquire other companies. While leveraged buyouts require a great deal of financing, they may lead to significant returns for a private equity firm and its investors. Due to the sky-high debt levels that come with leveraged buyouts, as well as great potential for profit, buyout groups were able to mandate terms to their lenders. Cov-lite loans have grown significantly since 2005. By 2020, they made up over 85% of the leveraged loan market.
Pros and Cons of Covenant-Lite Loans for Borrowers
Pros Explained
Favorable terms: You may find the terms of covenant-lite loans favorable because there is flexibility in when and how you can repay them. With traditional loans, terms are usually laid out in the loan contract and non-negotiable. Chance to participate in other transactions: The leniency of covenant-lite loans may allow you to engage in other deals without seeking consent from your lender, paying consent fees, or worrying about whether you’ll receive consent.
Cons Explained
Potentially higher interest rate: Depending on the covenant-lite loan you take out, you may be stuck with a higher interest rate than a traditional loan. This could cost you thousands of extra dollars over the life of your loan.May take on too much debt: Since a covenant-lite loan can open the doors to financing that you may not get approved for otherwise, it may steer you into excessive amounts of debt. It could also cause you to overpay for an acquisition.
