Prior to the early 2000s, covenant-lite loans were far from the norm as banks and other financial institutions tended to err on the side of caution, only providing such structures to their strongest borrowers. However, with the dramatic expansion of investors moving into the direct lending space in recent years, flexibility on documentation has become a routine point of differentiation among lenders trying to put money to work.
Recent studies have shown that, in today’s market, covenant-lite loans constitute 80 percent of outstanding leveraged loans versus 15 percent a decade ago. (i) While covenant-lite loans have become increasingly prevalent in the broadly syndicated lending market, (ii) it should be noted that this same rate of growth has not yet been reflected across the middle-market lending environment.
Covenant-Lite Loans in Practice
As evidenced by their moniker, covenant-lite loans are generally characterized as loans with relatively limited restrictions and obligations on the part of borrowers. In the context of corporate loans specifically, covenant-lite refers to agreements that lack maintenance covenants, or those covenants that require the borrower to maintain certain financial metrics, such as a maximum total leverage ratio or a minimum fixed charge coverage ratio. Instead, covenant-lite loans contain incurrence covenants, which are tested only when certain specific actions are taken rather than being looked at on a regular basis as with a maintenance covenant.
The absence of such maintenance covenants and the default that would have otherwise been triggered in the event of a borrower’s EBITDA deterioration, means a lender is left without an early warning sign of trouble or the ability to take action to preserve value. Increasing the interest rate, demanding fees or accelerating the loan are all on hold while the borrower, often backed by a private equity firm, explores more and more creative ways to seek equity value. Lenders typically have their hands tied until the debt matures.
Default and Recovery Rates
With respect to default and recovery rates, many market observers agree that, historically, covenant-lite loans fared relatively well. Some reports indicate that during the last recession, covenant-lite loans fared better than their covenant-heavy counterparts with lower default rates and higher recovery rates.
Specifically, the default rate in 2009 for covenant-lite loans was 5.19 percent while the default rate on covenant-heavy loans was 10.81 percent. (iii) Additionally, between 1987-2017, the average rate of recovery for covenant-lite loans was relatively high at 71 percent. (iv) However, as noted, with covenant-lite loans traditionally being reserved for the strongest borrowers, today’s expanded deployment of the structure should negatively impact correlations between the two datasets. As expected, recent forecasts on future recovery rates for covenant-lite loans predict a drop to 60 percent. (v)
Document Deterioration in General
Beyond fighting to preserve maintenance covenants, in today’s competitive environment, lenders also face a general deterioration of terms in their credit documents, which can also negatively impact their ability to recover. The following are just a few examples:
Looser Adjusted EBITDA definitions: EBITDA add-backs have increased in both size and scope. For example, borrowers regularly demand EBITDA credit for subjective estimates such as expected cost savings and synergies from acquisitions and cash operating expense items such as management fees, restructuring charges and software development costs. Adjusted EBITDA is used by lenders to set basket amounts for various negative covenants, such as restricted payments, transfer of assets, investing in third parties and debt incurrence. Increasing add-backs can lead to an overstatement of Adjusted EBITDA and make those baskets easier for the borrower to access, potentially increasing credit risk.
Incremental Debt: Many loans now allow borrowers to add new loans equal to up to 50-100 percent of the borrower’s pro forma closing date EBITDA without additional lender consent and without meeting any additional financial tests, a so-called “free and clear” basket. With current attachment points, this can often mean up to 25 percent dilution of the first lien collateral pool without any input from the existing lenders. Furthermore, some loans will also allow further leverage through ratio debt baskets that permit borrowers to incur additional senior or subordinated debt up to agreed-upon maximum senior secured or total leverage ratios. In looser documents, these ratio debt baskets can be available to the borrower on the closing date, leaving the “free and clear” basket for a later date when the ratio debt baskets have been exhausted.
Incurrence Based Negative Covenant Baskets: Loan documents now routinely allow for additional incurrence-based baskets in their negative covenants that give the borrower the ability to increase certain other existing basket amounts without lender approval. For example, available amount baskets (also known as builder baskets) typically give the borrower credit for retained excess cash flow proceeds, contributed equity proceeds or declined proceeds in addition to a free and clear amount, and grower baskets typically give credit for growth in a borrower’s EBITDA or total assets.
Collateral Stripping: The proliferation of the unrestricted subsidiary concept in loan documentation has opened the door for borrowers to transfer assets from credit parties to those unrestricted subsidiaries sitting outside of a lender’s lien on assets. As seen in the J. Crew, PetSmart and Neiman Marcus cases, this can have a dramatic impact on collateral value.
Path Forward for Lenders
While increased downside risk should caution lenders when making covenant-lite loans, a myriad of other factors can affect a lender’s ability to recover, not the least of which are a lender’s own underwriting standards.
To increase the chances of recovery, especially in the event of a downturn, lenders should remain vigilant on their underwriting criteria, keep a close eye on their borrowers and intimately understand the strengths and weaknesses contained in their credit documents. Taking ground where they can in their loan documents and holding the line on provisions that most directly impact their underwriting thesis should provide lenders with a key advantage going forward.
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(i) Next Debt Crisis: Will Liquidity Hold?, Global Leveraged Finance, June 2019.
(ii) Generally defined as loans for companies with greater than $50 million of EBITDA.
(iii) Will Covenant Lite Loans Be An Issue?, UPFINA, September 24, 2019, https://upfina.com/will-covenant-lite-loans-be-an-issue/.
(iv) Id.
(v) Moody’s Weak structures of cov-lite loans, now the majority of US leveraged loan market, suggest lower-than-average recoveries in the next downturn, May 23, 2017, https://www.moodys.com/research/Moodys-Weak-structures-of-cov-lite-loans-now-the-majority--PR_367132.
