Nov 2016 by Caroline Rasmussen
Proponents of covenant-lite loans, which are common in the public syndicated markets, may point to such loans’ purported low default rates as an argument that covenant protection for lenders is overrated.
Proponents of covenant-lite loans, which are common in the public syndicated markets, may point to such loans’ purported low default rates as an argument that covenant protection for lenders is overrated. Certainly, it is generally a better decision to lend with fewer covenants to a higher quality company than to lend with more covenants to a company with lower credit quality. But certain statistics, such as supposedly lower default rates since the financial crisis for covenant-lite loans than for “covenant-heavy” loans (defined as loans with at least one maintenance financial covenant), could be interpreted to suggest that covenant-lite loans actually perform better in general. This would be a highly misleading conclusion for reasons we will explain, the primary reason being that a decline in a borrower’s business results that would be flagged as a default under a covenant-heavy loan would not be under a covenant-lite loan to that same borrower.
It may be useful at this point to provide a brief overview of covenants. A covenant-lite loan is defined as a loan that lacks financial maintenance covenants. All loans, as well as bonds, include basic positive and negative covenants that regulate actions the borrower must take, such as providing quarterly financial statements to lenders, and actions the borrower must not take, which typically include disposing of collateral that lenders have a lien on or taking cash out of the company by making dividend payments to shareholders above a certain agreed level, for example.
In addition to positive and negative covenants, senior loans feature financial covenants, which come in two forms: incurrence and maintenance. Incurrence covenants are only tested when the borrower takes an affirmative action, and are breached when the action causes a relevant financial ratio to move beyond a pre-specified level. For instance, a company may have a debt incurrence covenant in its loan agreement that prevents it from taking on leverage that would cause its debt / EBITDA ratio to exceed 6x. This borrower would be in default with respect to this covenant only if it actively added debt that caused its leverage ratio to rise above 6x, and the ratio would be scrutinized only at the time of the additional debt incurrence.
Maintenance covenants, in contrast, are tested on an ongoing basis (either quarterly or semi-annually), and therefore require the borrowing company to maintain an agreed level of financial health from period to period. Returning to the same example, if a company had a 6x maximum debt / EBITDA maintenance financial covenant, it could breach this covenant not only by adding debt but also if its EBITDA declined, and the ratio would be tested regularly, generally every quarter. While covenants are customized and may be defined in different ways across different loan agreements, examples of common financial covenants include maintaining a minimum interest coverage ratio (e.g. EBITDA / interest expense), and maintaining a maximum level of senior debt relative to cash flow (e.g. senior leverage / free cash flow).
Violating a covenant puts a borrower in default, which gives lenders the right to demand immediate repayment ("calling" the loan). In practice, lenders will generally waive defaults that are more technical and less severe in nature, in exchange for a fee and/or a modification of loan terms. Such changes may include things like increasing the interest rate or resetting covenants to better reflect the likely trajectory of the borrower’s future financial results, to avoid foreseeable defaults. Covenant breaches effectively allow lenders to extract better terms going forward and to force action by the company that is favorable to them. Thus, the more covenants a lender has, the more influence and control it has over the borrower.
High yield bonds and covenant-lite loans only include incurrence-based financial covenants, meaning that lenders are only alerted to problems if and when a company takes a covered affirmative action. By contrast, maintenance financial covenants found in "covenant-heavy" loans, such as senior bank loans and most middle market direct loans, act as an ongoing check on the borrower’s cash flow and overall financial health, thus providing these lenders with much greater monitoring visibility than is available to bond market investors or investors in the broadly syndicated loan markets. In fact, in some cases private direct lenders actually receive monthly rather than quarterly financials from the companies to which they lend, allowing them to flag changes in actual versus forecasted budgets and assess whether a borrower is getting close to breaching a covenant in advance of any actual default. If a breach of a maintenance financial covenant does occur, given the nature of these covenants the problem has likely been flagged at a relatively early stage, and given their ability to call the loan, lenders have real leverage to work with the company to fix the problem.
Having now discussed covenants, we can see that the "low default rates" supposedly exhibited by covenant-lite loans make sense, because if there are no covenants, there will be no defaults. In other words, without covenants, how is one to know there has been a default? Maintenance financial covenants allow lenders to actually become aware of changes in a borrower’s financial health relatively early on, and such changes might never be flagged if a debt financing lacks such covenants. This allows lenders to take control of potential issues with advance notice, giving them a better chance of avoiding impairment, whereas in financings that lack maintenance covenants, a problem may not be surfaced until it has become acute.
In sum, while covenant-lite loans may appear to have performed better historically than covenant-heavy loans in terms of defaults, in a fundamental sense this is misleading and simply a reflection of the fact that covenant-lite lenders have essentially chosen to be less informed about the business results of their borrowers.
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