With interest rates continuing to hover around historic lows, many borrowers have refinanced their credit facilities or have taken on new debt in order to finance new acquisitions. At the same time, the total volume of deals for the middle market (smaller than $1 billion) has shrunk, which has meant that more money from commercial banks, finance companies, and collateralized debt obligation and collateralized loan obligation funds is chasing fewer deals. And deal terms are becoming more borrower favorable—a lot more favorable.
The most dramatic example of how borrower-favorable financings have become is the recent return of covenant-lite loans. In 2007, pre-Credit Crisis, CLO and CDO funds were injecting tremendous amount of liquidity into the market for middle market loans. This permitted borrowers to have maximum leverage to negotiate senior credit agreements with very limited covenants—often simply incurrence-based financial covenant tests. The lines between senior credits and high yield notes blurred. But borrowers still had to comply (at some point) with financial covenants.
Today, we are seeing the return of covenant-lite loans, what is being called "Covenant Lite 2.0". Covenant Lite loans are loans which scale back, or eliminate, lender protections, such as financial covenants (leverage ratios, fixed charge coverage ratios) and negative covenants restricting dividends and incurrence of third party debt. The 2014 version of covenant-lite has, in many cases, reduced the number of financial covenants down to a leverage covenant only. And some recent financings have introduced a springing leverage covenant that is only tested if the Revolver is drawn over a certain percentage. Imagine—a covenant-free loan!
Interestingly, covenant-lite is even creeping into smaller deals that are not considered middle market. This creep is taking the form of lenders giving borrowers a more significant cushion in covenant levels off of the borrower's base-case projections. This cushion has risen to be as high as 30% to 45% in some 2014 deals, as opposed to 10% to 20% in the recent past. This should be troublesome to lenders because it means that a large drop in borrower Earnings Before Interest, Taxes, Depreciation and Amortization, which is traditionally an early warning sign of financial trouble, may not necessarily trigger a covenant default. Lenders should take little comfort in financial covenants, if they give borrowers substantial cushions off base-case projections that make the covenants meaningless.
In this second coming, it appears that covenant-lite has not just invaded the market for middle market loans. It is creeping down-market into smaller loans. Caveat Lender indeed.
Are you a lender? Are you seeing more covenant lite loans? What are some issues you are seeing with covenant-lite loans?
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