Cov-lite

Cov-lite ("covenant light") is financial jargon for loan agreements which do not contain the usual protective covenants for the benefit of the lending party. Although traditionally banks have insisted on a wide range of covenants which allow them to intervene if the financial position of the borrower or the value of underlying assets deteriorates, around 2006 the increasing strength of private equity firms and the decreasing opportunities for traditional corporate loans made by banks fuelled something of a "race to the bottom" with syndicates of banks competing with each other to essentially offer ever less invasive terms to borrowers in relation to leveraged buy-outs.

Cov-lite lending is seen as more risky because it removes the early warning signs lenders would otherwise receive through traditional covenants. Against this, it has been countered that cov-lite loans simply reflected changes in bargaining power between borrowers and lenders, and followed from the increased sophistication in the loans market where risk is quickly dispersed through syndication or credit derivatives.

Covenants

Practise varied, but characteristically, cov-lite loans would remove the requirement to report and maintain loan to value, gearing and EBITDA ratios.

More aggressively negotiated cov-lite loans might also remove:

• events of default relating to "material adverse change" of the position of the borrower
• requirement to deliver annual accounts to the banks
• restrictions on other third party debt
• restrictions on negative pledges
• requirements for bank approval to change the form of the debtor group's business

Concerns

Many at the time were alarmed by the development; The Economist in particular thought it was a concerning and short-sighted development,^[1] and the Financial Times endorsed the view of Anthony Bolton of Fidelity Investments who warned on his retirement in May 2007 that cov-lite could be "the tinder paper for a serious reversal in the market."^[2], the movement in the market was inexorable. Others argued that the move to cov-lite was a welcome simplification of loan documentation, and was fully justified as the banks would hedge their risk by transferring exposure to the loan in the CDO market.^[3][4] It was also pointed out at the time that cov-lite loans operated in a very similar way to bonds, but at lower values.

The high water mark of cov-lite loans came in the acquisition by Kohlberg Kravis Roberts, a US private equity firm, by way of a record $16bn cov-lite loan for its buy-out of First Data.^[2]

2007 credit crunch

The tendency towards cov-lite loans ended abruptly with the 2007 subprime mortgage financial crisis. Some commentators subsequently sought to attribute the credit crunch arising from crisis to cov-lite loans, although the LBO market is almost entirely unconnected with the sub-prime mortgage market in terms of exposure. However, in the credit crunch which ensured, cov-lite loans significantly hampered the ability of banks to step in and both seek to rectify positions which were going bad, and to limit their exposure once matters had gone bad. The suggestion that banks risks were mitigated through the CDO market was difficult to sustain in light of difficulties in that market itself as a result of the credit crunch. In March 2011, the Financial Times reported that in the three months prior, cov-lite loans to the value of $17bn had been issued.^[5]

References

1. ^ "You only give me your funny paper - Debt markets turn grouchy as creditors ask for more". The Economist. June 28, 2007.
2. ^ ^{a b} "Bolton warns of bubble fuelled by “cov-lite” loans". Financial Times. May 18 2007. (subscription required)
3. ^ Salmon, Felix (June 12 2007). "A Closer Look at Cov-Lite Loans". Market Movers. Portfolio.com. BizJournals.
4. ^ Comment, Deal (March 29, 2007). "Through the looking glass with leveraged finance". Legal Week blogs. Archived from the original on June 30, 2007.
5. ^ Tett, Gillian (March 4, 2011). "The return of cov-lites hints at more caution not madness". (Financial Times) Fidelity Worldwide Investment. Archived from the original on March 4, 2011.

External links

• Money Terms - "cov-lite"