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Cov-lite ‒ much ado about something or nothing?

The term ‘covenant-lite’ or ‘cov-lite’ is a much quoted phenomenon in the European leveraged loan market. But what does it actually mean and does it deserve the airtime that it is receiving?

If we were to go on size alone then the focus is more than justified. Rewinding to 2011, there were zero cov-lite deals in Europe. Today cov-lite accounts for almost 75% of all institutional deals in the European market. They are now very much the norm rather than the exception.

Cov-lite loans in the EU reached a staggering 70%+ in 2017

Source: LCD, an offering of S&P Global Marketing Intelligence, as at Q2 2017

What is cov-lite?

Simply put, cov-lite leveraged loans do not contain the same degree of protection for lenders. In a ‘traditional/old style’ leveraged loan the borrower’s financial performance and credit metrics were typically tested quarterly. The company was required to show that it was complying with a set of financial criteria or tests (maintenance covenants) on an ongoing basis. Failure to comply with these tests necessitated some sort of ‘cure’ – typically a fresh injection of equity or some other form of self-medication to bring the company back into compliance with its operating parameters and ensure its ongoing health.

As the name suggests, these protections are largely missing from cov-lite transactions. The borrower does not have to ‘prove’ its ongoing compliance with a set of financial parameters and instead can conduct its business without these restraints, only being tested if it wants to engage in a particular action (for instance pay a dividend, make an acquisition or issue more debt).

Why has it grown in recent years?

The reasons for the growth of this phenomenon are simple. First and foremost, today represents a seller’s market. There is tremendous demand for income generating assets from all corners and in order for loans to compete with high yield bonds (which typically have less restrictive parameters) and fulfil the appetite of the multiple pockets of demand (Collateralized Loan Obligations (CLOs) and institutional investors), lenders have been able to dictate their own terms to varying degrees.

Why do investors need to monitor this trend?

After all, the European economy is experiencing a broad cyclical recovery in growth and corporates are showing improved revenue and earnings progression. With the market in such robust shape we believe we are in no danger of breaching the vast majority of these covenants anyway.

Stating the obvious, while it may matter a little less right now, it most certainly will be of significance in the future. As the credit cycle begins to turn we will inevitably be provided (the hard way) with a reminder as to what we (the market) have agreed to today. The lack of maintenance covenants precludes lenders from taking early action if an issuer’s fortunes turn or run into financial distress. Precluding or deferring preventive action is highly likely to result in lenders being left in a much worse position.

While we would clearly rather see lender’s positions protected, it is important to remember that the existence of covenants doesn’t make bad businesses good, however, a lack of covenants most certainly can allow a good business to become bad from a lender’s perspective.

For us, the current trend merely serves to underscore the importance of diligent credit work and of equal importance the necessity of ongoing monitoring and engagement with management.

The active perspective

We are doing what we always do and being highly selective in choosing which borrowers we lend to. From our perspective, the lack of covenants is only part of the equation (and it’s something that we have been considering in the high yield bond market for years so we are well attuned to the perils). We are in many senses just as focused on the growing levels of leverage being put on businesses from the outset and are highly sensitive to the level of equity and subordinated debt underpinning the businesses to which we lend. A suitable layer of subordination tends to be essential to our investment thesis and our comfort that our capital will be protected over the long term.

Covenants or the lack thereof are an important issue, but it’s just one factor in assessing the credit worthiness of a business.