What is a covenant-lite loan?

Commonly called ‘cov-lite’ loans, covenant-lite loans are less restrictive for borrowers but typically riskier to the lender, but the high-risk coefficient offers potential for larger profits. Cov-lite loans are favourable to borrowers given borrower-friendly terms like the level of income, payment terms and collateral.

A borrower often looks for financing with fewer restrictions, a covenant-lite loan caters to that need. A covenant-lite loan means fewer restrictions on the borrower and lower protections for the lender, in contrast to traditional loans. Most loans have protective covenants built into the contract for the safety of the lender. This includes financial maintenance tests – a measure of the debt-service capabilities of the borrower. 

Cov-lite loans are generally senior secured term loans that give maximum flexibility to the issuer through the limited use of maintenance covenants. While these loans have become a backbone of the capital structure for highly levered companies due to their relatively low cost and high flexibility, they are riskier and may become a burden for the lender.

Covenant-lite loan example

Let’s say, company XYZ needs to raise capital and decides to issue bonds as an alternative to borrowing from a bank. Bank loans are restrictive and often more costly than paying bond investors. While issuing bonds also demands getting into a legal agreement that would put restrictions like reducing its ability to take on more debt, a covenant-lite bond would have virtually no restrictions or requirements on XYZ. Covenant-lite loan’s low yield characteristics open up an opportunity for XYZ, and investors are willing to take on more risk to get higher yields.

How is covenant-lite loan calculated?

Covenant-lite loans are generally offered only to corporations, investment firms, and high net worth individuals. It tends to be risky for the lender as the borrowers can opt for paying out dividends to investors while deferring scheduled loan payments.

With covenant-lite loans explained, let’s run through the calculation of this instrument. Traditional loans have less flexibility. Lenders lock in a deal amount and adding additional debt at any level is prevented. Borrowers often prefer to reserve cash for other purposes and look for flexible options to raise money when needed. This happens in a covenant-lite loan, where restrictions are lower. 

Cov-lite loans leverage on net debt/earnings before interest, taxes, depreciation and amortisation (EBITDA) ratio. This gives significant allowances, add-backs and adjustments to EBITDA, making the loan even more forgiving. The parameters for the calculation can also include pro-forma cost savings that have not yet been achieved. The allowance of incremental EBITDA allows for more overall leverage. The area where covenants are used frequently with these loans are builder and grower baskets.