A covenant-lite loan is a loan agreement that, when compared to traditional loans, has fewer protections in place for the lender and fewer restrictions on the borrower. Covenant-lite loans are typically used for buyouts and other types of extensive corporate transactions.
Let’s take a closer look at what a covenant-lite loan is and how it works so you can determine if it makes sense for your situation.
Definition and Example of a Covenant-Lite Loan
Covenant-lite loans are considered borrower-friendly loans. While traditional loans require borrowers to meet a number of financial maintenance covenants, covenant-lite loans do not. This means that lenders may approve borrowers even if they are in a poor financial situation and likely to default.
- Alternate name: Cov-lite
Financial maintenance covenants measure a borrower's performance, usually on a quarterly basis, to ensure that the borrower doesn’t go outside the financial parameters that they agreed on at the beginning of the deal.
Although covenant-lite loan lenders disregard financial maintenance covenants, they do consider incurrence covenants. These must be met if the borrower wants to take a certain action, such as incurring more debt.
Let’s say you're a business owner who wants to take out a traditional loan. The lender will check your finances to make sure you’re able to repay them and are unlikely to default. If your finances aren’t in the best shape, the lender might not extend you the loan.
Say you apply for a covenant-lite loan because you hope to acquire another company. There’s a good chance you'll get approved, no matter where you stand financially. You won’t have to meet strict requirements, and you may receive the funds you need even if you’re a risky borrower.
How a Covenant-Lite Loan Works
Even though all covenant-lite loans are different, most of them are structured in the same way. They are widely seen in cash-flow financing and asset-backed lending.
A typical cov-lite loan will have a loan agreement with a funded term loan or a series of term loans. In some cases, there may be a smaller revolving credit facility. If there is not, there may be a separate asset-backed lender. Cov-lite loans will also have credit facilities with most of the same covenants and that are backed by the same collateral. And, generally speaking, cov-lite loans won’t have any financial maintenance covenants.
If you move forward with a covenant-lite loan, you’ll likely be able to take on additional debt, pay dividends, repay junior debt, and make an unlimited amount of acquisitions.
Back in the 2000s, private equity groups used covenant-lite loans and leveraged buyouts (LBOs) to acquire other companies. While leveraged buyouts require a great deal of financing, they may lead to significant returns for a private equity firm and its investors. Due to the sky-high debt levels that come with leveraged buyouts, as well as great potential for profit, buyout groups were able to mandate terms to their lenders. Cov-lite loans have grown significantly since 2005. By 2020, they made up over 85% of the leveraged loan market.
Pros and Cons of Covenant-Lite Loans for Borrowers
Chance to participate in other transactions
Potentially higher interest rate
May take on too much debt
- Favorable terms: You may find the terms of covenant-lite loans favorable because there is flexibility in when and how you can repay them. With traditional loans, terms are usually laid out in the loan contract and non-negotiable.
- Chance to participate in other transactions: The leniency of covenant-lite loans may allow you to engage in other deals without seeking consent from your lender, paying consent fees, or worrying about whether you’ll receive consent.
- Potentially higher interest rate: Depending on the covenant-lite loan you take out, you may be stuck with a higher interest rate than a traditional loan. This could cost you thousands of extra dollars over the life of your loan.
- May take on too much debt: Since a covenant-lite loan can open the doors to financing that you may not get approved for otherwise, it may steer you into excessive amounts of debt. It could also cause you to overpay for an acquisition.
- A covenant-lite loan doesn’t require borrowers to comply with financial maintenance covenants that say the borrower must maintain a certain financial performance throughout the life of the loan.
- Covenant-lite loans are common in buyouts and other complex corporate transactions.
- Most covenant-lite loans offer favorable terms and give borrowers the chance to participate in other deals.
- The major drawbacks of covenant-lite loans are potentially higher interest rates and the increased risk of taking on too much debt.