Loan Covenants: Out of Date or Out of Fashion?
It's hard to ignore the growth of covenant-lite lending in private equity deals, when even famous investment gurus like Anthony Bolton remark on it, and at his farewell dinner no less. Here is what Mr. Bolton had to say on the topic:
“I think the phrase is ‘covenant-lite’, but in many cases it appears to mean no covenant at all,” Mr Bolton said. He added: “Covenant-lite borrowing ... will come back at some stage to haunt the banks,” he said.
Quotes about covenant-lite lending are usually paired with a dire prediction, such as the premonition of another financial bubble. But will covenant-lite lending really come back to haunt the banks?
In a typical covenant-lite deal, the lenders give up what are called "maintenance" covenants. As the name suggests, these are requirements that the borrower maintain certain financial standards at regular intervals. For example, a borrower might be required to certify that at the end of each quarter, it has maintained a certain ratio of EBITDA to total debt. These covenants are designed to be an early warning system that the borrower's earnings are deteriorating, and it might become unable to meet debt service requirements at some time in the future. With these maintenance covenants gone, the lenders rely solely on what are called "incurrence" covenants. These require that a borrower meet defined financial standards not on a regular basis, but only when there is a specific event, such as an acquisition. For example, if the borrower wants to make an acquisition, it must certify that it will meet a specific EDITDA coverage test after the acquisition is taken into account.
Finally, in covenant-lite deals, the other covenants are less restrictive, for example allowing for more extensive dividend payments or larger capital expenditures.
How bad are covenant-lite loans? Despite the publicity these deals receive, they appear to be limited to large private equity deals involving companies with earnings cycles that are relatively well known or at least fairly predictable. With companies like these, perhaps the function of maintenance covenants -- to provide an early warning system -- isn't necessary. What good is a warning when the funds have already been loaned? Perhaps maintenance covenants aren't really needed, and their elimination is simply a matter of efficiency.
Perhaps the traditional way of lending, where a borrower is required to certify periodically that it remains healthy enough to maintain its debt, is out of date. Then again, if it is merely out of fashion, we may see it come round again. Time will tell.
