A Closer Look at Cov-Lite Loans

Catherine Craig has a great, in-depth look today at the "cov-lite" phenomenon whereby loans are increasingly being syndicated without the restrictive covenants of yesteryear.

Craig's piece is excellent because she doesn't go down the lazy knee-jerk route of automatically saying that cov-lite loans are toxic and dangerous and something which pose a massive systemic risk to the international financial architecture. Instead, she looks at the development in an impartial manner, and although she doesn't make any explicit conclusions, it's clear that there are quite a few reasons to consider cov-lite loans a good thing.

It's certainly true that banks with cov-lite loans will have less power over borrowers than they had in the past. But this is not necessarily a bad thing.

For one thing, many recent cov-lite loans, such as the $16 billion in acquisition financing that KKR is lining up for First Data, or the same amount that it might borrow to acquire Alliance Boots, are huge. As a result, any bank creditors committee would be enormous, unwieldy, and would probably cause more harm than good.

What's more, many banks with these loans will hedge their exposure in the CDS market, which means that the real default risk is being borne not by the creditor of record but rather by any number of hedge funds, CDOs, and the like. In such a situation, it makes little sense for the bank in question to have serious control over the debtor company.

It's also worth noting that if a company doesn't have restrictive covenants on its loan, that gives it an extra couple of degrees of freedom should it ever run into difficulties. The company's owners can repay its bank debt however they like, without being second-guessed by their creditors. Most importantly, volatile financial results are much less likely, in and of themselves, to lead to receivership or bankruptcy.

Many firms with cov-lite loans are highly leveraged, which means their financial results are naturally going to be much more volatile. Cov-lite loans simply make that volatility less likely to result in technical default on the part of the company, with all the nasty consequences that implies.

And there's also evidence that banks are receiving a premium for agreeing to cov-lite loans:

At the riskier end of the spectrum, where more highly leveraged deals are using deferred repayment instruments such as second lien instead of senior debt, banks are cautious and likely to demand a higher price for the privilege of covenant-lite terms.

This is great for all concerned: banks get the yields they're looking for, while sponsors get the freedom of action that they're looking for.

The fact is that cov-lite loans are all negotiated, as it were, between consenting adults. Maybe the banks, looking at the history of the likes of KKR, have decided that KKR is actually better at running companies and working out what the smart moves are than their own loan officers are. Or maybe they just think that they can boost their total returns by lending cov-lite.

So does this mean there's no systemic risk associated with cov-lite loans? I'm not sure. No one seems to think that there's major systemic risk associated with bonds, and cov-lite loans are essentially loans which behave quite similarly to bonds. But the collapse of a bondholder is a lot easier to cope with than the collapse of a bank. So really it probably all comes down to the question of how much of this debt is being retained by banks, as opposed to being sold off or hedged. And that's something which nobody knows.