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When it comes to corporate financing, not all debt is created equal. Appetite for risk varies among lenders and even among portfolios of a single lender. Higher risk debt typically commands higher interest rates. One such type of debt, known as covenant-lite loans, has grown significantly over the past six years in its percentage of the overall U.S. leveraged loan volume – from approximately 30 percent of all outstanding loans in 2012 to 77.8 percent as of July 2018, according to Standard & Poor’s LCD.

Before looking at the causes of this dramatic increase, let’s discuss what covenant-lite means in the lending world. Covenants are agreements between the lender and borrower that limit the actions the borrower can take or not take that increase the risk of the lender receiving the agreed upon interest and payment of principal.

Covenants come in two forms. Positive covenants state what the borrower is required to do. These actions can include reaching certain financial ratio thresholds or providing annual audited financial statements. Negative covenants state actions the borrower cannot take, such as paying cash dividends over a certain amount, borrowing more debt or selling certain assets. A borrower who fails to follow the loan covenants is considered in breach of contract.

Compared to traditional business loans, covenant-lite debt typically requires fewer (or no) financial maintenance tests – monthly or quarterly metrics reported by the borrower and used by the lender as signals of the borrower’s ongoing ability to repay the loan.

For companies, covenant-lite debt provides greater freedom and flexibility to manage cash flow and reduces risk. These loans may allow the business to incur additional debt with no limit as long as certain maintenance tests are met after each loan.

They may allow the company to pay unlimited dividends subject to a percentage of net income or EBITDA – a tactic that can be appropriate for closely held family businesses. They may also allow the business to make acquisitions or repay junior debt – actions not allowed under the covenants of traditional business loans.

With all those potential benefits for the borrower, what makes covenant-lite loans worthwhile for lenders?

Financier Worldwide in October 2015 identified three factors as contributing to the surge: companies seeking capital for growth, low interest rates and growing competition among lenders. Banks must lend money to make money; in a low interest rate environment, they must lend more money to make the same profit. Although capital demand grew, it didn’t outgrow the available supply from lenders. To be competitive, lenders had to become more flexible business partners.

Relaxing covenants for borrowers allows lenders to charge higher interest because, without those early warning maintenance tests, they assume greater risk. If the borrower does experience temporary financial issues, covenant-lite loans provide it the opportunity to correct those without the lender being forced to call the loan. And the lender doesn’t wind up owning a company or collateral like property and equipment that it doesn’t want and can’t easily liquidate.

So what does all this mean for companies raising capital? It means taking on debt can be done in flexible ways customized to the needs of the company and its shareholders, and additional options are available to companies beyond those offered by traditional covenant-oriented banks.

Bridgepoint Investment Banking provides advice to companies considering debt financing and access to a wide variety of capital resources. Contact us for a no-obligation review of your situation to determine if covenant-lite debt is right for your business.

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