This erosion of creditor protections reflects the shift in the market from the immediate aftermath of the financial crisis, in which creditors tightened lending conditions, to the present, where increased competition from nonbank entities including hedge funds, private equity, business development companies, and more recently, interval funds, has created market conditions more conducive to borrowers. Moody’s notes that covenant-lite loans account for the largest share ever of the leveraged loan market. This may indicate that borrowers are refinancing previous issuances that may include covenants into covenant-lite loans. Note that issuances of covenant-lite loans exceed the new money issuances in the chart above.
The following charts highlight covenant-lite issuance and the percentages of issuances that are covenant-lite. Note the predominance of refinancing activity in 2016-2017. The following charts, from Thomson Reuters PLC, outline leveraged loan issuance over the past decade. It is important to note that leveraged loan investors are typically subordinated, in the capital stack of borrowers, to financing from revolving lines of credits. This mitigates risks that would subject the creditor to principal losses, helping to prevent the borrower’s financial performance from further deterioration or prohibiting the borrower’s management from taking actions adverse to creditors, including issuing dividends to equity holders, as early distress signs are exhibited. The primary purposes of the covenants are to protect the creditor and allow the creditor to take actions, including calling the loan or liquidating the borrower, upon the occurrence of deterioration of the financial performance of the borrower. In the event the borrower’s performance recedes below certain thresholds contained in the financial maintenance tests, the creditor may take certain actions, including calling the underlying loan. Other covenants may require percentage repayments to the creditor upon asset sales by the borrower.
Additional traditional covenants may restrict the borrower from issuing additional debt in certain situations and require interest rate increases to the creditor’s loans upon additional debt issuance by the borrower, as well as incorporation of any subsequent covenants the borrower is subjected to with other creditors. These financial maintenance tests may include EBITDA ratios and loan-to-value metrics, among others. These protections take the form of financial maintenance tests of the borrower which are reported periodically, usually monthly or quarterly, to the creditor. Covenant-lite loans are loans that lack traditional protective covenants that may protect creditors in the event of borrower distress. Recent trends in leveraged loan space include the resurgence of covenant-lite loans. Leveraged loans comprise a significant portion of the investment portfolios of many alternative investment products that FactRight reviews, including business development companies and more recently credit-focused interval funds.