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COV Loan: Covenant-Light Loan Definition & Explanation

COV Loan – What are Covenant-Lite Loans?

COV LoanA COV loan or COV-Lite Loan is a covenant-light type of term loan. It is structured more like a bond with maximum flexibility and minimal constraints for the borrower.

A covenant-lite loan is a type of flexible financing.  It is a term loan issued with fewer restrictions on the borrower and fewer protections for the lender. Traditional loans typically include protective covenants within the contract for the lender’s protection.  For example, financial maintenance metrics are often included to measure and maintain the borrower’s debt-service capacities. However, Covenant-lite loans are more flexible in terms of the borrower’s collateral, income level, and loan payment terms. COV loans are also referred to as covenant-lite or cov-lite loans.

COV Loan – A Closer Look

A COV Loan provides qualified borrowers with a higher level of financing.  As a result, they can borrow more money than they would likely be able to obtain through a regular loan.  Simultaneously, they are given more borrower-friendly terms. However, covenant-lite loans carry more risk for the lender than regular loans.  They also allow individuals and organizations to do things that would be difficult or impossible to do under a traditional loan agreement.  For example, paying out dividends to investors while deferring scheduled loan payments. A COV Loan is typically only available to investment firms, corporations, and high-net-worth individuals.

Covenant-lite loans became popular when private equity groups employed highly leveraged buyouts (LBOs) to purchase other companies. Leveraged buyouts necessitate a high amount of financing versus equity.  Nevertheless, they can result in large profits for the private equity firm and its investors.  Often, they result in a leaner, more successful company that focuses on returning value to shareholders. These transactions required high levels of debt but offered a high potential for profit.  So, the buyout groups were able to begin demanding favorable terms from their banks and other lenders.

COV Loan and Maintenance Covenants

Maintenance covenants are not included in the documentation that governs cov loans. Instead, they include incurrence covenants, which provide lenders with significantly less security. Incurrence covenants are only tested when pre-agreed-upon events occur. For example, a major drawdown on a revolving credit facility or the payment of a dividend. This is opposed to review on an automatic basis.  This means that debtors can simply dodge financial ratio tests.

For instance, by refraining from taking the specific actions that trigger them. Loosely-structured cov loans, on the other hand, usually include only one maintenance covenant.  This is commonly a debt-to-EBITDA ratio minimum. The point at which the borrower’s earnings would have to degrade to trigger a default is usually set too high.  By the time a covenant breach occurs, lenders have already missed the opportunity to engage with the borrower.  As a result, it is impossible to try to resolve the underlying issue and maximize loan recovery.

The value of maintenance covenants

Maintenance covenants give lenders strong negotiating powers, forcing an early discussion with management, as soon as trading performance declines and usually before there are any liquidity problems. In such circumstances, the options available to lenders can include:

  • Increasing the yield of the loan to reflect the increased risk
  • Requiring the borrower to prioritize cash generation over corporate expansion in order to pay down the loan
  • Requiring the borrower to sell business divisions or assets to pay down the loan
  • In a worst-case scenario, enforcing the security provided in the loan documentation to take ownership of the business. (Source: hermes-investment.com)

Pros and Cons of a COV Loan or Cov-Lite Loans

Private equity firms were able to go bigger and broader in their deal-making with relaxed loan terms.  In addition, they gained more advantageous conditions regarding how and when their loans had to be repaid. As a result, many analysts believe that the leveraged buyout concept was taken too far.  In the 1980s, some companies began to fail as a result of the heavy debt load they were now carrying. Even if the loans were covenant-lite, they still needed to be prepared at some point.  Many companies were unable to service the massive debt they carried on their balance sheets.

Leveraged buyout deals were arguably out of control in the 1980s.  Highly leveraged companies and their employees often paid the price.  Nevertheless, later analysis revealed that many LBOs were financially successful.  And, the overall performance of covenant-lite loans was comparable to traditional loans.  The expectation of covenant-free, flexible financing has now developed within some financial circles. It is a red flag when a deal does not receive attractive financing terms or a covenant-lite loan. Their belief is that the inclusion of traditional loan covenants is a clue that the deal is poor.  Not that the covenants are a normal precaution that any lender would take to protect itself.

Pros and Cons

  • Climbing default rates – Since the rise of cov loans, default rates have rapidly increaseded. This is not to say that credit quality has deteriorated with these loans, but rather that the lack of maintenance covenants does not provide lenders with many tools or enough time to intervene and fix problems before they arise. When a borrower defaults on a payment, it is frequently too late. Equity cures, which offer the sponsor time to provide equity to alleviate the situation, are becoming more common in these transactions as a form of problem resolution.
  • Riskier to lenders – Covenant lite loans carry a higher risk than standard loans. Borrowers must meet a number of standards before being approved for a traditional loan. Further, they must demonstrate their ability to repay the loan and comply with specific payment terms. A covenant-lite loan does not include any conditions.  There is nothing to alert a lender that a borrower’s financial position is deteriorating or is going to default.
  • Perception of a flawed deal if COV-Lite loans are not offered – COV loans have become a backbone of the capital structure for highly levered companies.  This is by convention as well as their relatively low cost and high flexibility.

COV Loan Example

Consider Company XYZ that requires capital.  The company decides to issue bonds rather than borrow from a bank.  This is because a bank loan would impose too many restrictions.  A traditional loan would also be more expensive than paying bond yields to investors. Normally, a legal agreement for issuing bonds would impose constraints on a company. For example, limiting its capacity to incur additional debt. However, Company XYZ receives a covenant-lite bond transaction that imposes virtually no restrictions or constraints. One reason Company XYZ was able to obtain a covenant-lite agreement is that yields are higher.  As a result, investors are willing to take on more risks in order to obtain better payouts.

Up Next: What are Diagonal Spread Options?

Diagonal SpreadDiagonal spread options refer to buying and selling equal amounts of call or put option contracts with different strike prices and expiration dates.  In options trading, the strategy is a modified calendar spread involving different strike prices. It is put into play by simultaneously entering into a long and short position in two options of the same type.  This can either be two call options or two put options.  However, with different strike prices and different expiration dates.

This tactic can be bullish or bearish, depending on the structure and the options that are used. The strategy combines horizontal, or calendar spread as well as a vertical spread.  The term diagonal spread comes from the options chain layout where the two options contract with different strike prices and expiration dates would be diagonally oriented.

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