A cov-lite loan is a type of loan that has weaker financial covenants than those found in traditional loans. This makes them more enticing to potential borrowers, as they come with fewer strings attached. But, it’s important to note that cov-lite loans are not without risk and should be entered into only after careful consideration.
When it comes to financing the growth of a company, most people think about conventional business loans or SBA loans. However, there are other types of financing methods available to businesses worth mentioning, including covenant-lite loans.
Though relatively risky, a cov-lite loan doesn’t have the same stringent requirements as other loans, making it a popular choice for businesses that are looking for leveraged financing. Read on to learn about what covenant-lite loans are, how they work, and whether or not this type of financing is right for you.
What does covenant mean?
Before we dive deeper into the definition of cov-lite loans, it’s important that we define what a covenant is. A covenant is an agreement or promise between two parties. In the lending world, covenants are often used to protect the lender’s interest. For example, a covenant might require that the borrower maintains a certain debt-to-equity ratio or financial performance level.
With covenants in place, lenders can help reduce their risk and protect their investments. Keep in mind that violating a covenant can trigger a default, which gives the lender the right to accelerate the loan, and demand repayment in full.
What are cov-lite loans?
So, as its name suggests, a covenant-lite loan is a leveraged loan that’s issued with less stringent restrictions on the borrower. These loans also come with fewer restrictions on the use of proceeds, and more flexible repayment terms.
However, covenant-lite loans have a higher degree of risk for lenders because there’s an increased possibility of default. For this reason, covenant-lite debt generally carries a higher interest rate.
Covenant-lite loans have also become increasingly popular in recent years, as they offer borrowers a higher level of financing than they would likely be able to access through a traditional loan. In fact, in 2021 alone, more than 90% of all leveraged loans issued in the United States have been covenant-lite loans — setting an all-time high.
When is covenant-lite debt used?
Typically, covenant-lite deals are offered to businesses and investment firms and are often used in leveraged buyouts. Let’s say that you own a private equity firm and want to buy out another company — this is where covenant-lite loans can come in handy.
Unlike traditional term loans that generally come with financial maintenance covenants, a cov-lite loan tends to disregard that. This means you won’t need to continuously meet certain financial performance thresholds to avoid going into default. For many businesses, this is an exciting financing method since lenders won’t care too much even if the business’s finances aren’t in the best shape.
However, if you prefer the traditional approach of business financing, check the list of lenders below to see which one is best for your company.
Pros and cons of cov-lite loans
As with any other financing method, there are advantages and drawbacks of covenant-lite loans. Be sure to carefully weigh the pros and cons before making a decision.
Here is a list of the benefits and the drawbacks to consider.
- Favorable terms and fewer restrictions. With a traditional loan, the terms are typically non-negotiable. With covenant-lite loans, however, you have some flexibility in terms of repayment. This can be particularly helpful if your business experiences a downturn, or unexpected expenses arise.
- No financial maintenance covenant. Another advantage of a covenant-lite loan is that there is no financial maintenance covenant. This means that the borrower doesn’t have to maintain a certain level of financial performance to keep the loan in good standing.
- You can risk taking on too much debt. Taking out a covenant-lite loan can be a risky proposition. If your business conditions take a turn for the worse, you may find yourself unable to meet the repayment obligations. So, approach covenant-lite loans with caution, and make sure your company can handle the additional debt.
- Potential higher interest rate. Another potential downside for borrowers is that these loans may come with a higher interest rate. Since there aren’t many covenants in a cov-lite loan, there’s an increased risk for lenders. To offset this risk, lenders will typically charge higher interests.
Are covenants legally binding?
Yes. Depending on the nature of the covenant, they may be enforceable by law. However, in some cases, covenants may be unenforceable. For example, if the covenant is too ambiguous or is contrary to public policies, you could argue that the covenant is not legally enforceable. Because of this, be sure to consult with an attorney to determine the enforceability of a particular covenant.
What are the two types of debt covenants?
Debt covenants help protect the lender’s interests by ensuring that the borrower is taking steps to repay the loan, and by limiting the borrower’s ability to take on additional risk. There are two primary types of debt covenants: affirmative covenants and negative covenants.
- Affirmative covenants. Actions that the borrower agrees to take, such as maintaining a certain level of insurance coverage or making timely payments.
- Negative covenants. Actions that the borrower agrees not to take, such as incurring additional debt or selling assets.
In general, financial institutions will view companies with higher levels of debt as being higher risk and will therefore require more restrictive covenants. This is because companies with high levels of debt are more likely to default on their loans, which could lead to losses for the lender.
What is a unitranche facility?
A unitranche facility is a type of financing that combines both senior and junior debt (subordinated debt) into one debt instrument. This type of facility is often used by companies that are looking to finance a large project or expand their business.
Because it’s a hybrid model that combines multiple loans into one, it allows businesses to acquire more capital through a single deal. This eliminates costs associated with multiple issuers and facilitates the entire lending process. Because of its convenience, unitranche facilities have become an increasingly popular option for businesses seeking growth capital.
- A covenant is an agreement between two parties, typically related to the terms of a loan. The borrower agrees to certain conditions, such as maintaining a certain debt-to-equity ratio, and the lender agrees to provide the loan funds. Covenants can also be found in other types of contracts, such as leasing agreements.
- Covenant-lite loans are a type of loan that typically has fewer covenants than a traditional loan. For example, they don’t usually have financial maintenance covenants that require borrowers to meet financial benchmarks.
- When it comes to loans, covenants can help to reduce the risk for the lender and make it more likely that the borrower will repay the loan. For this reason, cov-lite loans are riskier for lenders.
- Covenant-lite loans are often used by private equity groups or businesses in leveraged buyouts.
View Article Sources
- Banking Trends: Measuring Cov-Lite Right — Federal Reserve Bank – Philadelphia
- Leveraged Lending and Corporate Borrowing — Federal Deposit Insurance Corporation
- How to Get a Business Loan If You Have Bad Credit — SuperMoney
- 8 Creative Business Loan Types You Should Know About — SuperMoney
- What is a Shared Equity Financing Agreement? — SuperMoney
- What is In-House Financing and How Does It Work? — SuperMoney
- Best Startup Business Loans (Even If You Have Bad Credit) — SuperMoney