The Case for Covenants (Part One)

It’s a fact of life in leveraged lending that terms are market-driven. During periods of excess liquidity – when loan demand exceeds supply – structures become issuer-friendly. When investors pull back, for any reason, terms swing in favor of lenders.

When concerns about China and commodities roiled markets in August 2015, the Dow dropped 2000 points in two weeks. But by the spring of 2016 things began to normalize. The market then entered its current issuer-friendly cycle, with structures continuing to erode. Absent another correction, we see no end to this trend.

A good barometer for sell-side exuberance is prevalence of covenant-lite structures in the middle market. As our Chart of the Week shows, the share of cov-lite has shrunk and swelled over time. Today cov-lite loans less than $250 million are 27% of total volume, less than the 40% for loans above $250 million (and less than $350 million).

What causes this effect? Why are loan arrangers pushing cov-lite for smaller loans? And why are loan investors accepting it?

To answer these questions, let’s go back to the origin of these structures. As we’ve discussed in past commentaries,