Cov-lite
Encyclopedia
Cov-lite is financial jargon
for loan agreement
s which do not contain the usual protective covenants for the benefit of the lending party. Although traditionally banks have insisted on a wide range of covenants which allow them to intervene if the financial position of the borrower or the value of underlying assets deteriorates, around 2006 the increasing strength of private equity
firms and the decreasing opportunities for traditional corporate loans made by bank
s fuelled something of a "race to the bottom
" with syndicates of banks
competing with each other to essentially offer ever less invasive terms to borrowers in relation to leveraged buy-outs.
Cov-lite lending is seen as more risky because it removes the early warning signs lenders would otherwise receive through traditional covenants. Against this, it has been countered that cov-lite loans simply reflected changes in bargaining power between borrowers and lenders, and followed from the increased sophistication in the loans market where risk is quickly dispersed through syndication or credit derivative
s.
, gearing
and EBITDA
ratios.
More aggressively negotiated cov-lite loans might also remove:
in particular thought it was a concerning and short-sighted development, and the Financial Times
endorsed the view of Anthony Bolton
of Fidelity Investments
who warned on his retirement in May 2007 that cov-lite could be "the tinder paper for a serious reversal in the market.", the movement in the market was inexorable. Others argued that the move to cov-lite was a welcome simplification of loan documentation, and was fully justified as the banks would hedge their risk by transferring exposure to the loan in the CDO
market. It was also pointed out at the time that cov-lite loans operated in a very similar way to bonds
, but at lower values.
The high water mark of cov-lite loans came in the acquisition by Kohlberg Kravis Roberts, a US private equity firm, by way of a record $16bn cov-lite loan for its buy-out of First Data
.
arising from crisis to cov-lite loans, although the LBO market is almost entirely unconnected with the sub-prime mortgage market in terms of exposure. However, in the credit crunch
which ensured, cov-lite loans significantly hampered the ability of banks to step in and both seek to rectify positions which were going bad, and to limit their exposure once matters had gone bad. The suggestion that banks risks were mitigated through the CDO market was difficult to sustain in light of difficulties in that market itself as a result of the credit crunch.
In March 2011, the Financial Times reported that in the three months prior, cov-lite loans to the value of $17bn had been issued.
Jargon
Jargon is terminology which is especially defined in relationship to a specific activity, profession, group, or event. The philosophe Condillac observed in 1782 that "Every science requires a special language because every science has its own ideas." As a rationalist member of the Enlightenment he...
for loan agreement
Loan agreement
A loan agreement is a contract entered into between which regulates the terms of a loan. Loan agreements usually relate to loans of cash, but market specific contracts are also used to regulate securities lending....
s which do not contain the usual protective covenants for the benefit of the lending party. Although traditionally banks have insisted on a wide range of covenants which allow them to intervene if the financial position of the borrower or the value of underlying assets deteriorates, around 2006 the increasing strength of private equity
Private equity
Private equity, in finance, is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange....
firms and the decreasing opportunities for traditional corporate loans made by bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s fuelled something of a "race to the bottom
Race to the bottom
A race to the bottom is a socio-economic concept that is argued to occur between countries as an outcome of regulatory competition, progressive taxation policies and social welfare spending...
" with syndicates of banks
Syndicated loan
A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers....
competing with each other to essentially offer ever less invasive terms to borrowers in relation to leveraged buy-outs.
Cov-lite lending is seen as more risky because it removes the early warning signs lenders would otherwise receive through traditional covenants. Against this, it has been countered that cov-lite loans simply reflected changes in bargaining power between borrowers and lenders, and followed from the increased sophistication in the loans market where risk is quickly dispersed through syndication or credit derivative
Credit derivative
In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...
s.
Covenants
Practise varied, but characteristically, cov-lite loans would remove the requirement to report and maintain loan to valueLoan to value
The loan-to-value ratio expresses the amount of a first mortgage lien as a percentage of the total appraised value of real property. For instance, if a borrower borrows $130,000 to purchase a house worth $150,000, the LTV ratio is $130,000/$150,000 or 87%.Loan to value is one of the key risk...
, gearing
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
and EBITDA
EBITDA
EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization. It is a non-GAAP metric that is measured exactly as stated. All interest, tax, depreciation and amortization entries in the income statement are reversed out from the bottom-line net income...
ratios.
More aggressively negotiated cov-lite loans might also remove:
- events of default relating to "material adverse change" of the position of the borrower
- requirement to deliver annual accounts to the banks
- restrictions on other third party debt
- restrictions on negative pledgeNegative pledgeNegative pledge is a provision in a contract which prohibits a party to the contract from creating any security interests over certain property specified in the provision....
s - requirements for bank approval to change the form of the debtor group's business
Concerns
Many at the time were alarmed by the development; The EconomistThe Economist
The Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd. and edited in offices in the City of Westminster, London, England. Continuous publication began under founder James Wilson in September 1843...
in particular thought it was a concerning and short-sighted development, and the Financial Times
Financial Times
The Financial Times is an international business newspaper. It is a morning daily newspaper published in London and printed in 24 cities around the world. Its primary rival is the Wall Street Journal, published in New York City....
endorsed the view of Anthony Bolton
Anthony Bolton
Anthony Bolton is one of the UK's best known investment fund managers and most successful investors, having managed the Fidelity Special Situations fund from December 1979 to December 2007...
of Fidelity Investments
Fidelity Investments
FMR LLC or Fidelity Investments is an American multinational financial services corporation one of the largest mutual fund and financial services groups in the world. It was founded in 1946 and serves North American investors. Fidelity Ventures is its venture capital arm...
who warned on his retirement in May 2007 that cov-lite could be "the tinder paper for a serious reversal in the market.", the movement in the market was inexorable. Others argued that the move to cov-lite was a welcome simplification of loan documentation, and was fully justified as the banks would hedge their risk by transferring exposure to the loan in the CDO
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
market. It was also pointed out at the time that cov-lite loans operated in a very similar way to bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, but at lower values.
The high water mark of cov-lite loans came in the acquisition by Kohlberg Kravis Roberts, a US private equity firm, by way of a record $16bn cov-lite loan for its buy-out of First Data
First Data
First Data Corporation is an American payment processing company headquartered in Atlanta, Georgia. First Data is a provider of electronic commerce and payment solutions...
.
2007 credit crunch
The tendency towards cov-lite loans ended abruptly with the 2007 subprime mortgage financial crisis. Some commentators subsequently sought to attribute the credit crunchCredit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...
arising from crisis to cov-lite loans, although the LBO market is almost entirely unconnected with the sub-prime mortgage market in terms of exposure. However, in the credit crunch
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...
which ensured, cov-lite loans significantly hampered the ability of banks to step in and both seek to rectify positions which were going bad, and to limit their exposure once matters had gone bad. The suggestion that banks risks were mitigated through the CDO market was difficult to sustain in light of difficulties in that market itself as a result of the credit crunch.
In March 2011, the Financial Times reported that in the three months prior, cov-lite loans to the value of $17bn had been issued.