Covenant-lite loans may not be so toxic after all

February 10, 2011

By Lauren Silva Laughlin
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Covenant-lite loans may not be so toxic after all. So says Blackstone’s President Tony James. And the numbers suggest he could be partly right. Borrower-friendly covenant-lite loans, once considered very risky for lenders, perform no worse or a bit better than debt with covenants.

More than 25 percent of first-lien loans issued so far in 2011 have cov-lite structures, a higher percentage than in 2007, according to S&P Leveraged Commentary and Data. The recently announced $5.3 billion buyout of Del Monte, for instance, came with a $2.7 billion cov-lite loan package that investors snapped up.

In theory, cov-lites are hazardous for investors. Bank loans traditionally come with a requirement that a borrower doesn’t exceed a certain level of debt. If it breaches the limit, creditors get a chance to negotiate what happens next, like higher interest or even a restructuring. Cov-lite loans remove this protection. In theory a company could borrow more and more, with earlier lenders helpless.

In practice, though, cov-lites have done OK. They returned a total of 33 percent in the five years to January compared with 31 percent for covenant-heavy loans, according to S&P LCD. Narrowing the sample to the single-B rating category, the gap is even wider. There are a couple of explanations. One is that lenders generally give up covenants only for stronger-looking borrowers, even within a rating category. Another is that the flexibility of cov-lites helps long-term healthy borrowers get past short-term difficulties without defaulting — more or less the argument presented by Blackstone’s James.

Further, it may be that covenants often don’t bring much protection anyway. Since they typically cap debt at a level 20 percent to 30 percent above a company’s initial debt load, a highly leveraged borrower could easily run out of cash long before breaching a debt covenant.

Investors are still rightly taking care. Del Monte’s seven times debt-to-EBITDA ratio is high, but it’s not outrageous for a leveraged buyout — especially with EBITDA growing 36 percent in 2010. But lenders shouldn’t get carried away. Covenants may not always seem worth much — but if investors let them go completely, they will come to miss them.

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