Covenant-lite loans, which largely disappeared during the credit crunch, have reappeared in the syndicated loan market. A convenant-lite (or cov-lite) loan is a borrower-friendly type of loan facility found in some, but by no means all, leveraged financing. Cov-lite loans are most likely to be found in syndicated loan transactions.

Cov-lite loans became widespread at the top of the last credit cycle before the 2007 credit crunch. During the credit crunch, however, new cov-lite loans largely disappeared from the market because lenders had greater market power to reject these types of borrower-friendly deals. At that time, many market participants thought that it would be many years before new cov-lite loans returned. However, starting in 2010, cov-lite loans began reappearing in the syn¬dicated loan market.

Borrowers can obtain cov-lite loans because of market dynamics. Currently, two key factors are influencing market dynamics:

Purpose of Financial Covenants
Financial covenants are one of the key protections for lenders in a leveraged loan transaction. Syndicated loan transactions generally are either investment grade or leveraged. Leveraged loans are perceived to have greater credit risk than investment grade loans.

Most often the distinction is determined by the rating on the loan from a rating agency. A loan with a rating in one of the four highest rating categories is typically an investment grade loan. A loan with a rating below the four highest categories is a leveraged loan. A loan without any rating can also be categorized as investment grade or leveraged based on how the borrower's credit profile, including its leverage ratio or interest or fixed charge coverage ratio, compares to rated loans for similar borrowers.

Because of their perceived greater credit risk, leveraged loans typically have greater protections for the lenders. These pro¬tections include, but are not limited to:

Common Financial Maintenance Covenants
Financial maintenance covenants require a borrower to meet certain financial performance criteria periodically, usually quarterly but sometimes monthly. Failure by the borrower to meet the financial performance criteria can result in a default under the loan documents which potentially can have several adverse consequences.

There are many types of financial maintenance covenants, but the most common are tied to an agreed definition of the borrower's cash flow available for debt service. Often this is defined as EBITDA (earnings before the deduction of inter¬est, taxes, depreciation and amortization). Common financial maintenance covenants are:

Maximum leverage ratio. The borrower must not exceed a specified ratio of debt to EBITDA (or some other cash flow measure). Depending on a borrower's capital structure and market conditions at the time of the loan, leverage tests can apply to total debt, secured debt, senior debt or first lien debt, and the loan agreement may include a combination of leverage tests.

Minimum interest coverage ratio. The borrower must, at a minimum, meet a specified ratio of EBITDA (or some other cash flow measure) to interest expense. As with leverage tests, depending on a borrower's capital structure and market conditions at the time of the loan, interest coverage tests can apply to total interest or only cash interest that is payable on total debt, secured debt, senior debt or first lien debt, and the loan agreement may include a combination of interest coverage tests.

Minimum fixed charge coverage ratio. The borrower must, at a minimum, meet a specified ratio of EBITDA (or some other cash flow measure) to an agreed definition of fixed charges. Some of the items that can be included in fixed charges are interest expense, capital expenditures, dividends and other distributions and scheduled payments of principal. In some deals, several of these items may be subtracted from EBITDA in the numerator of the ratio rather than included in the fixed charge denominator.

A leveraged loan that has financial maintenance covenants may have one, some or all of the covenants described above. The definitions and required ratios are set when the loan is negotiated. Normally, the required ratios are based on financial projections prepared by the borrower for the lenders plus a cushion on top of the projected performance. The purpose of financial maintenance covenants is to provide the lenders with an early warning that the borrower is not performing as expected and that action to improve performance or adjust the loan terms may be needed.

Financial maintenance covenants apply any time they are required to be tested, usually at the end of a quarter or, sometimes, at the end of a month. The borrower is required to comply with the financial maintenance covenants regardless of whether it is looking to engage in a transaction restricted by its negative covenants or is currently able to pay its debt service and other obligations when due.

In contrast, an incurrence-based negative covenant only applies when a borrower wants to voluntarily engage in a transaction or activity restricted by that covenant. An incurrence-based negative covenant prohibits a borrower from those actions only if it does not comply with the specified covenant. Therefore, a borrower that is underperforming relative to its projections can avoid violating its incurrence-based negative covenants by not engaging in the activities restricted by those covenants.

Cash Flow Deals
A typical cov-lite cash flow loan has the following structure:

Generally, these deals either have no financial maintenance covenants or financial maintenance covenants that only apply to the revolving credit facility. In the latter case, remedies upon a breach of the financial maintenance covenants (usually a single covenant, such as a maximum leverage ratio) will be within the control of the revolving credit lenders only. The revolving credit lenders (usually by majority vote of the class), to the exclusion of the term loan lenders, will have the power to:

Only if the revolving credit lenders do not agree to a waiver of the breach within a specified time period (usually between 45 and 90 days) can the term loan lenders declare a default and begin exercising their remedies for the breach of the financial maintenance covenant.

It is also typical in these cov-lite loan transactions for the financial maintenance covenants to be “springing” in nature. This means they will only apply to the revolving credit facility if certain thresholds are met. For example, the threshold can be that no revolving credit loans are outstanding or the revolving credit outstandings are below a certain dollar amount or percentage of the total revolving commitments. As a result, the borrower can avoid being required to meet any financial maintenance covenant if, at the time the covenant would otherwise be measured, it reduces its revolving credit usage below the threshold trigger.

In contrast, in deals with full financial maintenance covenants, breach of one of these covenants is normally an immediate event of default regardless of the amounts outstanding at the time. If an event of default occurs, all of the lenders (term and revolving lenders voting as a single class) by majority vote can exercise available rights and remedies.

Asset-Based Lending
Cov-lite loans can also be structured using an asset-based lending (ABL) component for the revolving credit portion. Typically, this involves an ABL revolving credit facility with a separate cash flow term loan (or multiple term loans).

In these transactions, the ABL revolving credit facility is documented separately from the term loan, and will have a different covenant package and prepayment events. The ability of the borrower to use the ABL facility is limited by a borrowing base formula often tied to a percentage of accounts receivable and a percentage of inventory meeting certain eligibility criteria in the ABL documents. The ABL documents generally have a springing financial maintenance covenant for minimum fixed charge coverage. Unlike a cash flow cov-lite loan transaction where springing covenants are tied to the usage of the revolving credit facility, the trigger in an ABL cov-lite transaction is tied to the amount of remaining availability under the borrowing base formula.

In an ABL cov-lite transaction, the term loan is documented in a separate agreement that would not have any financial maintenance covenants. To prevent the term loan lenders from getting the benefit of the ABL financial maintenance covenant, the term loan agreement usually has a cross acceleration to the ABL facility rather than a cross default. This means the term loan lenders only have an event of default in their transaction related to the ABL facility if the ABL facility has an event of default and the ABL lenders accelerate their debt as a result.

Common Cov-Lite Features
The absence of a financial maintenance covenant for the bene¬fit of the term loan lenders is the core feature of a cov-lite loan. Cov-lite loans also often have other borrower-favorable terms that make them more like high-yield bonds than traditional loan transactions with full covenant packages. In particular, cov-lite loans have looser negative covenants. Many cov-lite loans allow the borrower to take one or more of the following actions, subject to certain restrictions:

Elements of Post-Credit Crunch Cov-Lite Loans
Generally, post-credit crunch cov-lite loans have many of the common features and provisions described above. For example, recent cov-lite loans do not have any financial maintenance covenants for the benefit of the term loans and include looser incurrence-based negative covenants.

However, one trend that was emerging before the credit crunch and has continued since is the reluctance of lenders to provide revolving credit facilities in cash flow financings. This means that a leveraged borrower's debt structure will include an ABL facility for the revolving portion that funds ongoing liquidity needs. Therefore, the cov-lite cash flow term loan is documented in a separate loan agreement and does not ben¬efit from any financial maintenance covenants in the revolving facility agreement, even after a standstill period.

In short, there are market factors that have brought about the reappearance of cov-lite loans. In addition to a disciplined approach, a clear understanding of the traits and elements of any financing option are an effective starting point.

By Eric Goodison, partner of Paul, Weiss, Rifkind, Wharton & Garrison LLP Corporate Development. This article is reprinted from the September 2011 issue of Practical Law The Journal.