Recovery prospects limited by 'covenant-lite' loans, S&P report says

By Jennifer Chiou

New York, July 18 - "Covenant-lite" loan structures will result in lower recoveries when borrowers default, according to a Standard & Poor's report titled "Covenant-Lite Loan Structures Diminish Recovery Prospects."

The agency added that covenant-lite structures, in which lenders give up most of the traditional controls that banks had over their borrower's performance, have appeared in almost one-third of all new leveraged loan structures so far this year - four times as many as a year ago.

The report said that strong loan market liquidity, the continuing pace of merger and acquisition activity, and the ongoing demand for loan assets by hedge funds and structured finance vehicles are the key reasons for the weakening in credit standards that the covenant-lite phenomenon represents.

"Over 80% of the covenant-lite borrowers are rated in the single-B category, and about one-third of B credits default at some point over the term of the loan," Steve Bavaria, vice president of the recovery ratings practice at S&P, said in a news release.

"This means covenant-lite lenders are giving up a basic tool that they will surely need at least one-third of the time."

S&P noted that its recovery ratings evaluate the likelihood of loss and recovery in the event of default, analyzing the effect of covenants, as well as collateral and other protective features, and, according to the report, recovery ratings are typically lower for loans with covenant-lite structures.

"We estimate that enterprise valuations for covenant-lite financings are, on average, 10% lower, which translates into recovery estimates that are 8% to 14% lower than for equivalent borrowers with 'full' maintenance covenants," S&P recovery analyst Ana Lai said in the release.

What makes a covenant-lite loan less protective than the loans traditionally made by professional bank lenders is the limited ability it gives lenders to take remedial action if the borrower's financial performance deteriorates beyond certain specified limits during the loan term, which may be five to seven years or more, the report said.

More traditional "maintenance" covenants allowed the banks to step in at any point if the borrower's performance dropped below certain benchmarks, S&P noted. With covenant-lite loans, the tests are "incurrence" rather than "maintenance," and only come into play if the borrower attempts to take specific actions, like incurring more debt or making an acquisition.

Short of one of these events occurring, the borrower's business can deteriorate steadily throughout the loan, and all the lenders can do is watch from the sidelines. "This means by the time a default occurs, there may not be much business enterprise value left to recover," Lai added in the release.

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