What is a Cov-Lite Loan, Why Should I Care?

If you took out a mortgage for 500 million to 1 Billion dollars would you expect your lender to  ask you to provide more than your last pay stub as proof you could repay the loan?  Of course!  Since the financial crisis underwriting standards for residential mortgages have become much more strict than they were in the no income verification days of 2005-06.  In the leveraged loan market where corporate lenders seek financing to fund everything from acquisitions to new equipment, underwriting standards have loosened in at least one key way.  Where lenders used to require periodic proof that a borrower was still capable of meeting their financial obligations in the form of financial maintenance covenants they now do not in the overwhelming majority of loans issued.

Source: http://www.leveragedloan.com/primer/#!second-lien-loans

What is a financial maintenance covenant?  This is where a lender requires a corporate borrower to submit proof that certain key metrics have not deteriorated….or that they’ve been maintained.  Usually the frequency would be quarterly.  Some examples of those key metrics are interest coverage ratios, leverage ratios, or loan to value ratios.

Why should you care, after all only the largest of banks could underwrite loans this size, right? You would probably be surprised to learn that banks almost never hold these entire loans by themselves. Much like a chop shop would part out a stolen Honda Civic the banks will break up these loans into small pieces and sell them off to many other lenders. Ok, so who are the people buying these parted out loans. In some cases you are. The two largest buyers of these loans are CLO’s and mutual funds. CLO’s are typically funded by institutional investors, think insurance companies, or any company needing to invest a large pool of cash in a AAA rated asset. Mutual funds however have been increasingly buying a larger share of leveraged loans issued and if you look in your 401K there is a good chance that you’ve unknowingly invested in cov-lite loans through a mutual fund. Buyer beware!