What are covenant-lite loans?

Covenant-lite (or "cov-lite") loans are leveraged loans that lack the traditional maintenance covenants historically standard in bank lending. Maintenance covenants require borrowers to continuously meet financial tests, such as maximum leverage ratios, minimum interest coverage ratios, or minimum EBITDA thresholds, tested quarterly. If a borrower breaches a maintenance covenant, lenders can accelerate the loan or force restructuring negotiations even if the borrower is still current on payments.

Cov-lite loans instead feature only "incurrence" covenants, which are tested only when the borrower takes a specific action (such as taking on additional debt, paying a dividend, or making an acquisition). As long as the borrower makes its interest and principal payments on time, lenders have limited ability to intervene even if the company's financial health is deteriorating. This structure was borrowed from the high-yield bond market, where incurrence-only covenants have always been standard.

The share of cov-lite loans in the leveraged loan market has grown from negligible levels before 2005 to approximately 90% of all new leveraged loan issuance by the 2020s. This shift was driven by strong demand for leveraged loans from CLOs and institutional investors during a period of low interest rates, giving borrowers leverage to negotiate away covenant protections. Private equity sponsors, who are the largest users of leveraged loans for buyouts, strongly prefer cov-lite structures because they maximize operational flexibility and delay lender intervention.

The systemic concern with widespread cov-lite lending is that it delays default recognition. Under traditional maintenance covenants, a struggling borrower would trip a covenant and trigger restructuring discussions early, potentially preserving more value for all parties. Under cov-lite structures, a deteriorating borrower can continue operating and potentially accumulating more debt before an actual payment default forces the issue. This can mean that when defaults do occur, recovery rates are lower because the company's financial position has deteriorated further before lenders gain leverage.