The slow erosion of lender protections in leveraged loans has reached its logical end. What began years ago as covenant-lite, loans stripped of the maintenance tests that once gave lenders an early warning, has in many deals become covenant-gone. The documents that govern hundreds of billions in debt now offer creditors far less than they imagine.
The danger is not visible in good times. As long as borrowers pay, the absence of covenants costs lenders nothing and saves borrowers the discipline of quarterly tests. The bill comes due in a downturn, when a lender that once could have stepped in early discovers it has no right to do so until a payment is actually missed, by which point the value may be gone.
The quiet erosion
Each cycle, borrowers and their advisers negotiated away a little more. Flexible definitions let companies move assets beyond a lender's reach. Generous baskets allowed more debt to be layered on top. Add-backs flattered earnings so leverage looked lower than it was. Individually, each concession seemed minor. Together they have rewritten the balance of power between borrower and lender.
Private credit was meant to reverse this, and in unitranche deals it largely has, restoring covenants and tighter terms. But the broadly syndicated market that funds the largest deals remains borrower-friendly, and the documents written at the peak will govern those loans for years.
What gets tested
When defaults rise, the recovery rates on these loans will reveal what was given away. Lenders who assumed the protections of an earlier era will find they negotiated them away without fully pricing the loss. The funds that read the documents closely and priced the weakness will fare better than those that trusted the label on the loan.
Covenant-lite was always a bet that nothing would go wrong before the loan was refinanced. For much of the last decade that bet paid. The next downturn will settle whether covenant-gone was a sophistication or a mistake dressed up as one.