Recently, rating agencies have reported a sharp increase in the issuance of covenant-lite loans due to low interest rates, a competitive credit environment and investor willingness to take on increased risks. To date, the total value of covenant-lite loans issued in 2012 has reached between $49 billion and $53 billion (depending on the source), representing some 31% of institutional loans issued. This signals a large increase in covenant-lite loan activity over 2011 which, according to Thompson Reuters, totaled $33 billion for the entire year.

The increase is due largely to private equity secondary buyouts and dividend recaps, as nearly 90% of the Moody's rated 2012 covenant-lite loans were to portfolio companies of private equity firms. Covenant-lite loans for these purposes may be more risky for investors because a secondary buyout between private equity sponsors typically leaves the company with higher leverage. It may also increase the likelihood of a dividend recap by the new private equity buyer who wants to extract dividends and generate immediate returns. Accomplishing this by using a dividend recap is currently an attractive option for private equity firms because the dividend is financed by a loan at historically low interest rates.

Moody's reports that high leverage levels for covenant-lite loans, secondary buyouts and dividend recaps have been prevalent this year, with secondary buyout leverage reaching 7x and dividend recap leverage reaching pre-financial crisis levels.

Currently some borrowers are also combining cash flow based covenant-lite term loans with asset-based lending (ABL) revolvers to further increase flexibility and gain better pricing. While the recovery rates on covenant-lite loans rated by Fitch are slightly lower than the overall loan recovery rates, they warn that placing an ABL revolving loan ahead of a covenant-lite loan may result in worse recovery rates for the covenant-lite loan investors because the ABL investors will have priority access to the ABL collateral in a downside scenario.

Fitch also notes that the increase in covenant-lite loans was accompanied by an increase in the issuance of collateralized loan obligations (CLOs), which rose from $13 billion in 2011 to $37 billion in 2012.

Many lenders are concerned that covenant-lite loans are more risky because, without financial covenants in the loan agreement, in the absence of a default by the borrower, the lenders have no choice but to stand by while the financial condition of the borrower deteriorates. Also, the borrower has more flexibility to take risks with its business without fear of defaulting on its loan agreement. The credit risk is compounded for subordinated creditors and bondholders because, in the event of a default, it is likely that the borrower's financial condition has been significantly impaired leaving fewer assets and less chance for recovery on their loans.

For more information on covenant-lite loans and recent examples of covenant-lite loans, see Practice Notes, Covenant-lite Loans: Overview and What's Market: Covenant-lite Loans.