Unrelenting investor demand for higher-yielding assets and floating-rate exposure has enabled issuers to sell these loan products that allow for future acquisitions or aggressive credit policies, but offer less protection for investors.
Investors have poured money into floating-rate loans, fearing a rise in interest rates, and private equity firms have taken advantage of the demand to get looser debt structures.
Covenant-lite issuance so far this year is 74 percent higher than all of 2007 before the collapse of Lehman Brothers, and more than five times the $35 billion issued in the first nine months of 2012.
Multibillion dollar loans for computer maker Dell and hotels operator Hilton were launched this month as covenant-lite deals.
New covenant-lite loans of more than $2 billion each for video game publisher Activision and surgical product manufacturer Biomet were priced in September, with pricing cut in syndication due to high investor demand.
Oil and gas outfit Fieldwood Energy is now in the market with a $2.63 billion covenant-lite first- and second-lien acquisition loan.
Covenant-lite loans used to be reserved for stronger companies and credits, but are now so common in the U.S. leveraged loan market that investors are becoming wary of some credits with a full covenant package.
“Transactions with covenants these days can suggest other problems with the credit, maybe that it is new to the market, or exiting from bankruptcy,” said Christina Padgett, senior vice president at Moody’s Investors Service.
Covenant-lite has mainly been used by private equity firms, but non-sponsored issuers seeing the robust investor demand have begun seeking these financings.
In today’s hot financing market, the volume of non-sponsored covenant-lite loans has risen to nearly $50 billion year-to-date, with credits such as casino games maker Bally Technology and video game company Scientific Games opting for large covenant-lite loans to finance corporate acquisitions.
This is more than double nearly $20.4 billion of corporate covenant-lite loan volume in 2012, and more than triple the $16 billion in 2011.
Middle market loans for smaller, riskier companies, which are usually more likely to contain covenants, have seen increased covenant-lite issuance since the end of 2011. Middle market covenant-lite lending hit $2.73 billion in the second quarter of this year, the highest level since 2007.
As lending to lower-rated companies has increased generally, more of them are also opting for covenant-lite financings.
That trend is evident particularly in the B3 ratings category. Around 18 percent of covenant-lite loans are for B3 rated companies so far this year, versus 8 percent in 2012 and 3.7 percent in 2011.
Sources said that strong retail investor demand is driving covenant-lite lending. Lipper reported $1.33 billion in fund inflows for the week ending September 18, continuing a trend that has been ongoing since the start of the year, with $50.7 billion of money hitting the asset class in 2013 so far.
Loan portfolio managers said that new institutional clients are also seeking to invest. More than $57 billion of CLOs have been issued this year, topping 2012 volume.
“There’s a tremendous amount of demand and only so much supply. When there’s more demand than supply, you can certainly do things like get covenant-lite packages through,” said one portfolio manager.
“A few years ago, you always had three or four covenants. It’s one, maybe two these days,” said Jessica Reiss, the lead loan covenant attorney at Moody’s.
Despite the rise in covenant-lite lending, arranging banks and investors are reluctant to say that covenant-lite is the new market standard.
“I don’t know yet that I’d call it standard. It’s headed in that direction, but I don’t know that we’re quite there yet,” said the portfolio manager, noting that covenants remain a key negotiating point in loan syndications.
During June’s market disruption, covenants were added to several deals that were originally launched as covenant-lite loans. Oil and gas firm WildHorse Resources added a covenant to a $325 million second-lien term loan, and medical cost management services provider MedSolutions also included a leverage covenant on a $300 million term loan B.
CLO funds have restrictions on covenant-lite lending that have not eased in response to new developments, which could put pressure on covenant-lite issuance, or even curb it, if CLOs exceed their limits and are no longer able to buy the paper.
Natalie Wright is a reporter for RLPC in New York