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Insights

October 14, 2019

Expectations for Recovery on Covenant-Lite Loans in the Middle Market

By James W. Bartling, Eugenia "Gina" Kim

ABL Advisor

In an article published by ABL Advisor on October 14, James W. Bartling and Eugenia "Gina" Kim discuss covenant-lite loans in the middle-market lending environment. “Recent studies have shown that, in today’s market, covenant-lite loans constitute 80 percent of outstanding leveraged loans versus 15 percent a decade ago,” they state. “While covenant-lite loans have become increasingly prevalent in the broadly syndicated lending market, it should be noted that this same rate of growth has not yet been reflected across the middle-market lending environment.”

With respect to default and recovery rates, many market observers agree that, historically, covenant-lite loans fared relatively well. Some reports indicate that during the last recession, covenant-lite loans fared better than their covenant-heavy counterparts with lower default rates and higher recovery rates. “Additionally, between 1987-2017, the average rate of recovery for covenant-lite loans was relatively high at 71 percent,” Bartling and Kim explain. “However, with covenant-lite loans traditionally being reserved for the strongest borrowers, today’s expanded deployment of the structure should negatively impact correlations between the two datasets. As expected, recent forecasts on future recovery rates for covenant-lite loans predict a drop to 60 percent.”

Beyond fighting to preserve maintenance covenants, in today’s competitive environment, lenders also face a general deterioration of terms in their credit documents. The attorneys outline four examples, which can negatively impact ability to recover: looser adjusted EBITDA definitions, incremental debt, incurrence based negative covenant baskets and collateral stripping. They advise, “To increase the chances of recovery, especially in the event of a downturn, lenders should remain vigilant on their underwriting criteria, keep a close eye on their borrowers and intimately understand the strengths and weaknesses contained in their credit documents.”