The Structure Du Jour, Or Is Covenant Lite Here To Stay?

May 21, 2007

Despite how it vexes investors, the market's tilt toward the sell side keeps the "covenant lite" deals coming, increasing the concern of those who worry about such things and providing fodder for financial publications, conferences and client calls.

Some have called covenant lite the structure "du jour," comparing it to second liens, the new kid on the block a few years ago, then seemingly the "du jour," and the inspiration of not a few client calls themselves. When second liens hit the market, no one was sure if they would have staying power. Though now into its fourth year, the second-lien locomotion shows no sign of slowing down.

Prior to 2004, second-lien issuance barely registered on the loan market radar, according to data from Standard & Poor's/Leveraged Commentary and Data. It then jumped to $12 billion from $3.1 billion in 2003. By last year it was at $28.3 billion, and with this year less than half over, 108 second-lien loans totaling $20.3 billion have been issued.

Like second liens, covenant-lite debt leapt from obscurity to being a regular feature on the market in a very short period of time.

In 2005, there were four covenant-lite loans totaling $2.4 billion, according to S&P/LCD. That number jumped to 37 totaling $23.6 billion in 2006 and (this is where it gets interesting) 104 totaling $82.0 billion so far this year. Clearly covenant-lite is especially popular with the big issuers.

But will the structure endure or will it eventually wash away along with liquid market conditions? Only a shift in the market and an increase in defaults will finally answer that question, but I would agree with sources who believe the latter, especially if the market hits as hard as some predict it will. Fact is, neither of these structures "du jour" have yet to see any dark days.

"For covenant lite," said Adam B. Cohen, an attorney who specializes in covenants and publishes Covenant Review, "It's here to stay until defaults rise, and people realize what a dumb idea it is."

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