Borrower Flexibility vs. Lender Protection: The Shadow Price of "Covenant-Light"

Description

The past decade has seen a boom of the leveraged loan market, where covenant-light (“covlite”) loans — loans with little covenant enforcement — significantly increased in proportion. Cov-lite loans, in terms of origination volume, now account for more than 80% of all leveraged loans. Moreover, the increasing dominance of cov-lite loans appears to be universal for all loan purposes.Researchers have tried to figure out the reason for the prevalence of cov-lite leveraged loans and expressed worries — leveraged loans are risky (the majority below investment grade) but lenders of cov-lite loans lack the tool to timely restructure potentially distressed debt. A common narrative for the popularity of cov-lite loans is that debt investors waive covenant enforcement to achieve higher yields. Using Leveraged Commentary and Data, a data set provided by S&P Global that specializes in leveraged loan markets, I show that this is not the case — after controlling for credit rating and industry-by-year fixed effects, the spreads of cov-lite loans are lower than those of non-cov-lite loans on average, both within and between borrowers (i.e., with and without borrower fixed effects). Loan spreads also appear to be negatively correlated with loan size and borrower size. Moreover, among cov-lite loans, spreads are higher on average if the loan facility comes with a revolving credit line, which typically has covenant restrictions, making the overall effect of the cov-lite feature on loan spreads insignificant for these loans.These findings suggest that the use of the cov-lite feature in leveraged loan markets is rooted in borrowers’ preference for unrestrictive, cheaper debt, where creditors tailor to this preference for worthy borrowers. It is thus important to evaluate the benefit of flexibility in business operations brought by unrestrictive risky financing and the shadow cost of the resulted limited lender protection — little has been analyzed quantitatively about their magnitude, particularly in potential economic downturns. To fill this gap, I build a dynamic model in which firms need to finance their investments through loans, endogenously choose covenant enforcement type by trading off higher investment flexibility with increased bankruptcy costs due to limited debtrestructuring opportunity under the cov-lite feature, and optimally default on their debt. I use the model to quantify the value and cost associated with the cov-lite feature in terms of borrower and lender surplus based on loan and borrower data, and examine counterfactuals using imaginary economic shock scenarios.