Cov-Lite Loans And The Era Of Cheap Money: A Recipe For Creditor-on-Creditor Violence

The prolonged era of cheap money, characterized by ultra-low interest rates and abundant liquidity, gave rise to covenant-lite (cov-lite) leveraged loans. While these loans were highly attractive to investors seeking higher yields, they are now revealing their darker side. As companies face financial distress, the lack of protective covenants in these loans is leading to increased instances of ‘creditor-on-creditor violence,’ where creditors battle over distressed assets.

The Allure and Risks of Cov-Lite Loans

Cov-lite loans, which lack many of the restrictive covenants typically included in traditional loans, became popular during the cheap money era. These loans provided more flexible terms for borrowers and offered higher yields for investors in a low-interest-rate environment. However, the trade-off was a significant reduction in the protections typically afforded to creditors.

While cov-lite loans allowed companies to take on debt with fewer restrictions, they left creditors vulnerable. In times of financial distress, the absence of covenants meant that creditors could not enforce certain actions, such as limiting additional borrowing or demanding early repayment. This increased the risk for lenders, particularly senior creditors, who found their priority claims weakened.

The Impact of Financial Distress

As economic conditions become more challenging, the weaknesses of cov-lite loans are being exposed. The lack of protective covenants is leading to severe conflicts among creditors when companies default or enter bankruptcy. Senior creditors, who traditionally enjoy priority in claims, are finding it difficult to enforce their rights, resulting in complex and contentious legal battles.

These creditor conflicts, known as ‘creditor-on-creditor violence,’ are becoming increasingly common. Without traditional protections, creditors are left fighting over the limited assets of distressed companies. This often leads to protracted disputes in bankruptcy courts, increasing legal costs and creating uncertainty for all parties involved.

Notable Cases of Creditor Conflicts

Several high-profile cases highlight the severity of these creditor conflicts. The bankruptcy of J.Crew showcased a fierce battle among creditors, with junior lenders attempting to shift assets beyond the reach of senior creditors. In the restructuring of Neiman Marcus, similar disputes arose as creditors clashed over the distribution of assets. The bankruptcy proceedings of Revlon further illustrated the contentious nature of these conflicts, with junior creditors challenging the claims of senior lenders.

These cases demonstrate the widespread impact of cov-lite loans and the resulting creditor disputes. The outcomes of these cases have significant implications for the financial markets, highlighting the risks associated with the lack of protective covenants.

Market Adjustments and Investor Behavior

The rising incidence of creditor conflicts is prompting a reassessment of investment strategies. Investors are becoming more cautious about cov-lite loans and are demanding higher returns to compensate for the increased risk. This shift in sentiment reflects a broader recognition of the inherent risks associated with these loans.

There is also a growing movement towards reinstating stricter covenants to protect creditor interests. Investors and lenders are pushing for more robust protections to mitigate the potential for future conflicts and ensure a more orderly resolution in times of financial distress.

Regulatory Perspectives and Future Outlook

Regulatory bodies are increasingly concerned about the systemic risks posed by cov-lite loans and the resulting creditor conflicts. The Financial Stability Board has called for closer monitoring of the leveraged loan market and has suggested potential regulatory measures to address these risks. There is a growing emphasis on prudent lending practices and the need for enhanced protections for creditors.

Potential regulatory responses include measures to encourage more stringent covenants and to ensure that financial stability is not compromised by risky financial instruments. Increased regulatory oversight could help mitigate the risks associated with cov-lite loans and promote a more stable financial environment.

Conclusion

The era of cheap money and the proliferation of cov-lite loans have set the stage for ‘creditor-on-creditor violence.’ As the financial landscape adjusts to the realities of these risky loans, there is a clear need for more stringent lending standards and protective covenants. The ongoing conflicts among creditors highlight the importance of balancing the pursuit of higher yields with robust risk management practices. As investors and regulators grapple with these challenges, the lessons learned from the cheap money era will shape future financial practices and policies.

Author: Gerardine Lucero