A covenant-lite loan drops the maintenance covenants, the financial tests a borrower must pass every quarter. It keeps incurrence covenants, which only apply when the borrower takes an action such as adding debt. Lenders lose an early chance to step in when results slip.
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In private credit, a lender can lose its early warning, and still make the loan. It's called a covenant-lite loan. Older loans had maintenance covenants: tests the borrower must pass every quarter. Suppose debt can't go above five times earnings. Earnings fall, and debt reaches six times. With a quarterly test, the lender can step in now, and reset the terms. A covenant-lite loan drops those quarterly tests. Its tests only apply when the borrower acts, such as taking on more debt. In one recent year, more than ninety percent of new leveraged loans were covenant-lite. So why do investors care? Without the tests, trouble shows up later. By then, there can be less left to recover. No tests. No warning. Price it in.
A simple example with round numbers, not advice. Terms vary by fund.
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