Contracting Costs, Covenant-Lite Lending and Reputational Capital
53 Pages Posted: 7 Jan 2021 Last revised: 23 Mar 2023
Date Written: March 17, 2023
Using a large sample of leveraged loans, we provide evidence that, despite having fewer creditor control rights, covenant-lite loans have similar recovery rates and significantly lower spreads than loans with maintenance covenants. We find that the propensity to borrow covenant-lite is related to various proxies for the reputational capital of a borrowing firm’s private equity sponsor. We construct a simple model to illustrate the relationship between reputational capital, covenants, and loan spreads in the leveraged loan market. Our model illustrates how reputational capital can substitute for covenants in mitigating agency costs of debt, leading to lower loan spreads for covenant-lite loans.
Keywords: Cov-Lite Loans, Institutional Loans, Private Equity Firms, Reputational Contracting
JEL Classification: G21, G23, G29, G33
Suggested Citation: Suggested Citation