Will the Leveraged Loan Market Trigger a Financial Pandemic? Understanding Cov-Lite Loans, CLOs and EBITDA Add-Backs

Fordham Journal of Corporate & Financial Law blog (2020)

26 Pages Posted: 4 May 2020 Last revised: 8 May 2020

See all articles by Javier El-Hage

Javier El-Hage

Fordham University, School of Law

Date Written: May 4, 2020

Abstract

Even before the coronavirus plunged the world's financial markets, analysts and regulators had been describing the $1.2 to 1.5 trillion leveraged loan market as a ticking time bomb likely to play a role in causing the next financial crisis. Many have been denouncing problematic fundamentals in the current leveraged loan market and comparing them to those that caused the 2007 subprime mortgage crisis to spread into a full-blown financial crisis towards the second half of 2008. Two legal innovations in the world of corporate finance are the main anticipated culprits of a future financial meltdown: covenant-lite (or “cov-lite”) loans and Collateralized Loan Obligations (CLOs). Our paper argues that concerns of a systemic breakdown in the financial system as a result of cov-lite loans and CLOs may be overstated. To do this, we first draw from a seminal working paper by researchers at the Federal Reserve of Philadelphia that demonstrate that cov-lite loans are almost universally part of a syndication structure that binds borrowers to compliance with financial covenants. Secondly, the paper succinctly explains CLOs and compares them with similar structured finance and securitization products, such as Collateralized Debt Obligations (CDOs), CDO-squared and CDO-cubed, as well as with derivatives, such as synthetic CDOs and Credit Default Swaps (CDSs), all of which played a role in obscuring financial market fundamentals in the lead-up to the great financial crisis. Third, the paper briefly analyzes the latest stress test results and financial stability reports by regulators in charge of monitoring systemic risk in the banking and wider financial systems. Finally, the paper explores EBITDA add-backs, a product of contract law and accounting that have played an increasing role in large Leveraged Buyout (LBO) deals and could distort a lender's credit monitoring functions, but concludes that they are currently ignored in the ratings analysis of leveraged loans and CLOs.

Keywords: Corporate Finance, Banking, Leveraged Finance, Corporate Loans, Collateralized Loan Obligations, CLO, Securitization, EBITDA Add-Backs, Financial Stability, Private Equity, Financial Markets, Structured Finance

JEL Classification: K22, K23, K30

Suggested Citation

El-Hage Guaristi, Carlos Javier, Will the Leveraged Loan Market Trigger a Financial Pandemic? Understanding Cov-Lite Loans, CLOs and EBITDA Add-Backs (May 4, 2020). Fordham Journal of Corporate & Financial Law blog (2020), Available at SSRN: https://ssrn.com/abstract=3592065 or http://dx.doi.org/10.2139/ssrn.3592065

Carlos Javier El-Hage Guaristi (Contact Author)

Fordham University, School of Law ( email )

140 West 62nd Street
New York, NY 10023
United States

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