Bank Skin in the Game and Loan Contract Design: Evidence from Covenant-Lite Loans

Abstract

In a model of dual-agency problems where borrower–lender and bank–nonbank incentives may conflict, we predict a hockey stick relation between bank skin in the game and covenant tightness. As bank participation declines, covenant tightness increases until reaching a low threshold, at which point the relation sharply reverses and covenant protection is removed with a commensurate increase in spread. We find support for the hockey stick relation with bank’s stake in covenant-lite loans averaging 8% (0% median). We also find that covenant-lite loans are more likely when borrower moral hazard is less severe and when bank relationship rents are high.

Concentration of Control Rights in Leveraged Loan Syndicates

“…Our interpretation and empirical evidence also dier from those of Billett et al (2016), who view a covenant-lite contract as a mechanism to bypass the agent bank when intra-syndicate conicts are severe. In their model, covenants are removed entirely to reduce the costs of intra-syndicate conicts, even if the lack of covenants exacerbates borrower moral hazard.…”

“…2 For examples, see Becker and Ivashina (2016) and Billett et al (2016). We discuss the literature below.…”

Securities Laws, Bank Monitoring, and the Choice Between Cov-lite Loans and Bonds for Highly Levered

“…It also predicts that cov-lite loans have higher credit spreads and are more likely to be securitized. Billett, Elkamhi, Popov, and Pungaliya (2016) use a different approach based on the existence of two agency problems with loans. One problem is between the borrower and the lender; the other problem is between the bank and the non-bank investors.…”

“…4 While covenant-lite loan facilities are generally structured as term loans B, roughly half of the deals that contain a covenant-lite facility also contain a revolving line of credit. Billett et al (2016) examine 53 such revolvers in detail and conclude that 49% of revolvers accompanied by a covenant-lite facility have no maintenance covenants, 40% have springing covenants, and only 11% have traditional maintenance covenants. By contrast, in a recent paper, Berlin et al (2018) argue that most covenant-lite loan facilities are accompanied by a tranche that does contain maintenance covenants.…”

“…One reason for the difference in findings is that, as Berlin et al (2018) show, firms that borrow using a covenant-lite term loan often already have a revolver with maintenance covenants in their capital structure. Further, Berlin et al (2018) classify springing covenants as heavy, while Billett et al (2016) classify them as lite. In any event, as discussed in section 2.4, a borrower that has both covenant-lite and covenant-heavy loans at the same time can be compared to a borrower that issues both a bond and a traditional bank loan.…”