Contracting Costs, Covenant-Lite Lending, and Reputational Capital

Dominique Badoer, Mustafa Emin, and Christopher James

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. 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.