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The Cuffs Come Off: The New Decade Brings an Uptick in Cov-Lite Loans


Those who lived through the global financial crisis and survived to tell the tale no doubt have bad memories of the term “cov-lite.”

The widespread acceptance of covenant-lite (cov-lite) loans — or borrower-friendly loans that were made with a lack of protective covenants for the benefit of the lender — was a trend that was firmly in play pre-crisis.

SEE ALSO: ‘The Backstory’: Commercial Real Estate’s Turnover

While we’ve come a long way since the Wild West days of 2006, more than a decade later cov-lite is one hard lesson from the crisis that’s apparently being unlearned. Today’s competitive lending environment, buoyed by the proliferation of debt funds post-crisis, has created a borrowers’ market and the resurgence of cov-lite — and, some say, almost cov-free — loan  structures.

One of the largest loans to hit the commercial mortgage-backed securities (CMBS) market last year was the $1.2 billion mortgage on Century Plaza Towers, a pair of office towers in L.A.’s Century City neighborhood. The non-recourse loan was structured without a bad-boy carve-out guarantor, thereby limiting loan liability to the borrower entity should a “bad act” occur, and waiving the accountability of the borrower entity’s parent company, or “warm body” guarantor.

The debt on the property, which is owned by J.P. Morgan’s Strategic Property Fund and a Hines joint-venture, was chopped up into several CMBS deals.

“The loan does not have a non-recourse carve-out guarantor for certain ‘bad boy’ acts, such as fraud, gross negligence, or violating the loan’s [special-purpose entity] covenants,” reads a Standard & Poor’s report on one of the deals, which listed the risk factors behind the loan. The debt, originated by Deutsche Bank, Wells Fargo and Morgan Stanley, does not amortize over its 10-year term and also doesn’t carry a separate environmental indemnitor, according to loan docs.

A Deutsche Bank spokesperson declined to comment on the structuring of the bad-boy carve-out, as did Hines and J.P. Morgan officials.

Deals like this — which include some of the industry’s heaviest hitters — are illustrating exactly how far lenders are willing to stretch for certain sponsors and setting high expectations for other market participants.

“When we’re bidding on deals today, we’re being told that the market has agreed to light covenants and we have to respond to that in order to compete,” said one balance sheet lender, who spoke with CO on the condition of anonymity, adding, “we absolutely have agreed to covenants that make us uncomfortable.”

Let there be lite

The push for cov-lite structures in deals has strengthened over the past 18 months, sources said, with the market awash with capital and strong sponsors calling the shots.

“Four years ago, you saw very large sponsors with low-leverage requests starting to push back [against covenants] and getting some traction,” said Seth Grossman, a senior managing director at Meridian Capital Group. “So, the request from borrowers has always been there but up until recently, most lenders didn’t give much leniency. Today we see movement for the right sponsors and projects. It’s not typical that a lender will give away everything, but reasonable requests for reasonable sponsors you’ll see get done.”

Conversely, you won’t see much stretching on covenants for the weaker or lesser known sponsors unless they’re working with lenders who charge hefty fees.

“If a traditional bank that offers a very low rate is not willing to move on covenants, sometimes the sponsorship can go through a different lender and pay a higher rate by several hundred basis points and, as a trade-off, they’ll have several of those covenants lighten up,” Grossman said.

Alternatively, a less experienced sponsor who is requesting cov-lite portions in its loan agreement may have to drop its leverage request from 55 to 50 percent in return for its cov-lite requests being accommodated, Grossman said, adding, “You weren’t seeing that [bartering] five years ago.”

The uptick in cov-lite structures has undoubtedly been driven by the cut-throat competition for deals, Grossman said. “They’re still trying to be prudent, but in each category, lenders are having to figure out creative ways to win the business. And rather than cut up pricing or win deals on rate but make less money, they’re keeping the rate where it is and trying to win on covenants because they still believe in the deal.”

Indeed, winning deals is no walk in the park these days.

“It’s extremely competitive,” Danielle Duenas, a vice president at Mesa West, said of today’s lending environment. “There’s a lot of capital in the market; it’s very liquid, and rate compression has been consistent. There are multiple lenders playing within the same space, with some bleeding into other lenders’ spaces.”

Josh Zegen, co-founder of Madison Realty Capital, concurred that competitive forces are what’s driving cov-lite structures.

“I don’t think it’s so light that it’s aggressive,” Zegen said, “but lightening up on guaranties and pari passu funding [which puts lenders on equal footing in making a claim on assets securing a loan] — that’s where things are becoming a little more aggressive.”

Knowing they’re in the driver’s seat, borrowers are routinely pushing back on covenants surrounding everything from minimum leasing guidelines to parameters around future funding to carve-outs around bad-boy guaranties.

“Outside of basic structure such as proceeds and pricing and in addition to collateral performance tests — LTV, DSCR, debt yield — we are seeing heavy negotiations [around] loan term, extensions, Libor floor, hurdles for future fundings, and cash management,” Duenas said. “There are a multitude of levers involved in negotiating terms, so you see a lot of pushing and pulling; if you give up structure, you have to price that risk in. But there is a limit to the amount of risk each lender is willing to take on.”

One lender CO spoke with gave the example of his shop waiving cash management for the first 18 to 24 months on a transitional loan, when it really should be in place from day one.

“Where we have concerns on these cov-lite deals is that you can be in a position on a value-add loan where you start to see cash flow erode and a business plan going sideways, but you just have to stand by and watch things get worse without any ability to start sweeping cash or call default,” he said. “You can be in a very tough position where your borrower is seeing value erode and your hands are tied — you can’t do anything about it.”

Playing with the big boys

Several of those CO spoke with said that the behemoth borrowers are often able to command out-of-market terms today thanks to their name and reputation alone, with one lender adding that certain industry titans, “basically write the term sheets for you. They have out-of-market provisions that they’ve had in place for forever, like caps on their liability on some carve-outs in a bankruptcy scenario,” he said. “Frankly, there are a few names we know and we like, but we essentially won’t lend to them because they demand too challenging of a structure in our view.”

But that doesn’t stop other lenders from happily agreeing to next-to-no covenants when those big shops come calling.

“There are a few borrower names out there where the perception as an [equity] limited partner is ‘if you invest with them, you don’t get fired,’ or as a lender, ‘if you make a loan to them, you’re not going to get fired,’ ” the anonymous lender continued. “They’re doing large deals, and so [the overarching perception is] ‘hey, good job, you made a big loan to a really high-quality sponsor.’ ”

But lenders should be wary of placing all their trust in a name, Duenas said.

“It may initially seem easier to justify a deal because [big sponsors] have deep pockets, but you ultimately have to look at your basis and ask, ‘Are we comfortable with where this deal is going to go or could go in a downside scenario?’ Because who knows, what if you do get the keys back, what if the operating partner in a joint venture isn’t as strong and isn’t able to execute?” Duenas said. “It’s exciting to do a deal with big sponsors, but at the end of the day, it doesn’t mean that you should agree to metrics that don’t conform to your investment strategy and risk profile. We’ve all seen the tide turn.”

As such, Mesa West is staying the course in terms of their lending parameters, she said.

“We aren’t doing deals that are outside of our wheelhouse; we’re still very disciplined,” Duenas said. “A Mesa West deal is going to have a certain amount of structure in it, and if someone pushes outside of that structure then it’s not our deal.”

But while several lenders are passing up deals that don’t necessarily conform to their strategies, others are happily diving in.

Speaking on a Commercial Observer panel last December, Troy Miller, head of Starwood Property Trust’s West Region, noted that the push towards cov-lite structures comes down to the sheer number of players in the system.

“When everyone is gravitating around a similar spread or coupon level, guys are winning deals [by offering] cov-lite,” he said.

As one of the biggest borrowers in the industry on the equity side of its business, Miller said Starwood’s lending platform has an insider view into exactly what lenders are granting borrowers today: “I see what our guys can get on the buy side and it’s crazy; almost no covenants,” he said. “Of course, everyone knows what others are getting and we all push for that.”

A risky business

So, which lenders are saying yes to the cov-lite deals that others are passing on?

“It’s usually lenders I’ve never heard of before,” Mark Fogel, president of ACRES Capital, said, speaking of the waiving of bad boy guaranties, specifically. “New lenders in the space with a lot of capital to put out who aren’t too concerned with what happens two years down the road. The groups that are grasping for deals are the ones that will really bend on covenants.” 

There isn’t one group out there who is considered the “Wild West” lender right now, “at least in our space,” said a bridge lender who also spoke to CO on the condition of anonymity. “There are groups where you’ll talk to anyone there and they’ll say, ‘We’re maintaining structure, we’re not agreeing to any cov-lite deals’ … Yet … these deals are getting done.”

The stretching on covenants is also trumping the relationship aspect of the lending business on occasion.

“We’ve lost or passed on deals with borrowers we’ve done a lot of business with because someone is coming in way more aggressive,” Duenas said. “Even if we get last look on a deal, sometimes the terms are something we simply won’t compete with, or cannot get comfortable with, and we confidently pass.”

Bad boys, bad boys, whatcha gonna do?

Several sources said the biggest area of pressure on covenants and the most worrying trend is the number of lenders allowing the pushback against non-recourse bad-boy carve-out guaranties. The Century Plaza Tower deal is one example of this covenant being waived, but it’s hardly the only one.

“Most loans originated today outside of the traditional banking arena are non-recourse,” Jonathan Roth, a  co-founder of 3650 REIT, said. “Non-recourse loans have a certain level of recourse for ‘bad boy’ acts, but what I’m starting to see most prevalently is the willingness of lenders to accept corporate entities rather than a ‘warm body’.  Where the behavior against which a lender seeks protection is 100 percent within the sponsor’s control, the elimination of the warm body really makes me scratch my head.”

Fogel concurred that bad-boy guaranties are what borrowers are really fighting back on — hard. 

“Covenants are not really all that painful to deal with, but what can be very painful for a borrower is … bad-boy guaranties,” Fogel said.

To the extent that a borrower does something wrong, his or her loan becomes full recourse. This includes things like misappropriation of funds, fraud and bringing in new partners without the lender’s consent.

“All of those things can put a lender in a really bad spot — that’s why we have covenants in there — not so much because you’re going to recover money but because it gives you the leverage to control the transaction if things start going sideways,” Fogel said.

“We’ve seen more loans being done at typical value-add advancement rates in that 65 percent loan-to-value context with borrower-only carve-outs,” the bridge lender said. “It’s not something that we’ve done but we’ve definitely seen some of our peers in the debt fund space do it and we’ve lost deals because we’ve walked away.”

The anonymous bridge lender said that his peers who agree to these loans use justifications such as “they’re never going to let this loan go bad. They’re never going to file bankruptcy.” (Sound familiar?)

That said, “Fannie Mae and Freddie Mac don’t even require a warm body if you’re below 65 percent leverage and some other lenders will waive that as well, although most lenders won’t,” Grossman said. “There’s a lot more movement that sophisticated sponsors are getting in terms of the negotiation around carve-outs. No matter what, if you commit fraud or have willful misconduct of gross negligence you’ll trigger a carve-out. But there’s a lot of gray area in the loan documents and a lot of borrowers are pushing it away and getting really skinnied down carve-outs.”

Like the lender who spoke with CO, Grossman said he’s also seeing carve-outs being capped at certain dollar amounts. So even though there’s a warm body held accountable, the lender would be limited in the amount it can recoup.

Then, there’s the chipping away of the guarantor’s financial covenants.

“It’s very standard for a value-add bridge loan to get a net-worth covenant of 100 percent of the loan amount and liquidity of 10 percent from our guarantors,” the bridge lender continued. “That has progressively been chipped away at, particularly for larger loans, and there’s an acceleration of it over the last 12 months.”

R.I.P., structure?

Don’t go out and buy a black suit just yet, though. A degradation in covenants doesn’t necessarily signal a massive wave of upcoming defaults, losses or lawsuits. 

“Top lenders are making movements for top sponsors,” Grossman said. “Where you may see more issues are with the alternative lenders who are lending at higher leverage and higher rates and giving more away. But those lenders are lending at what is considered equity returns for debt and so they should be ready for there to be some issues. The expectation is not that all these loans are going to perform perfectly.”

“For the most part, lenders continue to exercise discipline,” Roth said. “Lenders are looking the other way, however, on things that historically we wouldn’t necessarily want to look away from. But will this be the death knell or the reason to lead us into the next real estate recession? I don’t think so.”

Roth continued with another prediction: “I candidly believe that the next crisis could very well be born out of all the leverage that’s currently embedded in the system, “ he said. “Lenders that go out and leverage the ownership of their loans will be impacted most when some event occurs in the capital markets where the lenders to those lenders have to make margin calls or exercise some other remedy.”

“I don’t think lenders are making stupid loans right now relative to what they could be doing or relative to 2007, 2008,” Grossman said by way of conclusion. “I think they’re definitely giving away more than they want to give away, so it’s a time to be cautionary, but it doesn’t feel like the end.

“If you come back to me in six months and I say, ‘We’re getting bad-boy carve-outs removed for any deal under 70 percent’ or [we’re] waiving completion guarantees on construction loans — that would be a scary thing,” Grossman continued. “To me, it feels more like nibbling around the edges to try to win transactions versus giving away the farm.”