Covenant-Lite Loans: The Systemic Risk I Almost Overlooked

In my previous article on First Brands, I spoke about how opaque private credit structures masked billions in debt. But I didn’t know how deep this rabbit hole went. A reader’s question put me on covenant-lite loans, and as I read through it, a familiar pattern emerged — one that explained not just First Brands, but potentially the next financial crisis. Before I dive into the implications, let me introduce covenant-lite loans, because this was something I didn’t know about.

What Exactly Are Covenant-Lite Loans?

Traditional leveraged loans came with maintenance covenants, which you can think of as monthly report cards for companies. Quarterly or even monthly, lenders would check: Is the company’s debt ratio below 6x? Is interest coverage above 2.5x? If the answers turned bad, lenders could step in, renegotiate, or even call the loan. It’s like a smoke detector constantly monitoring your home.

But Covenant-lite loans are far different; they bypass the maintenance covenants. Instead, you get incurrence covenants — these only trigger when a company takes specific actions, like issuing new debt or making acquisitions. It’s the difference between a smoke detector that runs 24/7 and one that only checks when you manually press a button.

The structure typically looks like this:

• Senior secured term loans at the top
• Zero financial maintenance covenants for the lenders
• Incurrence-based negative covenants (basically a promise not to do certain things unless authorised)
• Springing covenants that only activate if you use more than 35–40% of your revolving credit

The Market Takeover Nobody Noticed

As of year-end 2024, covenant-lite loans represented 91.09% of outstanding US leveraged loans — approximately $1.29 trillion in total. But the real metric is new issuance: 93% of all institutional leveraged loans issued in 2024 were covenant-lite. This isn’t a fringe product anymore. This is the market. These numbers actually stunned me.

Five years ago, this would have been unthinkable. In 2015–2017, these structures were controversial. Today? They’re standard. And here’s the thing I found most troubling: These loans don’t compensate lenders for weaker protections. Historically, covenant-lite instruments commanded a 50–75 bps premium over traditional covenanted loans. That premium has essentially vanished. Since Q1 2017, yields have converged. Lenders are accepting dramatically less protection for the same return, which is shocking!

But how are the defaults looking?

Moody’s data on defaults between 2023 and mid-2025 shows some unsettling trends. When covenant-lite loans default, lenders recover an average of just 57% on first-lien positions. Compare that to 66% recovery on covenanted loans. That’s a 9-percentage-point gap. When you multiply that across a $1.3 trillion market, we’re talking about potentially $117 billion in lost recovery value in a full default cycle.

The current default rates, however, tell us a different story. The Morningstar LSTA Index shows 1.45% by issuer count and 0.91% by principal as of December 2024. That’s below the 10-year average of 1.65% and the historical average of 2.6%. So lenders think they’re in the clear.

But when I looked deeper, what caught my eye was that in 2022, covenant-lite loans made up 91% of all defaults. In 2023, that dropped to 54%. In 2024, it rebounded to 85%. As these structures have come to dominate the market, they’re dominating defaults proportionally. The composition is telling a story that raw default rates are hiding.

So what could be the possible explanations?

- Payment in Kind — More akin to kicking the can down the road…

PIK is a way for a company not to pay interest in cash but instead, it gets added to the principal. So a $100 million loan at 10% interest with full PIK becomes $110 million after year one, and now interest accrues on the $110 million. The debt compounds exponentially while the company generates no additional cash.

If that sounds like a sure-fire way to go bankrupt, a report from S&P on BDCs(Business Development Company) quarterly filings indicates something alarming. As of Q2 2024, 11.7% of loans held by BDCs made PIK (Payment-in-Kind) payments, up from 9.9% a year earlier.

TO explain BDCs, think if an NBFC and a REIT had a kid. It’s essentially an investment company that lends to SMEs but must distribute at least 90% of taxable income as dividends to shareholders.

Why does this matter? If a company needs 5% of revenues just to operate, and it faces a 9.25% interest rate (roughly 4.25% SOFR + 5% spread), here’s the math:

The company needs 14.25% revenue growth just to survive without defaulting. The US economy is growing at 2%. Most companies can’t grow at 14.25%. So what’s their move? PIK. Defer the cash, add to principal, hope for a miracle. That’s not risk management. This is honestly frightening.

- Debt restructuring: another way out?

Liability management transactions (LMTs) — again, something completely new to me! These are restructurings where companies subordinate existing creditors without their approval.

So the ways this plays out

• A borrower convinces enough lenders (typically those owning >50% of debt) to amend the credit agreement, allowing issuance of new super-senior debt. The participating lenders swap their old debt for new senior debt at a discount. Non-participating lenders get pushed down involuntarily.
• Companies move collateral to “unrestricted subsidiaries” not bound by loan covenants(off-balance sheet), then secure new debt against that collateral. Existing lenders find their collateral has mysteriously disappeared.

In the end, only the lenders who come in last benefit the most and have the most claims, given that the collateral can actually cover the money owed. The older lenders just take haircuts after haircuts till they go bald!

And lenders just write it off if they can’t recover it, and they sell these distressed loans to Asset reconstruction companies or other institutions that have the power, patience and capital to legally fight this out. Well, hey, atleast there’s a bright future for the lawyers!

So now, this begs the question: how common has this become? LMTs have become routine.

Deutsche Bank found that distressed exchanges represented more than 3% of the Morningstar LSTA default rate in early 2025.

- Dividend Recaps: Extracting Returns Before the Collapse

This is another classic example of a prime candidate for cov-lite loans. Dividend recap volumes surged in early 2025. From January through mid-February 2025, volumes hit $22.4 billion, compared to $14.0 billion in the same period last year.

For full-year 2024, dividend recaps totalled $80.4 billion across 103 transactions. The median dividend was $300 million, levels not seen since 2021. The logic is transparent: Portfolio companies take on new debt to pay cash distributions to PE owners. LPs get returns. GPs get returns. The company gets leverage. Everyone wins until someone doesn’t.

The most creative versions use preferred equity structures that are 100% PIK and covenant-free to avoid refinancing existing 2020–2021 vintage debt. Some include “portability provisions” allowing ownership to transfer to new sponsors without triggering loan repayment. It’s a financial architecture designed to defer problems, not solve them.

- Continuation Funds — The Private Equity Maturity Wall

You can’t speak of dividend recaps without those who construct them, and nowadays, it has become somewhat synonymous with Continuation funds. Over 50% of PE funds are now six years or older. The traditional 3–5 year hold period has become almost quaint. 1,607 funds are scheduled to wind down in 2025–2026.

This is primarily due to the record 77 continuation funds closed in 2024, with $25 billion raised in just H1 2025. These vehicles now account for 14% of all PE exits.

The mechanism is elegant: Instead of selling portfolio companies at terrible valuations, PE firms create new funds to buy the assets from their old funds. This gives LPs who want an exit a cash back while GPs maintain control and hope for better exit conditions.

But here’s the problem. These portfolio companies are drenched in debt from the original LBO, often at 5.8–6x debt/EBITDA multiples or higher.

If they don’t grow that much, what happens? Continuation funds become zombie holders of zombie companies.

- The EBITDA Shell Game

Another new concept for me, assumed earnings! A company being sold/an acquisition target modifies its EBITDA by adding/subtracting certain costs(1-time costs, non-operating income, related party expenses) to represent the true profitability of the business. But, this can also be misused to wrongly state numbers and make a company appear healthier than it actually is.

S&P Global did a survey showing sellers are creating EBITDA addbacks averaging 28% of adjusted EBITDA. Let that sink in: More than a quarter of the “earnings” these loans are supposedly based on aren’t real cash. They’re projections.

The outcomes are predictable:

• 92% of companies miss their first-year post-close projections
• 50% of companies miss projections by 33% over a 7-year hold period
• The median leverage miss is 2.3x — meaning companies end up 2.3 times MORE leveraged than the models suggested

The addbacks include all the classics:

• “Synergies” and “run-rate savings” (often completely uncapped in the agreements)
• Transaction costs
• “Non-recurring operational expenses” (whatever that means in anyone’s real business)
• Management fee adjustments
• Supply chain optimisation costs
• Tariff-related expenses (a personal favourite of 2025)
• Stock-based compensation
• Litigation expenses

Let me give an example to show how this works. A company reports $50M GAAP EBITDA. Management proposes $6M in addbacks — $2M integration costs, $1M stock comp, $3M “facility consolidation savings”. The agreement permits this with a 20% cap on run-rate savings. Adjusted EBITDA becomes $56M. Leverage improves from 6x to 5.4x on the model. Except the company hasn’t generated a single additional dollar of cash…

So how are they spreading?

- The Private Credit Monster That’s Swallowing Everything

The Private credit market sits between $3 trillion (Fitch) and $4.5 trillion in global bank exposure (IMF).

This market has exploded from $1.2 trillion in 2018 to a projected $4 trillion+ by 2025. Private credit lenders, unconstrained by bank capital requirements and largely outside heavy regulation, have started extending cov-lite terms to smaller companies. The company size has dropped from firms with $50 million EBITDA to those with just $30 million. Competition and the race to get higher yields have forced terms to get more aggressive.

Then I found something even more troubling: Variations like “covenant-wide” or “covenant-loose” loans where covenants technically exist but are designed to be “unlikely to be triggered unless the borrower incurred a rapid and significant decline in its financial performance”.

In other words, covenants don’t actually protect lenders in a normal downturn, only in a collapse.

- The CLO Layer: Risk Distributed, Not Eliminated

Collateralised Loan Obligations have become the dominant buyer of leveraged loans, purchasing over 50% of all institutional issuance. The US CLO market is expected to see $200 billion in gross issuance in 2025.

CLOs work by pooling hundreds of leveraged loans and slicing them into tranches:

• AAA/AA tranches (Senior): Target default rates below 0.1%, offer SOFR plus 100–150 bps, attract insurance companies and pensions
• A/BBB/BB tranches (Mezzanine): Offer SOFR plus 300–800 bps, increasingly attracting retail/alternative managers reaching for yield
• Equity tranches: First-loss position, targets 13–18% IRRs

The structure provides apparent safety. AAA CLO tranches performed better than other structured products during 2008. But I found several critical differences from that era:

1. The underlying collateral is weaker. Covenant-lite loans have gone from <20% to >90% of issuance.
2. Recovery rates are lower. We just saw this: 57% on cov-lite vs 66% on traditional loans.
3. Leverage is at prior-crisis levels. Many deals are at 5.8–6x, approaching 2007 peak multiples.
4. Private credit CLOs are opaque. They have larger equity tranches and smaller AAA tranches than traditional CLOs — signalling higher credit risk.

Here’s my concern: What happens when defaults exceed the 1–2% range built into CLO models? Mezzanine tranches take losses. Equity gets wiped. That’s when the real selling begins.

So where are we now ?

- The 2025–2026 Maturity Wall

All of this converges at one point: the refinancing cliff. The scale is genuinely frightening:

• 29% of outstanding global high-yield bonds mature by the end of 2025
• 24% of global leveraged loans mature by the end of 2025
• $2 trillion in European CRE debt matures 2024–2026
• Nearly $1 trillion in US CRE loans mature in 2025 alone

For companies that borrowed at 3–4% in 2020–2021, refinancing at 8–10% rates is a big reality check. Consider: $500M in debt at 4% = $20M annual interest. Refinancing at 9% = $45M. That $25M gap has to come from somewhere. For most companies operating at marginal profitability, that gap is fatal.

Q4 2024 saw a record $757 billion in repricings — far exceeding the previous 2017 record of $432 billion. But this is just kicking the can down the road. Eventually, there may be no more road available.

- The Shadow Banking System Alarms

Fitch Ratings warned in October 2025 that the $3 trillion shadow banking sector exhibits “bubble-like traits” that could trigger broader financial shock. The ECB’s Elizabeth McCaul told the FT she sees private fund growth as “the biggest threat to eurozone financial stability”. Non-bank financial intermediaries in the EU now hold €42.9 trillion in assets vs €38 trillion in traditional lenders.

The Federal Reserve and Bank of England have both warned about rapid private credit expansion spilling into broader markets during stress.

University of Bath research found something troubling: Highly leveraged loans are increasingly underpriced, particularly among non-bank lenders not subject to the same regulatory scrutiny as traditional banks.

Since 2014, the pricing of leverage risk has weakened dramatically, particularly among shadow lenders offering covenant-lite and securitised loans

In December 2024, the FT reported default rates on US leveraged loans had climbed to 7.2%, the highest since the end of 2020. Many borrowers are resorting to distressed exchanges to avoid bankruptcy, which reduces investor recoveries and highlights underlying market fragility.

- The Zombie Fund Epidemic

As I looked at this from another angle, I noticed something else emerging: zombie PE firms and zombie portfolio companies becoming endemic.

Arctos Partners recently suggested we may see peak zombie PE funds in 2025 as fundraising becomes impossible. Ian Charles, their managing partner, noted that firms without institutional capital in seven years are functionally zombies: “As soon as you start to lose growth, you start to lose your talent.” Bloomberg reported more than 18,000 private capital funds worldwide are fundraising — $3 of demand for every $1 of available capital.

EQT’s chief suggested 80% of private capital groups could become zombies within the next decade.

So Here’s What I’m Seeing

This is probably my longest article yet, and if you made it here kudos to you! Let me try to summarise this. The system we’ve built has:

1. A $1.3 trillion cov-lite market with 57% recovery rates and zero early warning systems
2. A $3–4.5 trillion private credit market with limited transparency and regulatory oversight
3. 91% of new leverage issued without maintenance covenants, up from 10% in 2007
4. Over 50% of PE funds have passed their typical hold periods, unable to exit
5. Record continuation fund usage to avoid forced sales
6. EBITDA addbacks averaged 28% with 92% of companies missing projections
7. Rising PIK usage deferring cash while compounding debt
8. $80 billion in dividend recaps, extracting equity while adding leverage
9. Increasing LMT activity, subordinating existing creditors
10. 24–29% of leverage maturing in 2025–2026 at 2–3x higher refinancing rates
11. CLOs holding 50%+ of leveraged loans, spreading risk system-wide

This system more resembles a Jenga tower that’s a couple of blocks away from totally collapsing. We should wait to see who the lucky ones are to pull the trigger.

The Uncomfortable Questions

I keep thinking through scenarios. The optimistic case: Interest rates stabilise, economic growth remains positive, default rates stay under 3%, PE firms gradually exit, and everyone muddles through.

The pessimistic case is different. A recession hits as the maturity wall peaks. Defaults rise above 4–5%. CLO structures stress. Mezzanine tranches take losses. Private credit redemptions get gated. Banks face write-downs on $4.5 trillion in exposure. Interconnections amplify losses. As mentioned earlier, cov-lite loans protect only during a collapse; thus, we have zero early warning systems.

Which scenario plays out depends on macroeconomic variables beyond credit markets. But the structural weaknesses are undeniable. We’ve built a system where:

• Lenders can’t intervene before default
• Accounting is divorced from cash reality
• Recovery rates are materially lower
• Leverage mirrors prior-crisis peaks
• Exit channels are constrained
• Risk is distributed but not eliminated

A Familiar Pattern

The parallels to pre-2008 haunt me. We had opaque mortgage structures with poor underwriting hidden behind AAA ratings. Now we have opaque covenant-lite loans with poor protections hidden behind 1.45% default rates. We had CDOs spreading subprime risk. Now we have CLOs spreading leveraged loan risk. We had regulatory arbitrage between banks and shadow lenders. Now we have the same dynamic with private credit.

The covenant-lite loan market isn’t a bubble waiting to burst. It’s a loaded spring under increasing tension. The energy stored in it — in the form of unserviced debt, unenforced covenants, and unwind-able structures — will eventually be released. Whether that release is orderly or catastrophic depends on variables we can’t control and timing we can’t predict.

For now, the music plays on. PE firms extract dividends. Companies extend maturities. Private credit deploys capital. CLOs package it all with seemingly safe senior tranches. Everyone has rational incentives to keep moving. But First Brands showed what happens when you pull back the curtain.

What I’m watching closely:

• Default rates through 2025–2026 as the maturity wall hits
• Recovery rate data on covenant-lite defaults
• CLO performance under stress
• Continuation fund sustainability
• Regulatory responses to private credit opacity

The next crisis won’t look like the last one. It never does. But it might rhyme: complexity masking risk, innovation outpacing oversight, and structural weaknesses only visible in hindsight.

NOTE: These observations are based on extensive reading and analysis of public filings, regulatory warnings, and market data. I’d genuinely welcome your perspectives, corrections, and alternative interpretations.

• https://indexes.morningstar.com/indexes/details/morningstar-lsta-us-leveraged-loan-FS0000HS4A?currency=USD&variant=TR&tab=overview
• https://www.paulweiss.com/media/mjanpfpm/covenant_lite_loans_overview.pdf
• https://www.bloomberg.com/news/articles/2025-09-23/private-equity-leans-on-weaker-credit-safeguards-moody-s-says
• https://www.ft.com/content/7158431c-5ed3-4ef9-8b08-7057d2a0a3ce
• https://www.bath.ac.uk/announcements/systemic-risks-in-the-leveraged-u-s-loan-market-may-herald-new-financial-crisis-study/
• https://www.spglobal.com/ratings/en/research/articles/240327-leveraged-finance-adding-up-ebitda-addback-study-shows-moderate-improvement-in-earnings-projection-accuracy-13045496
• https://know.creditsights.com/insights/u-s-liability-management-transactions-quarterly-update-through-q3-2025/
• https://www.dechert.com/knowledge/onpoint/2025/6/dividend-recaps-in-2025--high-yield-bonds-crash-the-party.html
• https://www.dechert.com/knowledge/onpoint/2025/6/dividend-recaps-in-2025--high-yield-bonds-crash-the-party.html
• https://www.spglobal.com/ratings/en/research/articles/240327-leveraged-finance-adding-up-ebitda-addback-study-shows-moderate-improvement-in-earnings-projection-accuracy-13045496
• https://flow.db.com/trust-and-agency-services/outlook-for-clos-in-2025-reason-for-optimism