What is a key risk when using covenant-lite debt in PE financing?

• A. Covenant-lite debt offers fewer restrictions for sponsors, but higher risk for lenders
• B. Covenant-lite debt imposes stricter covenants than traditional
• C. Covenant-lite debt reduces sponsors flexibility and increases risk for lenders due to looser covenants
• D. Covenant-lite debt eliminates all risk

Answer: (C)

Covenant-lite debt relies on looser covenants, meaning there are fewer financial discipline mechanisms to protect lenders. In private equity financing, traditional debt typically includes covenants that require the borrower to maintain certain metrics or restrict actions that could increase risk. When covenants are lightened or removed, sponsors gain more freedom to run the business and pursue aggressive strategies, which shifts risk toward lenders. If performance deteriorates, there are fewer triggers forcing corrective action or allowing lenders to intervene early, so the potential for loss increases. The key takeaway is that looser covenants heighten lender risk, even though they give sponsors more operating flexibility.