Covenant-lite Deals, Non-Bank Deal Ownership and Financial Reporting Quality

Abstract

We examine how covenant-lite (“covlite”) deals – loan contracts that lack systematic financial/maintenance covenant compliance requirements – and non-bank institutional syndicate participation affect issuer-level financial reporting quality. We show that, given significantly reduced covenant compliance and information transfer mechanisms between lenders and borrowers, covlite issuers increasingly abandon financial reporting objectives that prioritize cash flow verifiability and timely loss recognition. Indeed, we contend that covlite issuers prioritize the quality of non-GAAP-based voluntary earnings information that is a better match with their non-GAAP-based contractual provisions and non-bank creditors’ investment screening criteria. Moreover, lack of financial covenant compliance does not necessarily result in subordinate financial reporting standards at issuer-level. Notably, however, we show that financial reporting quality is strongly influenced by the type of creditor profile participating in loan syndication and identify potential financial reporting issues when lack monitoring mechanism in covlite deals is accompanied with large non-bank institutional deal ownership.