The national press has put Legal Village's private equity blogger out of business over recent weeks. All the issues have been aired and the really thorny ones around taper relief and base cost shift on carried interests are in the spotlight this week.

However, deal mania in the private equity market is producing some intriguing results, including 'covenant lite' bank debt.

'Lite', of course, implies virtuous. Many of us wouldn't see covenants as inherently evil or flabby. The concept of finding virtue in doing away with what some would regard as a cornerstone of LBO transactions intrigued me.

Covenant lite
LBO credit comes from a myriad of sources, including banks, mezzanine funds, CDOs and hedge funds. As the market has become ever more competitive and aggressive, loan structures have softened. All sorts of interesting features have started to emerge. Quite apart from non-recourse, ring-fenced financings at staggering EBITDA multiples, we have seen pay-in-kind notes, toggle notes, second lien financings and so on.

However, covenant lite is a relatively new concept, accounting for 5% of the US market in 2006 but, according to some observers, almost 30% in the year to date. Few deals have been done in Europe as yet, but there are many in the market or under discussion and they tend to be the larger ones. Unlike traditional loans with financial covenants (such as debt coverage, loan to value covenants and cash flow covenants), these loans offer companies much more flexibility and lenders much less ability to call the shots when things start to go badly.

Some argue that these loans are a sign of a maturing market. Covenants are bothersome for lenders (because you have to police and, occasionally, waive them). Simpler loans are more liquid and therefore easier to buy and sell in the secondary market. This contributes to a greater variety of lenders participating in the market and reduced power for lending banks. From a borrower perspective, all this is no doubt positive. If there were evidence that covenant lite loans were more expensive (and that lenders were therefore pricing to reflect their loss of protection), that would be rational, but giving up protection for nothing other than the opportunity to lend suggests an imbalance in the market. There is a lot of pressure on lenders to lend and considerable power in the hands of the LBO sponsors, who are huge customers for bank debt.

If the banks can't or aren't doing the job they used to in imposing prudence on borrowers, who else will? The only relevant UK legal restriction – the prohibition on the giving of financial assistance by target companies – is due to be abolished with effect from next year. Logically, one would expect banks to insist that (as a precondition to lending) a process similar to that required by the law at present be undergone. In other words, the auditors would have to prepare cash flows to demonstrate that the target company can survive under the increased burden of the acquisition finance. However, if pressure to lend continues at the present levels, one wonders whether the banks will dig their heels in and voluntarily insist on this level of scrutiny.

It would be peculiar if the only people left objecting to target company leverage were the pension trustees!

Other market practices
In effect, we have 'purchaser protection lite' sale and purchase agreements in the present auction market frenzy. Sellers produce contracts and it is now normal to expect that these will contain very little in the way of warranty protection for a buyer. Two or three years ago (even in an auction) you would expect to see an attempt at a reasonable set of warranties and some sensible financial limitations on those. You might also well expect to find completion accounts/price adjustment mechanisms to give the purchaser comfort that it will actually get what it expects to get. The thinking was that if these things were not offered to buyers, it would adversely affect the price (which would not be in the vendor's interest).

Buyers have become more and more keen to compete to buy assets, such that sellers have not had to offer these provisions. The concession offered (instead of completion accounts) is a so-called 'locked-box mechanism': rather grand words for a straightforward contractual confirmation that the vendor has not extracted value since the date to which a set of accounts prepared by the seller's accountants has been drawn up. The word 'mechanism' implies something rather more effective than what you could expect to find in a decent accounts warranty.

Vendor due diligence also promises a lot and can deliver rather little. The scope is defined by the vendor and the preparers of the reports – be they legal, accounting or other – can often do little by way of independent verification beyond reviewing the materials they are supplied with and getting answers to questions raised. Often the volume of report produced is remarkable, given the lack of access and information supplied.

Both accountants and lawyers almost invariably limit their liability for this kind work, irrespective of the size of the deal. Even in a mid-market transaction, you will see limits at below 10% of the deal size. Nonetheless, some buyers find the work informationally helpful and some buyers and their banks are prepared to rely on it.

The words 'data-room' and 'disclosure' have become similarly devalued. A data-room is rarely a room (almost always online) and often contains an assemblage of material that can barely be described as data. The vendor will then insist its contents are disclosed for the purposes of any of the meagre warranties on offer.

The future
There are many other obstructive elements of the LBO process that must be called into question, along with covenants. For example, 'lawyer lite' deals would get done much more quickly. 'Banker lite' deals would remove those awkward credit committee approvals. 'Management lite' deals would mean that you wouldn't need to grip the awkward question of who is actually going to run whatever it is that is being bought or sold.

Clearly there is plenty more to be swept away and there will be many more 'price-heavy' deals before we really have seen the top of the market.

Charles Martin is a partner at Macfarlanes.

This article also appears in Legal Village.