Debt Covenants: The Downside

Banks have been battered for months and now it’s their turn to return the favour. They are taking a cold eye to debt covenants; miss one and you could find yourself between a rock and a couple of lawyers. In fact, default is one of the most significant risks that a company faces. Company boards routinely want to know whether the company is in compliance now and what processes are in place to monitor covenant compliance in the future.

Missing a covenant that causes a default can jeopardise their owners’ (e.g. shareholders or private equity firm) entire investment. Recent Federal Reserve loan surveys show many lenders have tightened their credit standards to lower their own risk. To borrowers these tightened standards mean:

• More restrictive covenants.
• Lower loan limits.
• Shorter maturities.
• Higher loan spreads.
• More collateral.
• Little or no grace periods to cure an event of default.

Figure 1. Net Percentage of Domestic Respondents Tightening Standards for Commercial and Industrial Loans

Source: Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices

Banks have low tolerance these days for surprises and misunderstandings about debt agreements. Banks, now more than in the recent past, expect companies to adhere to all of the requirements of the debt agreements as well as to live up to their financial forecasts. The banks are spending more time focusing on the assumptions behind borrowers’ financial models and assessing whether borrowers have the capability to manage their debt. They also want companies to explain how any deviations are likely to impact future financial results and possible covenant compliance. Lenders also want to avoid dealing with future misunderstandings when a credit need has to be addressed, i.e. “I thought this covenant meant….”

As a result, lenders are quicker to call foul when a covenant isn’t followed – even if it’s a minor one. At a minimum the company has reduced its negotiating power. At worst, a lender could say the entire agreement has been breached and the borrower is in default. That can be costly to the company and people’s jobs. For a typical US$50m credit facility, a default can cost between US$500,000 and US$1m in higher bank fees, higher interest expenses and legal fees.

As a result, lenders expect treasurers and their companies to fully understand all of the requirements of their loan and to operate within the terms of the debt agreements. Lenders also want to be advised well ahead of time about all material events that could impact the loan agreements.

Did we advise ‘no surprises’ yet?

Here are some best practices we advise treasurers and other company finance executives to follow these days:

• Read and understand debt agreements.
• Create a checklist of all key covenants.
• Create a financial model to track and forecast financial compliance.
• Create a debt calendar to schedule covenant compliance on a regular basis before events become defaults.
• Proactively communicate with lenders.
• Stress test covenant compliance under different cash flow assumptions.

Figure 2. 2007 Covenant Review Process

Source: Corporate Finance Solutions

Debt management and covenant compliance is a team effort and should involve treasury, legal, audit and the operating areas to ensure the needed compliance certificates are completed on time and are accurate. There are a few web-based tools available to help in this process that are better than today’s system of spreadsheets, emails and sticky notes adorning a dog-eared copy of a loan agreement. Using better technology could just end up saving the day.