Tool L10
We need to consider three main situations:
- When risk profile is perceived to be stable or improving throughout the life of the transaction and/or the client has normal leverage levels
- When risk is perceived to be deteriorating throughout the life of the transaction and/or the client has high leverage levels
- Seasonal businesses
1. Stable or improving risk profile and / or normal leverage
The basis of the calculation will be historic figures. These need two adjustments:
- Adjust number for one-off factors for example acquisitions or divestments
- Add a margin to give client some freedom say 10 – 20 %
Then consider how the financials will look at that covenant level.
For example, if historic Debt / EBITDA is 3:1 and the covenant is set at 3.5:1 ask:
- How much can debt increase from current levels if EBITDA is constant?
- How much can debt increase from current levels if EBITDA is growing at historic rates?
- How much can EBITDA reduce if debt stays constant?
If you are not happy with the result then you have the basis for discussion with your client to set a lower covenant level.
If refinancing is a critical aspect of the deal you have to judge whether the covenant levels will present an attractive proposition to the debt / equity markets. For large companies you can calculate an implied rating. Otherwise use the client’s historic ratio levels and peer analysis. Clearly the refinancing institutions will be looking to see covenant levels that do not allow significant deterioration of the financial position.
2. Deteriorating risk profile and / or high leverage
The starting point here is projections. Set covenants ideally with a 10 -15% margin to the base case projections. The margin will be decided by how much you think the company can under achieve its own projections before the Bank needs to take action. Link this to any pricing grid.
Set covenants that step towards more conservative levels until it is considered they reach “normal leverage” levels. Here the arguments will be much the same as 1 above except there may not be relevant historic trends available. In which case, implied rating or peer group analysis will need to be used.
3. Seasonality
Balance Sheet covenants are rarely of use with these types of client. However borrowing under the facility can be restricted by linking maximum outstandings to a Borrowing Base calculated as a percentage of inventory and receivables. Inventory should be adjusted to deduct unpaid creditors (who may have retention of title claims).
Care should be exercised in the definition of eligible receivables; in particular, receivables should be adjusted to deduct overdue and doubtful amounts.
You can also control seasonal facilities by
- Flexible limits (reduce cancel limits in the low season)
- Offering short term finance only
- Introducing a clean up clause during the low season
The most useful covenants in this situation are those based on the Income Statement and calculated on a rolling basis (for example, fixed charge coverage or interest coverage.
The approach to setting the level is the same as 1&2 above for the Income Statement covenants.
For borrowing base and highly leveraged deals you will want a large margin on the working capital facility to provide extra asset coverage for the rest of your facilities. However as leverage improves this margin could decline.
