TOOL L1
| What Risks | – Be clear which risk you are trying to mitigate and natural mitigant / business development opportunity you are trying to lock in (take care – is it legal to “tie” one product to another?) – Requires good identification and prioritisation of risks, natural mitigants and business development opportunities – Business, Financial, Structure |
| Who | – Should the borrower and / or the credit base give covenants? – Will they be direct or indirect? – Should covenants be set on a consolidated or unconsolidated basis? |
| Definition | – Financial covenants 1. What are the key accounting policies? 2. Is there creative accounting? – Non financial covenants 1. Are there any significant exceptions? |
| Projections | – The more you rely on projections, the more the financial covenants should follow the projections i.e. stepping and linked to Cash Flow (Refer Tool L7) – If you are relying on historical accouts, covenant level should be set in the context of historic trends. |
| “Bite” | – How quickly will covenant be triggered? Note the order of effectiveness 1. Restrictive / Event 2. Cash Flow 3. Income Statement 4. Balance Sheet – Will there still be a viable business to negotiate with? – When reliance on covenants are low, for example with strong credit bases, then internal triggers must be set to monitor early warning signals |
| Bank Action | – What option will the Bank really have when the covenant is broken? (Refer Tool L8) |
| Compliance | – How frequent and up to date will compliance information be? – Is it independent? – Is there a requirement to show detailed calculation? – Who will monitor within the Bank? |
Types of Covenant
- Restrictive Covenants (sometimes referred to as “Undertakings”)
- Event Covenants (usually “Events of Default”)
- Financial Covenants (these are based on financial calculations and can refer to figures which appear in the Balance Sheet, the Income Statement or the Cash Flow). They may also refer to figures which are calculated specifically for the purposes of the covenant and which may not appear in the published financial statements of the company concerned.
What are Covenants intended to do?
Restrictive covenants are:
- Intended to give the bank indirect control over cash or cash flows, assets or contracts of a client.
- Often defined so as to limit the actions of a company (for example a non disposal of assets clause or a limitation on dividends).
- Used to prevent other stakeholders getting direct control (for example the negative pledge clause) or to ensure that no other stakeholder takes action against our client before we do (cross default).
Event covenants are:
- Intended to give the bank control upon the occurrence of a specified event. The event should relate to a key business risk of the client. Common examples are the loss of a license, or a change in regulation.
Financial covenants are:
- Designed to set a financial course for the company to follow during the lifetime of the Bank’s exposure.
- The trigger default limit of that financial course. If the covenant is broken then the Bank usually has the right to renegotiate the terms and conditions of the loan agreement and, as a last resort, to call default and demand repayment.
- Based upon financial figures produced by the client. The most common covenants seek to restrict levels of debt (compared to Equity or EBITDA), to ensure a minimum level of shareholder support (Net Worth to Total assets for example) or to ensure that profits are sufficient to absorb interest costs (for example the Interest Cover Ratio – EBIT(DA) / Interest paid).
- For more complex or highly leveraged deals then cash flow (based on a calculation of Net Cash from Operations) covenants are appropriate (Debt Service Cover for example).
Key Issues to Remember
The usefulness of any covenant will depend upon its definition, which party it is set upon and, for financial covenants, the level at which it is set (how much “headroom” does the company have?) and the frequency of compliance.
The definition of any financial covenant will determine its immunity from creative accounting and hence its effectiveness. Beware of exceptions from non financial covenants (“carve outs” and “threshold” amounts).
