Posted on: December 23rd, 2019
Covenants are pesky little measurements that all borrowers are subjected to by their lenders. They intend to measure the health of business and are an early warning indicator of trouble ahead. The two most common covenants are a leverage ratio and fixed charge coverage.
The former tracks the debt to EBITDA ratio, the later tracks the Free Cash to debt service ratio. Covenant levels are usually specified early on in the game, usually when the company is soliciting funding proposals. Due to the time it takes to get from the initial proposal to the first covenant period, there’s usually a fair bit of bewilderment by the borrower to understand compliance issues post-closing.
Sometimes deals take longer to close and the covenant start period may have pushed out, leading to an apples to oranges comparison with covenant levels. Other times, the lender may not have specified that EBITDA for the historical trailing twelve month period can include adjustments. They may have approved the loan with this in mind, but the lawyers sometimes overlook this basic point. Occasionally, the wording of the covenants does not include pro forma changes to the balance sheet that occur at closing. This can lead to improper inclusion of repaid loans in your leverage multiple covenant. Finally, there can also be a gotcha covenant that is set at a much tighter level than the others.
This functions like a hair trigger mechanism that can lead you to a quick covenant breach. The concept of a covenant is in itself, not a bad thing, but the implementation often misfires. This is caused by faulty covenant design and lack of proper covenant discounting. When negotiating covenant levels, borrowers are usually too quick to agree to things. The lender may want more frequent measurement than the borrower can deliver. Rather than speak up, the borrower will go along with it to get the funding and then worry about problems down the road.
Additionally, lenders usually apply a 15 to 20% discount to projected EBITDA when setting covenants. This level may be fine for stable earnings company but could pose an issue for unpredictable ones. Borrowers should be more vocal during covenant negotiation and make sure that the requested covenant is measuring the right metric, at the right level, over the right measurement period. Here are 4 ways to help you do this:
- Run your own covenant calculations – learning the market levels will allow you to beat the lender to the punch and calculate your own levels. If the lender is asking for a 2 times leverage multiple and the market is 2.5 times, you have room to push it up.
- Covenant-align your reporting – ensure you can produce information to easily calculate covenants. It’s advisable to have sample reports as exhibits in the closing documents as an audit trail so there is no post-closing guessing. If you can’t report it, you cannot covenant measure it.
- Opt for Single Measure Covenants – complex covenants include many variables and create interpretive confusion. It is always better to have single measure covenants such as, EBITDA level, working capital level as opposed to a multi-layered ones.
- Ensure ample cushion – make sure you test their proposed covenants and fight for a more favorable discount. Lenders usually will not lose a deal over covenant levels, unless your requests are perceived as radical. Fight for your right for flexibility and cushion.