How Covenant Structures Influence Acquisition Financing Approval

Acquisition financing approval creates fist-pumping joy for most acquirers, who have worked hard to gain the confidence of the acquisition financing lender. Borrowers, due to the difficulty of diligence and the fog of questions, often conflate approval with 100% confidence. Just because the acquisition financing lender has exhaustively underwritten you does not mean that they are comfortable with everything and will not use market level covenanting to derisk their position.

Acquisition financing lenders use diligence to verify that your processes and performance are strong enough to make the loan. Covenant structures are used to ensure that future performance is adequate to repay the loan. Borrowers need to understand that most lenders use management projections minus a discount in setting covenant structures. This structure is implicit in the acquisition financing approval as the credit decision makers assume the covenant levels will reflect the norm for their portfolio. They take your projected results and trim it 15% to 22% and calculate the covenants off this discounted level. There is some ability to influence the level of discount during the closing, as there may be unique issues to consider. In most cases, the standard discount is used, and this is baked into the approval process. This discount cushion is usually more than sufficient for performing companies.

Managing Covenant Expectations in Acquisition Financing It is essential for the acquisition financing lender due to the sensitivity of debt capacity to EBITDA erosion. For example, a 25% cash flow reduction causes a 25% increase in leverage ratio. If you begin the acquisition financing loan at 3 times leverage ratio, a 25% miss puts you at 4 times leverage ratio. This is a sharp increase which occurs in an abrupt manner usually causing the lender to put the loan on watch list. The key to navigating the covenant setting process is to work with an experienced investment banker who can communicate the need for more cushion without alarm bells ringing.