What are Debt Covenants?
Debt Covenants are conditional terms in lending agreements to ensure the borrower’s financial performance remains steady and management continues to be responsible when making corporate decisions.
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How Debt Covenants Work
Debt covenants protect the interest of the lenders, but in exchange, borrowers obtain loans with more favorable terms since the risk to the lender is lower.
For the two parties in a loan agreement – the borrower and lender – arriving at a compromise regarding the terms on the debt security often require negotiating a list of stipulations, which are referred to as “covenants.”
Debt covenants are defined as requirements and/or conditions imposed by the lender and agreed upon by the borrower during the arrangement and finalization of a financing package.
Since covenants help protect against potential downside, the imposition of covenants allows lenders to present more favorable terms to prospective borrowers.
With that said, debt covenants are NOT intended to place an unnecessary burden on the borrower or hinder their growth with strict restrictions.
In fact, borrowers can benefit from debt covenants by receiving more favorable debt pricing – e.g. lower interest rate, less principal amortization, waived fees, etc. – and forced operational discipline.
Types of Debt Covenants
- Affirmative Covenants → Affirmative, or positive, covenants state certain obligations the borrower must fulfill to remain in compliance.
- Restrictive Covenants → Restrictive, or negative, covenants are intended to prevent borrowers from taking high-risk actions without prior approval.
- Financial Covenants → Financial covenants refer to pre-specified credit ratios and operating performance metrics that the borrower must not breach.
Affirmative Covenants (or Positive)
Affirmative covenants, otherwise called “positive” covenants, require the borrower to perform a certain specified activity – which essentially creates restrictions on the company’s actions.
If the company is publicly traded, the lender could place requirements that the borrower remains in compliance with the SEC on all the filing requirements, as well as follow the accounting rules established under U.S. GAAP.
Examples of Affirmative Debt Covenants:
- The company must maintain good standing with the SEC and file financials on time per U.S. GAAP reporting standards.
- The company must get its financial statements audited on a regular basis – whether the borrower is public or private.
- The company must be covered under insurance as a hedge against unexpected, disastrous events that would result in significant fees if uninsured.
- The company must remain on top of all required local, state, and federal tax payments (IRS).
Restrictive Covenants (or Negative)
While affirmative covenants force certain actions to be taken by the borrower, in contrast, negative covenants place restrictions on what the borrower can do – hence, the term is used interchangeably with “restrictive” covenants.
There are numerous types of restrictive covenants that tend to be company-specific, but the recurring theme is that they often limit the amount of total debt the company can raise.
Examples of Restrictive Covenants:
- The company cannot issue dividends to shareholders unless strict approval of lenders was received and signed on paper.
- The company cannot partake in mergers and acquisitions (M&A) without lender approval.
- The company cannot shake up upper-level management without the consent of lenders.
- The company cannot purchase or sell fixed assets without obtaining approval – typically, the upper limit on the price is set on what can be purchased/sold.
- The company cannot place additional liens on its asset base (i.e. collateral), as doing so can reduce the recoveries of the lender if the borrower were to default and undergo liquidation.
In the case of restrictive covenants, the lender does not want management to make major, potentially disruptive changes to the company – and therefore sets requirements for needing lender approval before taking such actions.
By requiring the borrower to maintain certain credit ratios and operational metrics, the lender confirms the company’s financial health is kept under control.
Financial covenants are imposed to ensure the borrower maintains a certain level of operating performance (and financial health).
Since the tests are done regularly, management must constantly be prepared, which is precisely the lender’s objective.
Financial covenants can be separated into two different types:
- Maintenance Covenants
- Incurrence Covenants
First, “maintenance” covenants require the borrower to avoid breaching specified credit ratios:
Examples of Maintenance Covenants:
- Leverage Ratio (Total Debt/EBITDA) < 5.0x
- Senior Leverage Ratio (Senior Debt/EBITDA) < 3.0x
- Interest Coverage Ratio (EBIT/Interest Expense) > 3.0x
- Downgrade in Credit Rating – i.e. Cannot Fall Below Certain Rating from Agency (S&P, Moody’s)
The second type of financial covenants is “incurrence” covenants, which are tested only if the borrower takes a specific action (i.e. a “triggering” event).
Compliance for incurrence covenants is not tested regularly, yet the lender would likely prefer not to test for potential breaches constantly.
Examples of Incurrence Covenants:
- For instance, a potential incurrence covenant is that the borrower cannot raise more debt financing if doing so causes the debt-to-EBITDA ratio to exceed 5.0x.
- However, if the borrower does not participate in any external financing but its debt-to-EBITDA ratio exceeds 5.0x due to a lower EBITDA, the borrower has NOT breached the incurrence covenant (although there may be other covenants in breach).
Breaches of Debt Covenants
Loans are contractual agreements, so violating a debt covenant represents a breach of a legal contract signed between the borrower and lender(s).
If a company violates a covenant, the company is in “technical default,” with consequences that could range from the breach being “waived” by the lender to the lender bringing the issue to Court. Moreover, the severity of the consequences is circumstantial and dependent on the lender.
For example, the extent to how much the covenant was violated is one consideration. The relationship between the parties involved (and with other creditors) can also determine how the breach is dealt with (i.e. trust, past/future business).
In exchange for not taking legal action, the debt lender could adjust the terms of the debt obligation – e.g. change from cash interest to paid-in-kind (PIK) interest or extend the length of the borrowing term.
Typically, the lender will also request collateral (i.e. a lien) and/or higher interest rate pricing since the borrower gets to conserve cash and has more time to obtain the required funds.
Otherwise, the lender could have a clause to terminate the loan agreement, which requires immediate principal repayment plus fines.
In the worst-case scenario, if the borrower cannot meet the required debt payments and the lender is unwilling to negotiate out-of-court, the Bankruptcy Court becomes involved in the often lengthy and complex restructuring process.