What is a Financial Covenant?

What is a Financial Covenant?

Tim Skeet

35 years: Debt capital markets

Covenants oblige borrowers to adhere to a set of conditions, typically in the form of a set of financial metrics and ratios. Here, Tim goes into further detail by outlining typical triggers, consequences and specific types.

Covenants oblige borrowers to adhere to a set of conditions, typically in the form of a set of financial metrics and ratios. Here, Tim goes into further detail by outlining typical triggers, consequences and specific types.

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What is a Financial Covenant?

9 mins 7 secs

Overview

Covenants are conditions in a borrowing document that ensure the borrower maintains certain financial ratios to assure the lender that they are, and will continue to be, financially able to repay them.

Key learning objectives:

  • Define covenants

  • Explain the purpose of covenants and what they prevent

  • Describe the different types of covenants

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Summary

What are covenants?

Covenants refer to the formal conditions contained in loan and bond documentation that oblige borrowers to adhere to a number of financial and operating metrics and ratios.

What is the purpose of covenants?

They prevent borrowers from engaging in certain types of behaviour or activities that might push them beyond covenant triggers. Financial triggers are expressed via financial ratios, such as debt-to-equity multiples.

The conditions of underlying covenants are critical components of risk protection for lenders, and offer headroom against any weakening in a borrower’s financial standing. Lenders may, at their own option, grant covenant waivers in specific circumstances.

What happens if a borrower violates their covenant package?

If they fail to cure the breach within a set period of time, lenders may have the right to increase the financing margin on the facility, demand additional collateral, demand immediate repayment, declare the borrower in technical default or even outright default.

What types of actions do covenants prevent?

This includes preventing borrowers from:

  • Making acquisitions
  • Raising more debt
  • Taking certain operational or business decisions
  • Reducing working capital below set levels
  • Having their credit score deteriorate, or requiring them to maintain a given credit rating or remain in a given credit rating category
  • Paying out earnings to shareholders via dividends or extraordinary payments above a set percentage of earnings

Covenants can also extend to key-man metrics, such as having key executives remain with the company.

What types of covenants exist?

Maintenance covenants - Borrowers are required to update and report to their lenders on a regular basis, typically quarterly (the financial metrics that underlie their covenants). These are typical of covenants embedded in loan documentation.

Incurrence covenants - Prevent lenders from taking action until such time as a specific financial ratio has been breached at the time it occurs. These are more typical in high-yield bond documentation and in so-called covenant-lite loans.

What is the difference between positive or negative covenants?

Positive covenants (affirmative covenants) - are covenants that outline what companies are required to do by dint of the covenant package.

Examples: The provision of timely key information to lenders such as financial statements, debt loads, earnings, interest coverage etc.

Negative covenants - are the ones that prevent borrowers from taking certain courses of action if they weaken the company’s financials and pierce the financial ceilings contained in financial ratios.

Examples: Caps on debt to earnings, dividend pay-out caps, caps on aggregate debt-raising, and caps on any debt-raising at a more senior level in the company’s capital structure.

What does cov-lite mean?

The market has seen a return to what are known as covenant-lite or cov-lite for short borrowing facilities. As the name suggests, this refers to loans and bonds that have fewer covenants in what is therefore borrower friendly documentation.

Cov-lite documentation became the norm in those heady pre-crisis days, moved into abeyance in the depth of the crisis when risk-aversion made a dramatic comeback but returned fairly soon afterwards.

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Tim Skeet

Tim Skeet

Banker with more than 35 years experience in the financial markets. Tim has been an ICMA board member and an ECBC steering committee member. Tim is a Freeman of the City of London.

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