Debt Covenants – Friend Or Foe
Should you be worried about debt covenants?
The first time you take on debt that includes covenants, it can be a daunting experience. Clients often try to resist debt with covenants, or become very concerned about the consequences, but should they be? Below we try to address some of these concerns.
What are debt covenants?
Debt covenants may be referred to as banking covenants, loan covenants or financial covenants. They are a series of conditions or tests that are written into the loan agreement which, if not met, could put the loan in default.
Debt covenants help protect the lender by prohibiting certain actions by the borrowers, or by raising early warning signs of underperformance. This allows the lender to work with the borrower to address issues or, failing that, as a last resort, call in early repayment of the loan.
Covenants can be positive or negative covenants. Positive covenants stipulate what the borrower must do, such as meet defined financial ratios, maintain insurance, provide financial reports.
Negative covenants stipulate what the borrower cannot do, such as pay dividends over a certain amount, sell assets, take on other debt or change its business.
Debt covenants as discussed here tend to be on larger loans, usually £0.5m and higher.
The inclusion of debt covenants in the loan agreement means the loan is deemed less risky by the lender, and a borrower should therefore benefit from lower interest rates and fees.
Can I negotiate the debt covenants?
Yes. You can and you should negotiate the debt covenants before taking on the debt. The lender will have been presented a business plan and financial forecast for your business which they will use to determine the amount of debt they can lend but also the level of covenants that they deem to be appropriate.
The lender will want to set covenants that they believe you will meet. They do not want you to be in default. Therefore, it is important that the forecasts presented to the lender are sensible and achievable to ensure headroom in financial covenants.
It is important to also identify items that you do not wish to be overly restricted on. A common restriction is dividend distribution. For owner-managed businesses this is particularly important. Set the level low and it helps to achieve financial covenants, such as cash flow cover, but then it may be set too low to allow a dividend that meets your lifestyle and earning expectations.
What are the most common types of debt covenants?
Financial covenants may include:
Debt Service Cover being a measure of earnings (often Earnings Before Interest Tax and Depreciation or ‘EBITDA’) to Debt Service (interest and capital payments). So, for example, the lender may state that earnings need to be 1.5x greater than the debt service costs.
Gross Leverage being a measure of total debt to earnings. So for example, debt may be set at no more than x2 earnings.
There are many different ratios that could be used depending on the exact nature of your business and the loan requirements.
Covenant levels may not be fixed for the whole term of the loan. Lenders will often tighten covenants throughout the term to match the expected growth of the business and repayment of the loans.
Alignment of interests
Properly set covenants will align the interests of the borrower and the lender. If the business grows as planned or within a fair tolerance, then all covenants will be met and management’s strategy is met.
Debt covenants are a necessary requirement for businesses that need to step up the level of debt to support growth or acquisitions. They can be complicated and if not negotiated correctly from the outset can cause problems. However, properly thought through covenants should add value to the business.
Once the loan is in place it is vital to build good communication channels and relationships with the lender. There will be reporting requirements that need to be met but on top of that, keeping in regular contact, updating the lender on possible issues as early as possible is key as lenders will normally try to work out solutions to covenant breaches in advance of them occurring wherever possible.
Take advice from an adviser or broker who has experience in negotiating covenants and understands their impact on your business as this will help you get set up correctly from the start.