Updated July 14, 2023
What is Covenant?
The term “covenant” refers to the legal bindings imposed on the borrower by the lender as part of a debt agreement. For example, suppose the borrower fails to comply with the pre-decided conditions. In that case, the borrower may default, and the lender can either inflict a penalty on the borrower or rightfully ask the borrower to make the entire debt payment immediately. Covenants are created to restrict the borrower from making any decision detrimental to debt repayment.
Explanation of Covenant
One of the major concerns for a lender is the complete recovery of the loan from the borrower. It has been observed that in cases where no restrictions are imposed on the borrower, there is a high probability that the management of the borrower company will completely ignore the lender’s interest and make confident decisions that will jeopardize their future debt servicing ability. So, covenants are tools lenders use to ensure their money is safe. These legal bindings ensure that the borrowers abide by certain pre-decided conditions, or the default clause will be triggered per the agreement. So, if the borrower breaches any of the covenants, the debt agreement allows the lender to demand repayment immediately.
In most cases, financial covenants are expressed in ratio ceiling or floor. For example, the debt-to-equity ratio shouldn’t breach the ceiling of 1.5x, or the interest coverage ratio shouldn’t breach the floor of 2.2x. However, covenants are not just restricted to financial ratios. They can cover many other aspects of company operations, such as maximum dividend payment, working capital requirement, retention of critical employees, etc.
How Does Covenant Work?
Now, let us look at how covenant works in a company setup.
- Corporations often require money to expand their business or support their daily operations. In cases where they wish to raise funds at a lower cost, they opt for bond issuance or bank debt and pay interest on the borrowed money. In such a scenario, one of the primary concerns of the lender is the protection of their money against default.
- So, the lenders then set some covenants that are legal agreements between the lender and the borrower. These impose pre-determined conditions before the issuance of the bonds. Now, if the borrower agrees with the terms and conditions of the debt agreement, the lender will only go ahead with the lending. In addition, the covenants take cognizance of the rating of the company and the debt instrument. So, these covenants add extra protection for the lender’s money.
- For instance, the lender imposes a covenant that mandates that the debt-to-equity ratio shouldn’t exceed 1.5x. However, the borrower incurred heavy losses in the current year, resulting in equity erosion, pushing the debt-to-equity ratio beyond the threshold of 1.5x. The debt agreement states it is a breach and will trigger a default. So, in this case, the covenant acts as an early warning signal for the lender that the borrower’s business is in trouble which may result in liquidity problems. Hence, it is better to call back the borrowed amount immediately.
Example of Covenant
Let us take the example of ABC Inc., which is planning to raise $50 million through the issuance of bonds at the beginning of 2019. Now, the company has approached many lenders to discuss the terms and conditions of lending. As a result, some banks agreed to purchase the bonds after adequately evaluating the creditworthiness of ABC Inc. However, all the banks proposed the following covenants before buying the bonds.
- These bonds (until their maturity) must be the senior most debt in the company’s capital structure.
- The company’s interest coverage ratio (EBITDA/ Interest expense)must never fall below 3.0x
- The company’s debt-to-equity ratio cannot exceed the ceiling of 1.2x
Solution:
Now, let us take the example mentioned in the above section and determine whether any of the covenants have been breached if the following annual financial figures were reported at the end of 2019:
- EBITDA = $10 million
- Interest expense = $3 million
- Outstanding debt = $60 million
- Total equity = $55 million
Now, we can calculate the interest coverage ratio of the company as follows:
- Interest Coverage Ratio = $10 million / $3 million
- Interest Coverage ratio = 3.33x, which is more than the covenant of 3.0x
Again, we can calculate the debt-to-equity ratio of the company as follows:
- Debt-to-Equity Ratio = $60 million / $55 million
- Debt-to-Equity Ratio = 1.09x, which is below the covenant of 1.2x
So, none of the covenants has been breached.
Types of Covenant
We can broadly categorize the covenants into the following significant types:
1. Affirmative covenants: This type of clause requires the borrower to perform certain specific actions, and if the borrowers fail to do so, then it is in outright default. However, lenders may offer borrowers a grace period, and if the borrower fails to comply within that period, it considers a default. Some examples of affirmative covenants include furnishing audited financial statements to the lender at regular intervals, maintaining proper accounting books, etc.
2. Negative covenants: This type of covenant is imposed on the borrower to refrain from undertaking any such actions that may lead to the deterioration of their debt serviceability. Some examples of negative covenants include maintenance of dividend payout below 50%, maintenance of gearing below 3.0x, etc.
Conclusion
So, it can be seen that covenants are significant from the point of view of the lenders. Covenants impose discipline on companies and offer better control to the lenders. However, it should be noted that too many covenants may end up restricting the company’s operations, which can be detrimental to its revenue growth and profitability.
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