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.
Lenders that structure secured debt, such as corporate loans, often require covenants as part of the financing arrangement to protect their downside risk.
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Debt covenants are limitations placed on borrowers to protect the interest of the lenders, as part of a lending agreement.
By agreeing to abide by the covenant, the borrower can 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.
There are three distinct types of loan covenants:
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 follows the accounting rules established under U.S. GAAP.
Examples of Affirmative Debt Covenants:
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:
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:
First, “maintenance” covenants require the borrower to avoid breaching specified credit ratios:
Examples of Maintenance Covenants:
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:
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.
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