The Pros and Cons of Covenants
23 November 2006
I have yet to see a term or operating loan without some kind of covenants. Mind you covenants come in a few different flavours and are not obvious to the naked eye, so let’s start with some background.
There are positive covenants which specify actions that the borrower is expected to do, such as maintaining corporate existence or keeping a certain number of independent directors on the board. There are negative covenants which specify actions that the borrower is expected to not do, such as defaulting on the loan or selling substantially all of its assets.
Borrowers rarely find fault with the kinds of boilerplate covenants mentioned above. Financial or performance-based covenants, however, can be a different story. So when a lender advertises “no financial covenants,” the offer can seem pretty compelling.
Before looking at the pros and cons of having financial/performance covenants, it is important to understand why a generic lender would want them. Covenants are generally put in place to initiate a discussion should things not unfold as originally planned. In other words the world is not unfolding as management had anticipated in the business plan originally put forth to, and funded by, the lender. The question the lender always asks him/herself after the actual results come in is this: The forecast was for positive EBITDA but the company lost $2 million EBITDA. Would I have done the deal had I known about a $2 million loss at the outset?
It should go without saying that both the lender and the company want the business plan to work as predicted. Since the lender does not manage the company, it really has little control over the outcome of the plan (management may also, at times, have little control over the outcome but that’s for another discussion). Given this lack of control, adding some financial/performance covenants gives an objective basis from which to judge the company’s performance and to allow the lender and management to discuss potential fixes should the company veer too far off course.
The “cons” for the company are pretty obvious here. Something outside of management’s control could result in an uncomfortable discussion at the least and could raise the spectre of a pulled loan at the extreme. The reality will likely include the uncomfortable discussion along with some kind of mid-course correction to get things back on track.
The “pros” are less obvious but are arguably more important to the company:
? financial/performance covenants are objective. The company knows how it is being measured which is important because it can:
1. negotiate a reasonable amount of wiggle room up front. No business plan will unfold exactly as presented, so most lenders will develop financial/performance covenants at a level below what the business plan contains;
2. often take corrective actions before covenants are tripped.
? loans with “no covenants” are usually better described as loans with “no obvious covenants.” There are a couple of ways a lender can slip in a tripwire or two without a borrower necessarily noticing:
1. The Material Adverse Change (or MAC) clause. It sounds so unassuming, but an “adverse change” such as missing a monthly revenue target may be considered “material” if the lender decides to interpret it that way. Who is to say that a miss of the forecast isn’t “material” to the lender or the business agreement?
This may be what happened recently when Xillix was declared in default of its 8-month old loan “by reason of the occurrence of material adverse effects” due to its “failure to meet its internal forecasts of sales and EBITDA for August, 2006.” In hindsight, most companies would prefer to negotiate sales and EBITDA tests at some safe threshold below their business plan forecasts – if given the chance.
The other MAC as declared by the lender for Xillix was that “total assets to liabilities ratio in August was less than 1.0 to 1.0,” which sounds like a standard tangible net worth covenant. This again is probably something the company, in hindsight, would have preferred to negotiate from the outset. Xillix filed for creditor protection under CCAA 10 days after receiving the demand letter.
Because the MAC clause has no objective metrics, accepting one in a loan agreement can be viewed as turning a term loan into a de-facto demand loan. The loan could potentially be called on any given day should the business not perform exactly as projected.
2. Cross default clauses. Term loans often allow (and may even require) a senior revolving line of credit – and senior lenders (ie. banks) can loan at prime plus 2% or so in part because they have restrictive covenants for metrics such as working capital, tangible net worth or EBITDA/interest coverage.
With a cross default clause in place, the lender with “no financial covenants” ends up with some pretty strong financial covenants courtesy of the bank. As an example, we recently “lost” a deal to a “no covenant” sub-debt lender. After the term sheet was signed the lender required the company to get a bank operating line in place. As such the sub-debt lender now has the benefit of the Bank’s financial covenants through a standard cross-default clause, despite having advertised themselves as having “no covenants.”
In summary, the most contentious loan covenants are based on financial/performance metrics. Lenders want to include these metrics in their loan agreements as guideposts, signaling to management the need to potentially take corrective actions. Covenants are best outlined up front so that all parties are aligned and understand where they stand at all times. Without clear disclosure of the metrics by which they are being judged, companies can end up with a hidden sword of Damocles hanging over them.
CWN
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