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Some Thoughts on Bank Covenants - The Relationship Manager Perspective

I regularly receive questions from various sources about bank covenants, how many covenants there should be, what is reasonable and how to best comply. Some borrowers may have been in violation of one of their covenants included in their loan documents, banks may have become more diligent in tracking covenants and the general economic climate may have put some strain on corporate performance, especially in some areas of the government contracting sector. Whatever the reason, the issue has taken on more urgency and importance. My comments in this article focus on covenants for privately held, Middle-Market companies with limited resources for financial reporting. Large, publicly traded corporations with a dedicated staff for financial and management reporting are a whole different story. I shall not discuss the wide variety of specific covenant definitions and their intended purpose, but instead outline some basic thoughts and principals.

What is the purpose of loan covenants?

Banks use loan covenants as a performance monitoring tool. Covenants, when correctly used, can provide valuable early warning signs of negative financial trends and provide an opportunity to evaluate underlying reasons for any observed changes and to discuss necessary adjustments to be made by the corporation. The basic idea is to measure performance (i.e. income and cash flow), balance sheet structure (such as leverage and working capital) and debt service capability. Properly designed and applied, loan covenants not only benefit the lender, but also provide a valuable monitoring and information gathering tool to corporate management. Loan covenants should not be viewed by management as an "imposition".

Now as a result, a useful loan covenant should be guided by some simple principles:

  • Covenants should be easy to understand and calculate.
    If the definition of a covenant takes more than a couple of lines in the loan documents, it may be too complicated. The information to calculate the covenant should be easily found or derived from the company's reporting system. Too many covenants are a distraction and may be in conflict with each other. My opinion is that with appropriately designed covenants "less is more".
  • Covenants should take into consideration the corporate legal form and the reporting capabilities of the company.
    For example: EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is a popular part of certain leverage or performance measures. It was originally developed in the 80s during the buy-out boom of publicly traded corporations to measure short-term debt service capabilities in capital intensive industries. In today's service-oriented industries it may not be as useful as it was then. Any pass-through legal entity that does not prepare rolling 12 months financial statements and monthly depreciation and amortization schedules would be ill advised to consent to a covenant using EBITDA that way.
  • Covenants should be correctly and consistently calculated.
    This goes back to the first point, if the covenant definition is too complicated, it may lead to errors in calculation. Many lenders will provide the company with a spread sheet outlining the formulas to calculate the covenants.
  • Covenants should be monitored and trended regularly.
    Only then can trends be observed and corrective action to be taken. The reporting period will depend on the specific company situation. For more "uncertain" environments, more frequent reporting may be appropriate.
  • The level and type of covenant should be set to fit the specific company and industry.
    This is common sense, but sometimes overlooked in standardized documents. A Fixed Asset Coverage covenant is more appropriate for a manufacturing company than for a service company. A volatile and uncertain industry may require higher equity and lower leverage than a stable and predictable industry.

If a company finds itself in a situation where it may be in violation of a covenant, timely communication with the lender is of utmost importance. There is no reason to panic, but banks do not like surprises. A covenant violation is an opportunity to have a meaningful conversation with the lender to evaluate a number of questions.

Was the level of the covenant set correctly in the first place based on the company's financial condition? Is the violation a result of an outside event, a temporary problem or a more permanent issue? Did the company make decisions that were not anticipated at the time the covenants were set? For example, if the company decides to purchase a building instead of leasing it, the company should discuss the contemplated transaction with its bank, since such transaction will, in all likelihood, result in the need to redefine certain covenants.

In summary, appropriately structured covenants provide a framework for the preparation, tracking and discussion of corporate financial information to the lender and to the company management. Such framework provides value to both parties. Covenants are not static, they should reflect the company situation at the time they are defined and include a certain flexibility to allow for acceptable variations in performance. As the company moves through different stages and economic cycles, covenants will have to be adjusted to reflect changing circumstances in general conditions and changes in the corporate strategy and performance. Covenants may on occasion be violated. Such an event is an opportunity for management in conjunction with the lender to evaluate corporate strategy and make the necessary adjustments.

by Stefan Hoenicke, a business banker
Dec. 17, 2015