A New Year, A New Approach to Loan Covenants

I decided to take a break from reviewing some of the economic news in this blog even though the world and markets are rife with it, from one of the worse starts in the U.S. stock market in years, to the collapse of oil prices and impending defaults from oil companies, to stagnant wage growth, to increasing federal deficits.  Also, it does not matter how good the Federal Reserve tries to assure you the economy is expanding at a pace necessary to raise interest rates, the fact it, when Wal Mart begins closing stores, it is time to realize that something is amiss.

So this week, I want to spend some time on financial loan covenants.  Covenants are various performance standards that measure your borrower’s financial capabilities.  Many of these standards are viewed during underwriting and a covenant helps review the financial health of the borrower throughout the life of the loan.  Typically, these are thought of more after year end, as many companies have covenants that are measured after their fiscal year end which usually coincides with the calendar one.  When these covenants are viewed and tested, it is a good time to assess how well you have structured these guidelines and how to improve in the future.

The lender should embrace the use of covenants as this is a good tool to monitor the health of the company and manage the business credit.  No one should fear putting in a covenant because they are afraid to act if one if one is broken.

First, are the covenants clearly defined?  Covenants are clear when they describe what is measured and how it will exactly be measured.  This should be clear enough for any borrower to be able to look at their financials and figure out how they match up with the standards set out in the loan documents.  An example of a debt service coverage covenant for a hotel may read, “The numerator will be all normal income from operations less all operational expenses.  Any capital improvements that are expensed will be added back and a 3% CAPEX allowance will be deducted.  This number will be divided by all annual debt payments.”

Second, do the covenants tell when the measurement will take place?  Good covenants explain when a measurement will start, how frequently it will be measured thereafter, and if there are any performance benchmarks that may allow the measurements to become more or less frequent.  An example would be a loan for a business to expand by purchasing new equipment.  I may want to delay the first measurement of DSCR or to have the standard ramp up in order to allow the company to realize the additional net income from the expansion at a stabilized rate.  I may want to check the covenant more frequently, say on a quarterly basis, while the company is ramping up to reach its new stabilized revenues.

Third, note that covenants can be both positive and negative.  Some loans can be structured to reward the customer with a lower interest rate if certain thresholds in DSCR, deposits held at the institution, or debt/worth are reached.  In some of these ways, this can actually reward the client for good performance and create an incentive for the business to be run profitability in order to reach the reward.

Fourth, recognize that different ratios will apply to different companies in judging their financial health.  On a manufacturing company, I may want to measure items like the current ratio, debt/worth and free cash on hand after all obligations.  However, a rental apartment building mortgage, could have most of the risk analyzed with reviewing the debt service only.  Viewing a debt/worth ratio on this type of loan is not helpful in determining the risk.  Selecting the right measures to judge the health of a credit is also important with your risk rating model you use.

Finally, the options the lender has for a violated covenant should be varied.  Your loan agreement should have the option of doing nothing up to calling the entire loan due if a covenant is violated.  Monetary penalties, such as increasing the interest rate should also be an option.  The lender can then select what course of action is most appropriate when a loan covenant is violated.