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A Primer on Loan Covenants

I’ve been thinking… Just what are loan covenants?

In my experience, the nature and extent of loan covenants in a commercial loan are fact-specific and are spelled out in detail in a so-called loan agreement, which is a legal document signed by the lender and borrower.  The loan agreement is designed to protect the lender and details the key terms and conditions of the loan arrangement.  For example, senior secured bank credit facilities use loan covenants to, among other things, preserve seniority of the lender’s loan position, protect the collateral securing the loan facility and assure that cash flow generated by the borrower is not inappropriately diverted.

Commercial banks are not the only alternative for entities seeking credit.  For example, investors can purchase debt securities directly from issuers in the so-called debt capital markets, which as discussed below are remarkably robust and diversified, including the markets for syndicated loans and high-yield debt securities.  In my experience, such debt capital market transactions always involve law firms and investment bankers to, among other things, help craft the language of the agreed upon covenants.  (Note: where applicable, this blog uses the umbrella terms creditor, instead of lender or investor, and debtor, instead of borrower or issuer.)

Credit facilities usually contain both financial and non-financial covenants, which are commonly either negative (prohibited debtor actions) or affirmative (debtor obligations).  In addition, senior secured creditors often require a debtor to pay down the secured debt under certain conditions, including for example if the debtor issues subordinated debt or sells assets.  In the final analysis, the agreed upon language of specific covenants is a product of lengthy and sometimes intense negotiations among creditors and debtors and their respective teams of legal and financial advisors.

In general, financial covenants protect creditors by restricting the debtor’s use of leverage.  Leverage – shorthand for the use of debt – is measured in a number of ways, including  (i) the amount of debt compared to equity, (ii) the amount of debt compared to total capitalization (i.e., the sum of equity and debt), and (iii) the amount of debt compared to cash flow, which often measured by Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).  There are a number of variations of EBITDA, including EBITDAR, where the final “R” stands for rent-related expenses, and EBITDAL, where the final “L” stands for lease-related expenses.  A smaller amount of leverage (that is, a smaller debt-to-equity ratio, a smaller debt-to-total capitalization ratio, or a smaller debt-to-EBITDA multiple) would typically be viewed positively by creditors.  Some of the more commonly used financial covenants operate to set quantified limits on total debt to EBITDA and senior debt to EBITDA as well as minimum levels of interest coverage (ability to make scheduled interest payments from cash flow, commonly reflected as a ratio calculated as EBITDA divided by interest payments during a selected period), EBITDA and net worth (excess of assets over liabilities).

A syndicated loan is made to a debtor by a group of creditors, which is called a syndicate.  The syndicated transaction starts with the negotiation of terms and conditions of the proposed loan between the debtor and a lead investment bank, known as the arranging bank. The arranger’s responsibility is to perform due diligence on the debtor, prepare a term sheet, seek out potential syndicate members and ultimately obtain sufficient commitments to fund the agreed upon amount of the loan.  Often a road show is used to, among other things, introduce the debtor, present key elements of the term sheet, answer any questions on the terms and conditions of the negotiated loan agreement and review the fee sharing arrangements (typically allocated amongst the syndicate in proportion to the amount committed).  Since the loan agreement needs to be signed by each creditor after conducting a reasonable and independent due diligence investigation, it not unusual for the original terms and conditions negotiated by the debtor and the arranging bank to be revised

In syndicated loans it is common to use so-called maintenance covenants, which require debtors to certify ongoing compliance with prescribed covenants, including preparing periodic analyses and signed certifications documenting such compliance.  In the case of a material breach of one or more covenants, the arranging bank negotiates with the debtor (on behalf of syndicate members) the set of acceptable cures to the breach, including the possibility of the debtor raising additional equity capital and/or paying additional fees to the creditors. In contrast, such maintenance covenants are not used in high-yield offerings, which instead use specifically negotiated incurrence-based provisions that must be met at the closing of the transaction as well as at the time of certain debtor-initiated actions, such as selling assets, paying dividends or incurring additional debt.

High-yield debt securities (aka junk bonds) are issued pursuant to a trust indenture, which is a negotiated agreement between a debtor and the trustee bank that is appointed to act on behalf of creditors.  The trust indenture includes terms and conditions negotiated (i) by the debtor and its counsel and, (ii) on behalf of potential creditors, by the trustee’s team of advisors, including the offering’s underwriters.  The trust indenture includes the negotiated covenants, the nature of which reflect, among other things, the specific facts of the proposed offering, the results of a reasonable due diligence investigation, current market conditions, and the nature and extent of covenants used in recent comparable high-yield transactions.