Financial covenants are an early warning system for lenders. A borrower failing to meet its covenant requirements is akin to a smoke alarm going off: not necessarily a problem, but worth checking to see if there’s a fire.

Given how critical covenants are to a lending agreement, borrowers need to understand negotiating best practices, lest they hamper their growth prospects with overly-restrictive terms. 

There are three classifications of covenants: financial, affirmative and negative. In this article, we will focus on best practices around financial covenants. Future articles will cover the other two classifications. 

Tips for Negotiating Financial Covenants

Below are six best practices for negotiating covenants with lenders:

1. Start with a 30% Cushion. Lenders want to set covenant levels that allow for a reasonable cushion (gap between a given period’s projected EBITDA, and the value used to calculate financial covenants). The typical range for a cushion is 20-30%, with banks on the lower end and direct lenders the higher end. So, if your projected EBITDA is $10 million, ask lenders to give you a 30% cushion, or use $7 million to calculate FCC and leverage covenants.
2. The Fewer the Merrier. More covenants afford lenders greater opportunity to monitor a business and achieve lower risk. Borrowers on the other hand, should maintain the flexibility to manage the business through cycles, and aim to negotiate as few covenants as possible. A balanced approach is outlined below.
3. Covenants and Levels for Leveraged Deals. Assume fixed charge coverage (FCC) and total leverage covenants as givens, and agree to add a senior leverage covenant if absolutely necessary. Most lenders want FCC to be greater than 1.1x, with 1.2x being the industry norm. Levels for leverage covenants would vary as per your projections, but it is typical to set at least 0.25x-0.50x higher than projections. 
4. Covenants and Levels for ABL Deals. A majority of lenders will agree to FCC of 1.0x, with more conservative lenders seeking a larger cushion of 1.1x. And with ABLs, liquidity forgives all sins. Thus, borrowers of ABLs should insist on having no covenant measurement unless liquidity is equal to, or greater than, 20%-30% of the line size. Once the liquidity trigger is activated, insist on FCC of 1.0x.
5. Covenant Cure. This allows a borrower to inject a certain amount of capital into the company to make up for the EBITDA shortfall responsible for a covenant breach. Negotiate a cure period of 30-45 days post covenant reporting date. Also, ask for the covenant cure amount (the injected capital) to be counted towards all future covenant periods (covenant measurement typically works off of TTM numbers).
6. Timing is Everything. Borrowers should insist on quarterly covenant reporting, due 30 days after the close of the quarter. Quarterly covenant reporting allows you to manage monthly business fluctuations, which are not readily predictable.

What to Do When You Breach a Covenant

Every business faces ups and downs, and sometimes, a downward phase results in a covenant breach. From the lender’s perspective, the key here is damage control. Lenders want to understand how safe their principal is, and to do that, they assess the following:

• The type of covenant infraction—certain covenants are more critical to lenders than others (more on this later)
• How severe is the magnitude of the violation?
• How important is this borrower to our portfolio—do we have a long-standing relationship worth salvaging? Is this a borrower we foresee a longstanding relationship with?

Once a covenant is breached, lenders may decide to perform a full reevaluation of the business’ credit profile, update current covenants or introduce new ones, and potentially increase interest rates on the loan.

Borrowers looking to avoid such punitive responses should take the following steps: 

1. Communicate. Lenders want to work with their borrowers to accommodate unforeseen negative events. If you expect to default on a covenant, call your lenders and let them know in advance. The more time you can give them, the greater the likelihood of achieving a negotiated solution.    
2. Consider the Hierarchy of Defaults. Lenders will be more accommodating on leverage covenant breaches than on an FCC breach. The worst type of breach is a payment default. Nothing stokes a lender’s wrath more—so avoid this at all costs.
3. Prolong Reporting. If your company’s financial performance is suffering due to macroeconomic issues beyond your control, ask for a waiver from the measurement of covenants in return for a simple liquidity trigger for a few quarters. Also, take a hard look at your projections, and ask to reset the covenant levels going forward.
4. Offer Lenders Security. If you have a leveraged or cash flow loan structure, explore the possibility of adding a borrowing base to provide an extra measure of risk management for lenders. And illustrate any pathways to additional liquidity through a well-reasoned financial projection revision.
5. Provide 13-Week Cash Flow Statements. Nothing makes a lender happier than visibility into the liquidity picture. Offer up a liquidity projection that you can revise weekly while you are in the covenant breach period, or until the new covenant measurement phase starts.

When a covenant is breached, borrowers should be prepared to pay fees for any waivers and amendments the lender will assign, as well as legal fees to draft those documents. 

The best you can hope for is to keep the amendment and waiver fee to a minimum–25 bps or less–by offering to reduce risk via one (or more) of the sweeteners listed above. In the case of an especially egregious default, expect to pay a default interest rate of 2-3% above your regular rate. The lender may also increase the interest rate of the loan to compensate for the additional risk they are assuming. 

If You Can’t Beat ‘Em, Replace ‘Em

If the suggestions in the section above sound too onerous and time-consuming, you can always explore options to replace your current lenders. This is especially true today, as credit committee processes are highly unpredictable–you don’t know what type of waivers will get approved. What’s more, the debt capital markets have never experienced so many lenders with so much dry powder to deploy, so borrowers have options. 

Instead of haggling with your lender, consider finding new lenders and starting afresh. Sometimes lenders react negatively due to issues in their loan portfolio that you are not aware of. It might be more productive and cost efficient to just refinance, reset covenants and turn the page with a new lending relationship.

CAPX can instantly scale your lender outreach nationally, at zero cost to the borrower. So you can quickly assess your refinancing options at no financial risk whatsoever.

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