Understanding financial covenants in loan documents

Loans with more borrower-friendly terms – “covenant-lite loans” – have emerged to dominate the leveraged loan market in recent years. From a meager one percent of the market in 2000, by late 2021 covenant-lite loans (cov-lite, for short) came to account for over 90% of new issues. Borrowers, selling loans to a market ripe with willing buyers, were well-positioned to negotiate favorable terms. Three of the most common financial covenant tests are the leverage ratio, the interest coverage ratio, and the fixed charge coverage ratio. Think about a borrower taking on high leverage (or gearing) to make an acquisition.

Definition and Examples of a Covenant

By incorporating risk reduction measures, lenders can mitigate potential default risks and guarantee timely repayment. Meanwhile, borrowers can benefit from increased transparency, enabling them to better manage their financial obligations and maintain a healthy credit profile. The use of “maintenance covenants” versus “incurrence covenants” is another advanced structuring technique.

By following the tips provided in this guide, you can ensure a smooth and successful borrowing experience. When a lender extends a line of credit to a borrower, the two parties are bound by a legal contract known as a credit agreement or a loan contract. There are stipulations—or covenants—within the agreement that dictate what a borrower can (affirmative covenants) and cannot (negative covenants) do during the life of the loan.

Debt Covenants

A property covenant is an agreement between multiple parties that stipulates how real property or real estate will or will not be used. These types of covenants may restrict the landowner or require specific action to be taken. For example, homeowner association (HOA) covenants often require property to have trees trimmed to a certain height or outline how parking spaces are to be utilized. In finance, covenants are often put in place by lenders to protect themselves from borrowers defaulting on their obligations due to financial actions detrimental to themselves or the business. Regarding business, covenants are most often represented in terms of financial ratios that must be maintained, such as a maximum debt-to-asset ratio or other such ratios.

While there are various types of covenants, the two most fundamental ones are affirmative and negative covenants. Understanding these distinctions is essential in various contexts, such as debt financing, real estate transactions, and legal obligations. Negative covenants  constrain or prevent the borrower from carrying out certain actions without explicit lender consent. These restricted actions typically involve changes to the company’s corporate or capital structure, or the distribution/sale of a company’s assets. Specific negative covenants may limit a borrower’s ability to engage in M&A activities, issue dividends to shareholders, purchase or sell fixed assets, or take on additional debt. A borrowing firm can still carry out these activities subject to certain exceptions and within specified limits.

Debt Service Coverage Ratio

Financial ratio covenants are specific metrics that borrowers must meet to remain in compliance with their loan agreements. These ratios often include debt-to-equity, interest coverage, and current ratios. For instance, a lender might require a borrower to maintain a minimum interest coverage ratio, ensuring that the borrower generates enough earnings to cover interest payments. These covenants provide a quantitative measure of the borrower’s financial health, offering a clear benchmark for performance. Regular monitoring of these ratios helps in early detection of financial issues, allowing both parties to take corrective actions before problems escalate.

The agreements usually end up with the lender having the upper hand, as they have control over the lending situation. A minimum EBITDA covenant is typically measured quarterly on a trailing twelve month basis. It measures a company’s EBITDA against certain minimum requirements set forth by the lender. Bondholders types of financial covenants may require covenant protections that restrict the company from engaging in activities that could adversely affect repayment ability to its bondholders. Before acquiring another business, the buyer will usually request the company’s financial statements and other proprietary information. The seller will typically comply with this request, but only after the potential buyer agrees to a confidentiality covenant.

All Truist mortgage professionals are registered on the Nationwide Mortgage Licensing System & Registry (NMLS), which promotes uniformity and transparency throughout the residential real estate industry. Historically, covenants played a crucial role in establishing relationships between gods and humans in various religious traditions. For example, in ancient Egypt, pharaohs entered into covenants with their gods to ensure their rule and the prosperity of their people.

Truist Securities

• The covenants listed from one contract to another may be entirely different, as different parties may wish to be protected in different ways.
• They include requiring the borrower to supply accounts receivable lists or monthly compliance certificates.
• Typical measures include debt-to-equity, cash-to-assets, and interest coverage ratios.
• More forgiving terms could also include “cure provisions” that give the borrower time to resolve default events and a safe harbor period before the lender is able to take punitive action.
• A covenant is an agreement or contract between two or more parties where obligations are set forth to ensure specific actions, conditions, or prohibitions are met.

Having appropriate negative covenants gives lenders better control over how lines of credit are utilized by borrowers during the credit term. These covenants give lenders more control over major asset disposals that could impact the borrower’s ability to service debt obligations. By including affirmative covenants for insurance, lenders ensure collateral remains protected if unexpected losses occur. You’ll learn key definitions, see real-world examples of common covenants, and gain insight into how covenants protect lenders while restricting borrowers.

Law Covenants: The Basics and Implications

Law covenants are essential for maintaining order and ensuring the proper functioning of society. They provide structure to business transactions, protect intellectual property rights, and safeguard personal relationships. A breach of a law covenant can result in legal action against the violating party, which may lead to fines, damages, or even imprisonment.

• It measures a company’s EBITDA against certain minimum requirements set forth by the lender.
• Some lenders use earnings before interest, taxes, depreciation and amortization (EBITDA) as the numerator in the calculation.
• To effectively understand financial covenants, it’s essential to distinguish between affirmative and negative covenants.
• A declining EBITDA can be a warning sign of deteriorating operational efficiency, prompting lenders to take a closer look at the borrower’s financial practices.
• Examples of loan covenants include ones that restrict a borrower’s ability to raise additional debt or make acquisitions without the lender’s consent.
• When a party violates a covenant, the consequences can vary depending on the agreement’s terms.
• Understanding these various types of covenants is crucial for individuals and businesses alike in navigating different industries and ensuring compliance with the terms of agreements.

This metric is often financial and may be a single number or calculation to derive a certain ratio for value. A financial covenant is often monitored closely over time as it is the most likely covenant to suddenly change. Typically, the lender will also request collateral (i.e. a lien) and/or higher interest rate pricing since the borrower gets to conserve cash and has more time to obtain the required funds.