35 years: Debt capital markets
Covenants oblige borrowers to adhere to a set of conditions, typically in the form of a set of financial metrics and ratios. Here, Tim goes into further detail by outlining typical triggers, consequences and specific types.
Covenants oblige borrowers to adhere to a set of conditions, typically in the form of a set of financial metrics and ratios. Here, Tim goes into further detail by outlining typical triggers, consequences and specific types.
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9 mins 7 secs
Covenants are conditions in a borrowing document that ensure the borrower maintains certain financial ratios to assure the lender that they are, and will continue to be, financially able to repay them.
Key learning objectives:
Define covenants
Explain the purpose of covenants and what they prevent
Describe the different types of covenants
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Covenants refer to the formal conditions contained in loan and bond documentation that oblige borrowers to adhere to a number of financial and operating metrics and ratios.
They prevent borrowers from engaging in certain types of behaviour or activities that might push them beyond covenant triggers. Financial triggers are expressed via financial ratios, such as debt-to-equity multiples.
The conditions of underlying covenants are critical components of risk protection for lenders, and offer headroom against any weakening in a borrower’s financial standing. Lenders may, at their own option, grant covenant waivers in specific circumstances.
If they fail to cure the breach within a set period of time, lenders may have the right to increase the financing margin on the facility, demand additional collateral, demand immediate repayment, declare the borrower in technical default or even outright default.
This includes preventing borrowers from:
Covenants can also extend to key-man metrics, such as having key executives remain with the company.
Maintenance covenants - Borrowers are required to update and report to their lenders on a regular basis, typically quarterly (the financial metrics that underlie their covenants). These are typical of covenants embedded in loan documentation.
Incurrence covenants - Prevent lenders from taking action until such time as a specific financial ratio has been breached at the time it occurs. These are more typical in high-yield bond documentation and in so-called covenant-lite loans.
Positive covenants (affirmative covenants) - are covenants that outline what companies are required to do by dint of the covenant package.
Examples: The provision of timely key information to lenders such as financial statements, debt loads, earnings, interest coverage etc.
Negative covenants - are the ones that prevent borrowers from taking certain courses of action if they weaken the company’s financials and pierce the financial ceilings contained in financial ratios.
Examples: Caps on debt to earnings, dividend pay-out caps, caps on aggregate debt-raising, and caps on any debt-raising at a more senior level in the company’s capital structure.
The market has seen a return to what are known as covenant-lite or cov-lite for short borrowing facilities. As the name suggests, this refers to loans and bonds that have fewer covenants in what is therefore borrower friendly documentation.
Cov-lite documentation became the norm in those heady pre-crisis days, moved into abeyance in the depth of the crisis when risk-aversion made a dramatic comeback but returned fairly soon afterwards.
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