Loan Default Survival Guide: What to do if You Trip a Loan Covenant
Mid-Market Lending Insights
Covenant defaults should be avoided at all costs. The moment a default has occurred, the borrower has effectively given full control over the consequences to the lender. At best, the lender could choose to waive the default, often for a fee; at worst, the lender could choose to increase pricing, add covenants, or simply call the loan in full. If the borrower is unable to pay, then the lender can liquidate collateral or call upon guarantees to repay the outstanding balance.
A loan covenant is a provision in a loan agreement that requires a corporate borrower to take a certain action, refrain from taking a certain action, or puts a prohibition or restriction in place for certain circumstances that may arise.
Covenants can be both financial and non-financial in nature:
- Financial covenants are ratios, limits, or thresholds put in place on the financial performance. An example is a debt service coverage ratio whereby the cash flows of the business need to be at least 1.25 times the principal and interest payments on their debt.
- Non-financial covenants are provisions that govern corporate behavior and actions taken by management aside from operational performance measures. For example, this could be the prohibition of borrowing additional debt, restrictions of liens, or financial reporting requirements.
Notably, financial and non-financial covenants incur the same amount of risk. Loan agreements are littered with specific provisions that, when triggered, cause the borrower to be in default. Despite how important these provisions may be, the lender rarely requires that these be reported on until they are tripped.
As a result, many borrowers don’t pay attention to them because their focus is only on the regularly reported financial ratios. Prudent CFOs should set up a process to ensure they regularly review their loan provisions and have projected out their covenant calculations for at least 12 months in advance.
Financial covenant breach
If you anticipate that a covenant default will occur, then the following actions should be taken:
Before communicating with the lender, the borrower should research the reasons for the default. The lender will need to know whether this is a systemic issue or a one-time event. It is critical that the explanation for the default be specific and detailed. For example, if the covenant is related to a drop in cash flows, then the borrower should be able to explain all the contributing factors.
Prepare and present a revised forecast showing that all upcoming covenant tests will pass. If that is not the case, then the forecast should come with suggested revised covenant levels that the lender should consider. The forecast should extend to the length of the term of the loan facility.
3. Communicate early
The timing of communication with the lender is critical. The best-case scenario is to inform the lender at least 60 days prior to the covenant test period end. The lender will then have time to inform their credit committee and deliberate.
Ideally, the lender will decide to adjust the covenant requirement so the company avoids a breach. The more prepared the borrower is at explaining the reason for the breach, and the plans to rectify it, the better chances the lender can work with them at an equitable solution.
If communication with the lender comes after the breach, then the relationship with the lender will likely be strained. The lender will view this delay in communication as either (1) the borrower failed to anticipate the breach or (2) the borrower expected the breach but decided against informing the lender. Both cases shows a lack of management competence and a distrust in the relationship.
Non-financial covenant breach
Non-financial covenant breaches are rarely forecasted and are more likely to surprise the borrower. When these are tripped, it is often due to a borrower being unaware of a provision or missing a deadline.
Many companies, even with large finance teams, lack a systematic process for flagging loan deadlines and reviewing all loan agreement terms each reporting period. The company’s legal team or general counsel will review the loan agreement at origination, but the CFO’s office should be aware of each reporting deadline and restriction. For example, a breach might occur because a compliance certificate was turned in a week late. While this is minor, it’s technically a default of the loan provisions.
These type of breaches give the lender the same amount of power as a financial covenant breach, so it is important to communicate with the lender immediately.
If the borrower fails to communicate in a timely manner or to draft a reasonable remediation plan, then it will increase the probability that the lender will charge a waiver fee, raise pricing, or put in place more onerous covenants.
If the borrower is experiencing continuous negative financial performance items, then all consequences will become amplified. Worst case scenario, the lender is looking for an excuse to leave a particular industry or type of loan. Even, small breaches give the lender the power to exit the relationship to the detriment of the company.
Ensure covenant compliance
Thankfully, Cerebro Capital has created a loan agreement management software that manages all aspects of loan compliance. Our software digitizes the full loan agreements, extracting both the non-financial and financial covenants, so the CFO and all other relevant parties can track covenants via a heat-map dashboard, generate reports automatically, and create a systematic approval process with audit trails. Furthermore, advanced analytics showing how loan terms compare to similar companies provide CFOs with the competitive information they need to better negotiate with their lenders.
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