The Dangers of Loan Covenants

Many years ago I remember sitting a banking exam. After the exam one of the other students asked whether anyone else attempted the question about Nuns. Confused, I asked whether he had the same paper as everyone else. It took some digging before the confusion over covenants and convents was uncovered. I have no idea if this gentleman is still in finance, sometimes I fear he may be a Government adviser these days.

Whatever happened to him one thing is for certain, loan covenants offer very little for you to smile about.

The reason I dislike covenants is very simple, they only work against the borrower and only come into play when you least need them. Covenants are a one way street, they are there to give the lender an ‘out’ if your business hits rocky times.

I am not cynical about covenants, I just understand them from an underwriters perspective.

But I Never Defaulted

There is a school of thought among borrowers that the lender can do very little providing you are making your loan repayments or servicing the finance agreement. It is when business gets rocky that covenants creep out of the dark and bite you.

For a lender, they want to be able to take action to protect themselves before the borrowing business deteriorates to the point of defaulting. This all seems pretty fair and reasonable, however there are a lot of one off events that can screw with your accounts and put you in breach of your covenants. It doesn’t mean you will, or ever were going to default.

This is where covenants can bite.

This is a covenant taken from a loan offer a client sent to me recently asking for some feedback on, it was an offer their bank had given them directly:

“Combined businesses EBITDAR hurdle to be £343k to be tested quarterly on a rolling 12month basis”

First things first:

• Would you understand it?
• Any idea what it may be at the moment?
• The use of the word ‘hurdle’ should worry you

EBITDAR is net income excluding tax, interest, depreciation, amortisation and rent costs. Or, maybe not rent as EBITDA is pronounced the same as EBITDAR. Confused? You should be.

What this means for the client is that if their businesses have not generated £343k of adjusted profit in a rolling 12 month period then they will be in breach of their loan, the bank could default them and/or adjust the price of their borrowing to a default, higher interest rate.

Let’s say something unexpected happens. A fire, flood, equipment breakdown or you decide to put some tax efficiency savings in place then you could be in breach. For seasonal businesses (and nearly every business is seasonal in some way) measuring on a rolling 12 month period could mean you failing at some point in the period.

My point is that even if you understand what is being measured, it doesn’t mean you can influence it.

In this case the client’s annual loan servicing costs were £112k, the bank wanted £343k of profit each year to cover it. If the client only produced £240k of profit it would still cover it’s commitments twice over, so would the bank really be at such an increased level of risk? I don’t think so.

Covenant Alternatives

Quite often there are other lenders who won’t put in such detailed and potentially harmful covenants. My point to clients is to always look at the bigger picture, look at the whole deal and not just the headline interest rate.

We are seeing covenants make a return to many bank loan agreements. Please read through the offer in full and if you still don’t understand what is being asked for then give your accountant or me a call. Sometimes the wording of covenants is such that they are not immediately clear.

Remember that covenants only work in one direction. The bank is not going to reduce your rate if you exceed your covenant.

Just be cautious and take guidance on the smaller details, it can make a whole load of difference.

By Dave Farmer