Debt covenants: Why they matter

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A debt covenant, also known as a loan covenant, is a provision or condition included in a loan agreement that sets certain requirements and restrictions on the borrower. These covenants serve to protect the interests of the lender and help ensure that the borrower maintains financial stability and meets its repayment obligations. Debt covenants are documented in the loan agreement and are legally binding. Think of debt covenants as providing a lender with an early warning system for potential financial deterioration of a business.

SBA loans offer a significant advantage over traditional loan in that there are no loan covenants. In this article, we will provide a detailed explanation of loan covenants for those considering a traditional commercial and industrial (C&I) loan. However, it is worth noting that SBA loans operate differently. As long as the borrower makes timely monthly payments, there are no debt covenants to worry about with an SBA loan.

Debt covenants overview

Debt covenants can cover a wide range of financial and operational aspects, and their specific terms can vary depending on the type of loan, the borrower’s creditworthiness, and the lender’s requirements. Some common types of debt covenants include:

1. Financial Covenants. These covenants impose restrictions and requirements related to the borrower’s financial performance and ratios. Examples include debt service coverage ratio (DSCR), loan-to-value ratio (LTV), leverage ratio, current ratio, and minimum net worth.

2. Operational Covenants. These covenants govern the borrower’s business operations and often focus on preserving the financial health of the company. They may include restrictions on dividend payments, capital expenditures, acquisitions, dispositions of assets, or changes in management.

3. Reporting Covenants. Reporting covenants require the borrower to provide regular financial statements, reports, and other information to the lender. These covenants help the lender monitor the borrower’s financial condition and compliance with other covenants.

4. Limitations on Additional Debt. These covenants restrict the borrower’s ability to take on additional debt without the lender’s consent. They aim to prevent the borrower from becoming overleveraged and to protect the lender’s position.

5. Events of Default. Debt covenants often specify certain events that, if they occur, would constitute a default under the loan agreement. These events could include failure to make timely payments, covenant violations, bankruptcy, or material adverse changes in the borrower’s financial condition.

It’s crucial for borrowers to understand and carefully abide by the debt covenants in their loan agreements. Failure to comply with these covenants can lead to severe consequences, such as default, acceleration of the loan, penalties, or even legal actions by the lender. Therefore, borrowers should closely monitor their financial performance and seek professional advice if they anticipate potential covenant violations or difficulties in meeting the requirements.

Event of default

When a loan covenant is violated, it typically triggers a default event, which means the borrower has failed to comply with the terms and conditions of the loan agreement. The consequences of a covenant violation can vary depending on the severity of the breach and the specific provisions outlined in the loan agreement. Here are some common actions that lenders may take when a loan covenant is violated:

  1. Notification. Once a covenant violation is identified, the lender will usually notify the borrower of the breach. The notification may include details of the specific covenant that was violated, the extent of the violation, and any required actions to remedy the situation.
  2. Remedial Measures. The lender may require the borrower to take immediate corrective actions to rectify the covenant violation. This could involve measures such as increasing collateral, providing additional guarantees, or injecting more equity into the business. Loan agreements will provide borrowers with a right to cure – a certain amount of time to cure or fix the covenant violation(s).
  3. Default Declaration. If the borrower fails to remedy the covenant violation within a specified period or if the breach is significant, the lender may declare a default. A default declaration typically accelerates the loan, meaning that the entire outstanding balance becomes due immediately.
  4. Imposition of Penalties or Fees. The loan agreement may stipulate that the borrower is liable for penalties or fees upon covenant violation. These charges could include late fees, higher default interest rates, or other financial penalties outlined in the loan contract.
  5. Negotiation and Restructuring. In some cases, when a covenant violation occurs, the lender may be willing to negotiate new terms or amend the loan agreement. This could involve modifying the covenants, extending the loan maturity, or revising repayment terms to accommodate the borrower’s financial situation.
  6. Enforcement Actions. If the breach is severe and the borrower is unable to rectify the covenant violation or reach a satisfactory agreement with the lender, the lender may initiate legal actions to enforce the loan agreement. This could involve pursuing legal remedies, such as seizing collateral, filing a lawsuit, or initiating foreclosure proceedings, depending on the nature of the loan and the applicable laws. Bankers call distressed loans “work outs,” and no bank wants to be part of a work out and have to liquidate assets, which is why senior lenders conservatively underwrite loans.

Common senior lender debt covenants

While specific loan debt covenants can vary depending on the lender and the borrower’s circumstances, here are five common types of loan debt covenants that are often included in commercial and industrial loans:

1. Debt Service Coverage Ratio (DSCR): The DSCR measures a borrower’s ability to generate enough cash flow to cover debt payments. It compares the borrower’s operating income to its debt service obligations. Lenders typically require a minimum DSCR to ensure that the borrower can comfortably meet its repayment obligations.

Even though DSCR is not a covenant in SBA loan agreements, SBA lenders will carefully review DSCR before making a loan. No lender – SBA lender or senior lender – will lend money to a business that is not generating enough cash flow to support the loan payments (aka debt service). In general, SBA lenders want to see DSCR of 115% or higher. For example, if the annual SBA loan payments are $100,000, an SBA lender will want to see annual cash flow from the business of at least $115,000.

2. Loan-to-Value Ratio (LTV): The LTV ratio compares the loan amount to the appraised value of the underlying collateral. It helps lenders assess the risk associated with the loan. Lenders may impose a maximum LTV ratio to limit their exposure and ensure that the collateral adequately secures the loan. LTVs of 60% to 80% is common.

An incredible feature of SBA loans is the borrower does not have to have any collateral – in essence a LTV ratio of 0%. The SBA does require that SBA lenders secure all available collateral, but a lack of collateral does not preclude an SBA lender from making a loan. As a result, borrowers frequently turn to an SBA loan to buy a business since acquisition are usually heavy on goodwill and lack hard assets.

3. Total Debt to EBITDA: Measures the borrower’s level of indebtedness relative to its earnings before interest, taxes, depreciation, and amortization (EBITDA). This covenant sets a maximum limit on the borrower’s total debt-to-EBITDA ratio, ensuring that the borrower maintains a healthy level of debt compared to its earnings. Lenders may include covenants that restrict the borrower’s ability to take on additional debt without the lender’s consent. These limitations help protect the lender’s position and ensure that the borrower does not become overleveraged. A Debt/EBITDA ratio of 2 – 2.5 is common with senior lenders during normal economic times. During boom times, ratios of 3 to 5 appear with aggressive lenders.

It’s important to note that the specific terms and thresholds for these covenants can vary widely depending on the loan agreement and the parties involved. Borrowers should carefully review the loan documents to understand the specific covenants applicable to their loan.

4. Minimum Net Worth: Lenders often require borrowers to maintain a certain level of net worth as a measure of financial strength. This covenant sets a minimum threshold for the borrower’s net worth, which may include assets, investments, and retained earnings.

5. Restrictive Financial Ratios: Various financial ratios can be used as covenants to monitor a borrower’s financial health. For example, lenders may impose restrictions on the borrower’s leverage ratio (debt to equity) or current ratio (current assets to current liabilities). These ratios provide insights into the borrower’s liquidity and financial stability.

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