An Introduction to Covenants in Leveraged Finance Debt

A review of various covenant types and the ongoing tug-of-war between counterparties over the stringency of covenant terms

Introduction
The Purpose of Covenants
The Three Types of Debt Covenants
Covenant Breaches
Trade-Offs in Covenant Design
The Rise of Covenant-Lite Loans
An Uncertain Macroeconomic Backdrop
In Closing

Introduction

Corporate lenders routinely take steps to limit downside risk and ensure that borrowers repay loans. A key safeguard takes the form of covenants, or rules inserted into loan agreements that borrowers must follow throughout the duration of a loan. Borrowers that violate covenants risk triggering penalties that could include a demand for immediate repayment. While procedural formalities can be found throughout most business contracts, including debt agreements, covenant terms are unique to each deal and remain subject to much deliberation and scrutiny. This paper covers essential aspects of covenants for members of the leveraged finance community, in particular CFOs contemplating new debt raises.

The Purpose of Covenants

An old formula holds that debt is best used to finance a predictable future, while equity is more suited to backing an unpredictable one. Through covenants, lenders try to keep their debt investments - and the businesses of the borrowers that underpin those investments - steady and predictable. Examples of loan covenants include ones that restrict a borrower’s ability to raise additional debt or make acquisitions without the lender’s consent. Still others provide the lender with a mechanism for monitoring the borrower’s financial performance. Taken together, lenders can enforce a degree of prudence on the borrower and preclude them from carrying out risky ventures.

A covenant violation alerts the lender to the possibility that something is amiss in a borrower’s business. The lender can then get ahead of a potentially troubled situation and remedy the underlying problem or take other steps to protect its interests.

The Three Types of Debt Covenants

In this section, we describe the three varieties of debt covenants – affirmative, negative, and financial.

Table 1: Summary of Covenant Types

Type of Convenant Thumbnail Description Example
Affirmative Covenant Action a borrower must perform Must pay federal, state and local taxes on time
Negative Covenant "Taboo" a borrower must not do Cannot issue new debt
Financial Covenant Financial soundness test a borrower must pass Must pass quarterly test showing debt to earnings ratio less than 3:1

Affirmative covenants specify actions a borrower is obligated to perform. Examples of affirmative covenants include requirements that the borrower pay taxes in applicable jurisdictions, maintain insurance, apply certain accounting frameworks, and fulfill any relevant SEC regulations. Many affirmative covenants cover best practices that a borrower would ideally follow in the normal course of business, with or without a loan and its attendant mandates. In addition to these standard practices, other affirmative covenants require borrowers to submit periodic financial reports to lenders, typically on a quarterly basis, along with attorney or auditor attestations that the borrower is in compliance with all covenant terms.

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. To be clear, negative covenants do not place an outright ban on these actions. A borrowing firm can still carry out these activities subject to certain exceptions and within specified limits. A loan agreement will, for example, typically spell out the separate thresholds below which the borrower can issue dividends or new debt without obtaining advance lender consent.

Financial covenants assess a borrower’s ability to honor its debt. These covenants consist of tests, expressed as a ratio, that measure a company’s cash flow against its obligations. EBITDA is the most commonly used proxy for cash flow. We will use this metric in the short discussion below. As with affirmative and negative covenants, a borrower that violates a financial covenant, in this case by failing a test, enters into technical default on the loan.

Three of the most common financial covenant tests are the leverage ratio, the interest coverage ratio, and the fixed charge coverage ratio.

The leverage ratio is calculated as the ratio of debt to EBIDTA and cannot exceed a specified maximum figure. For example, if the leverage ratio is 3.0, a borrower’s debt cannot exceed three times its recent earnings. Different leverage ratios can be calculated using either total debt, secured debt, senior debt, or first lien debt as the divisor.

The interest coverage ratio measures EBITDA against a firm’s interest expense and is used to judge a borrower’s ability to service the loan. In contrast to the leverage ratio (where a higher number indicates greater cause for concern), the interest coverage ratio is expressed as a minimum figure that must be achieved. High interest coverage ratios signify a borrower in good health. Like the leverage ratio, interest coverage ratios can be calculated using the interest owed on either total debt, secured debt, senior debt, or first lien debt.

Some loan agreements require the borrower to satisfy multiple versions of the leverage and interest coverage tests. So, for example, a debt agreement might require that a borrower pass one leverage ratio test that uses total debt as the divisor and another that uses secured debt.

Lastly, the fixed charge coverage ratio measures a modified version of EBITDA against a basket of the borrower’s fixed charges. The basket typically includes payments associated with principal and interest on all outstanding loans as well as real estate and equipment leases. The fixed charge coverage ratio provides an even fuller picture of the borrower’s ability to meet its obligations. Like the interest coverage ratio, the fixed charge ratio is expressed as a minimum threshold. A high fixed charge coverage ratio indicates that a borrower is well-positioned to service its debt.

In addition to these ratio-based tests that feature most commonly in loan agreements, smaller companies must also sometimes comply with a “straight” EBITDA covenant that requires them to exceed a minimum EBITDA figure in money terms.

Covenant Breaches

A borrower that violates a covenant risks triggering severe penalties. In response to a covenant violation, a lender can enact a higher interest rate, demand accelerated repayment, call the loan in its entirety, or declare a technical default, even if the borrower has consistently made its loan payments on time. A particularly aggressive lender could even look to enforce its security to recover amounts outstanding.

Addressing breaches can be costly and time-consuming affairs, even if the lender decides not to pursue any punitive measures. CFOs therefore invest time and painstaking effort throughout the lifecycle of a loan to ensure they remain in compliance with covenants. This is not just a backwardslooking exercise. It also requires the CFO to assess the firm’s planned activities and their likely impact on covenant compliance.

When drawing up a loan agreement, covenant terms are always under the microscope since it is possible to mold them in a way that tends to favor either the borrower or the lender. The former of course prefer looser terms that reduce the potential for breaches and the threat of default. 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.

Trade-Offs in Covenant Design

Covenant design is a nuanced topic addressed at substantially greater length in law review articles and other professional forums. We provide a few brief points here that can hopefully illustrate the types of concerns loan issuers consider when entering the debt market.

  • Given their potential to bind a firm's decision-making, covenants should be designed from the outset with a clear understanding of the borrower's business and financial model. Appropriate covenant structures help facilitate reasonable and customary growth strategies while maintaining assurances for lenders. The financial model upon which covenants are based should also allow some headroom for at least a limited degree of underperformance.
  • Covenants of course make up just one part of an overall loan package. Interest rates represent perhaps the most important factor. Different borrowers, each with unique funding needs and business models, will assign different values to each factor. For example, firms with tenured customer contracts - and more predictable cash flow - might choose to accept tight covenants, relatively easy for them to fulfill, in return for a lower interest rate. Meanwhile, a growth-oriented firm may be more willing to countenance a higher interest rate on its loan in return for the greater flexibility afforded by a looser covenant structure.

The Rise of Covenant-Lite Loans

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. Although several factors contributed to this development, the most important was the sustained increase in lender demand, buoyed by attractive yields in what for many years had been a low interest rate environment. With new lenders, including hedge funds and private equity firms, joining traditional institutional lenders in the leveraged loan market over the past decade, there had been no shortage of liquidity for leveraged finance borrowers to tap. Borrowers, selling loans to a market ripe with willing buyers, were well-positioned to negotiate favorable terms.

The defining characteristic of cov-lite loans is the loosening or absence of the periodic financial tests associated with financial covenants. Instead, borrowers are subject to much less restrictive incurrence-style tests. In an incurrence test, a borrower is only subject to financial tests when it decides to carry out certain material actions, such as repurchasing shares or issuing dividends. If the borrower otherwise continues on a normal course of business and avoids any specified incurrence actions, it also avoids triggering any financial tests. The borrower can then maintain any financial ratio it deems fit and could not violate a debt agreement on that basis. [The flip side of this apparent freedom is that a borrower that cannot pass all incurrence-based financial covenants will find itself restricted from carrying out many actions.]

Through incurrence tests, cov-lite structures often contain looser negative covenant terms, as well. In a fully covenanted loan, there will typically be a hard money cap on actions that affect a borrower’s capital structure. For example, negative covenants might prevent the borrower from issuing new debt or distributing dividends over certain amounts. Meanwhile, a covlite loan might allow the borrower to issue new debt and dividends on an uncapped basis, as long as the firm demonstrates that it will pass specified incurrence tests after the capital event takes place.

An Uncertain Macroeconomic Backdrop

The long decade between the recovery from the global financial crisis of the late aughts and the end of 2021 had been a markedly borrower-friendly era in the leveraged loan market. With liquidity and debt capital in ready supply, borrowers could easily obtain favorable terms, as seen by the emergence of cov-lite loans.

The Federal Reserve embarked upon tighter policies to start 2022, including interest rate hikes and ending asset purchases associated with quantitative easing. The effects of Fed policy, compounded by inflation, commodity shortages, and war in Ukraine, have caused demand to contract in markets ranging from housing to stocks. Leveraged loan markets have exhibited tightening as well with volumes drying up after steep increases in recent years. Against this backdrop it seems probable that lenders will be able to negotiate stricter conditions and operate from a position of newfound strength in setting covenant terms. While tighter conditions may still not cause cov-lite to lose its status as the predominant loan structure, it may be more difficult for more marginal, weaker issuers to enjoy the same relatively unfettered and under-covenanted access to capital that they once did.

In Closing

Covenant details represent a critical part of debt agreements in the leveraged loan space. Failure to abide by covenants can negatively impact a company’s finances and business operations. Proper diligence when negotiating a loan agreement is therefore key along with the adoption of monitoring tools that allow a CFO to track the firm’s fidelity to covenant terms. Measuring compliance, assessing the impact of planned business activities, and compiling detailed financial reports for lenders on a periodic basis for the duration of the loan can require significant effort from CFOs at borrowing firms.

As economic conditions tighten, loan conditions are starting to become more restrictive. During this period of change and dislocation, borrowers and lenders will likely spar over covenant terms as the market seeks a new paradigm to fit the modified business climate. While it is difficult to predict the duration and extent of any market shift, it is clear that actors will continue to monitor developments closely as they seek to allocate or obtain capital on the most favorable terms possible.