Just like a decade ago, our anemic economy is again making it hard for some companies to abide by their loan agreement covenants. If yours is one of these companies, keep in mind these principles as you review your compliance levels.
Your Goals Differ from Your Banker’s Goals: During the negotiation of your credit facility, you may have complained about the effort needed to finalize the loan covenant section. After all, as Shakespeare said, “Words pay no debts.”
Naturally, you’re thoroughly dedicated to your company’s success.
Having to agree to precise minimum performance levels feels like overkill at best---or distrust at worst.
Your goal is to pay back the funds you borrow. However, your banker has an additional goal: To make an acceptable profit on your loan. Loan covenants are a tool to accomplish this.
Risk Changes Over Time. Bankers pride themselves on being savvy assessors of risk. Accurately quantifying credit risk is a very important part of their job.
Getting paid for risk is an even more important part.
Unfortunately for bankers, the interest rate which they negotiated when your company’s fortunes were rising becomes woefully inadequate when your performance plummets.
Reflect for a moment on the volatility of our nation’s economy over the last three years. Consider the challenge facing a banker who was negotiating a three year loan in 1998. And how about that same challenge today?
Bankers hope you live within your covenants throughout the term of the loan. Your doing so validates their skill at analyzing your financial pro formas.
Plus, it’s proof that they adeptly structured the transaction to meet your needs.
But the longer your loan’s maturity, the less likely actual results will match your projections.
Bankers use loan covenants to keep the risk/reward equation in balance over the life of your loan.
To them, the longer the maturity, the greater the importance of covenants.
Covenants Are Price Triggers. Think of your covenants as the out-of-bounds stakes on a golf course. Stay within them, no penalty. Sail past them and much of the fun disappears.
And, there are no mulligans. Covenant violations entitle your banker to re-negotiate any and all aspects of your credit facility. A breach signifies higher risk.
Therefore, expect to pay a higher price, whether in fees, interest rate or both.
But don’t begrudge your banker for squeezing the price trigger when you’ve not lived up to the terms of your loan. The banker’s perspective is “Why spend so much time designing covenants if I’m not going to enforce them?”
Consider Performance Based Pricing. Borrowers now frequently request loan pricing tied to their company’s performance.
When it deteriorates, they’re willing to automatically pay more.
On the downside, this can delay the need to renegotiate (at least until they're so far out of bounds they've crossed over the adjoining fairway.)
On the upside, some bankers will even agree to releasing portions of collateral and personal guarantees if performance dramatically exceeds forecasts.
There are Two Types of Covenants: Your lawyer will gladly explain that all loan agreements contain affirmative and negative covenants. These require you to take certrain (affirmative) steps, but specifically prohibit other (negative) actions.
Violate either and your loan potentially can be called.
However, your banker carefully distinguishes between violations due to errors of omission and those caused by errors of commission.
Missing the financial projections upon which your covenants were based is an error of omission. Bankers recognize that a soft economy hampers meeting financial goals, despite your best efforts.
Taking any overt action that breaks a covenant is, however, the more serious error of commission. Examples include exceeding capital expenditure budgets, or caps on management salaries without first seeking approval. By violating such covenants you convey to your banker disregard for their loan contract.
The first such commission will prompt your banker to seek an explanation.
The second will earn you the moniker of “rogue borrower.” (Think rogue bull elephant to be culled from the herd.) Avoid this notoriety at all costs, even if you’re in the process of changing banks.
How Large is your Compliance Cushion? When you negotiated your loan covenants, you won some leeway between expected results and the agreed upon covenant compliance minimums. This gap is your compliance cushion.
Use your most recent financial data and calculate the size of your compliance cushion today. Has it shrunk or grown?
ACTION STEP: Update your worst-case forecasts. Any covenant violation is bad news, even if it is clearly beyond your control.
Yet don’t hesitate to alert your banker the very instant a breach is likely.
Keep the principles above in mind if you have to renegotiate your loan agreement. And remember that bankers really don’t shoot the messenger---except when they’re late.
