In credit facilities and loan agreements, as in M&A transaction agreements, covenants can similarly be divided into three categories:
- Covenants requiring action (i.e. promises to take a specified action);
- Negative covenants (i.e. promises not to take specified actions); and
- Financial covenants (i.e. promises to maintain certain levels of financial performance or not to take specific actions unless certain levels of financial condition or performance exist at the time).
Negative covenants are also referred to as restrictive covenants, because they restrict or prohibit certain actions (i.e. not permitting the creation of pledges over any assets of the borrower, or the undertaking not to grant any higher-ranking security rights over its assets compared to those of the lender).
Financial covenants. In their financing practice, banks have been developing great insight into the need to monitor their customers’ businesses. Those needs are satisfied by adequate financial covenants. Financial covenants restrict a borrower’s freedom to engage in activities that may worsen its financial condition. These activities include the following:
- Incurrence of debt. More debt means more interest and principal payments, implying a greater impact on the company’s cash flow.
- Creation of encumbrances (‘negative pledge’). The more assets are pledged or otherwise collateralised, the fewer assets are available to be used to satisfy the borrower’s unsecured claims and general obligations in the event of insolvency.
- Line of business. Especially in leveraged finance, finance agreements will require that the borrower does not change the essential scope or nature of its business activities.
- Sale of assets. Loss of income-generating assets could adversely affect the lessee’s cash flow. Sometimes also the assignment of receivables (factoring arrangement) is restricted or prohibited.
- Dividend distributions (‘leakage prevention’). Each euro distributed as dividend to shareholders reduces cash available for payment of rent. Also, intra-company transactions with affiliates that do not participate in the financial arrangement may endanger the leakage of valuable assets or cash out of the reach of the lenders.
- Investments. From a lender’s standpoint, cash spent on investments would be better spent on repaying amounts due to the lender.
Financial ratios in credit agreements. Financial covenants that require the covenanting party to periodically meet certain financial ratios are also used to address credit concerns. These ratios are set at levels designed as an ‘early warning signal’ in the event that the borrower is facing financial difficulties. Financial ratios are aimed at balancing the business decisions of a company’s management, in that the ratio established by a covenant requires that the company will at all times be capable of paying its debts, as should be determined on the basis of the company’s cashflow to debt ratio, a profitability (EBIT or PBIT) to interest indebtedness ratio, a current ratio (i.e. current assets to current liabilities) or a solvency ratio (e.g. borrowed money set off against equity). Such financial covenants will often also require that the borrower is of a certain ‘minimum net worth’.