Senior Debt Covenants: What to Expect

Debt financing is typically provided with certain terms attached.

Most companies we work with aren’t necessarily crazy about financial covenants. However, they are a typical attribute of debt financing. To satisfy senior lenders and qualify for the cheapest capital, companies will often agree to maintain certain financial ratios that serve as indicators of liquidity, profitability and capital adequacy. This article illustrates what companies can expect with senior debt covenants, and ultimately, how covenants can be used to help both the lender and the borrower.

Overview of Debt Covenants

Once a company has achieved the type of scale that allows for leverage, it will typically have to commit to certain covenants, whether working with a bank or institutional investor. However, there are certain things to be aware of:

Covenants are not meant to...

• Restrict a company’s day-to-day business operations
• Direct a company’s strategy
• Generate lender fees

Covenants are meant to…

• Strike the right balance that allows a lender to be assured of steady performance, and enables a management team to focus on business execution
• Assist the company in building and maintaining a responsible financial structure, to more easily navigate new capital needs ahead
• Establish an ‘early indicator’ that communicates financial challenges before a more serious issue emerges

Covenants differ based on the business, whether the financing at hand is secured or unsecured, and cash-flow based or asset-based. Companies can usually expect covenants to be categorized as either ‘affirmative’ or ‘negative.’ By becoming familiar with the most frequently-used covenants in the lending markets, borrowers can negotiate ratios that work for their specific business, identifying a common series of metrics by which they can discuss performance with lenders and investors alike.

Below we have highlighted a few covenants (both ‘affirmative’ and ‘negative’) that borrowers can expect to see. This is not an exhaustive list, but rather an illustration of the types of terms included in senior debt agreements.

‘Affirmative’ Covenants

Affirmative covenants are standards that the borrower agrees to maintain throughout the term of the loan. Common affirmative covenants include the following:

1. Information Requirements – Companies are typically asked to provide basic information about the business, such as financial statements (which include the balance sheet, income and cash flow statements) as well as their auditor's ‘no default and compliance certificate.’ This information is often required quarterly.
2. Maintain Priority of Obligation – A primary goal of senior lenders is to maintain their status as senior lenders and rank ‘pari passu,’ or on an equal level, with other senior lenders. Limitations and prohibitions on incurring ‘super senior’ debt is typically specified within priority debt provisions in the ‘Negative’ Covenants section.
3. Maintain Insurance Coverage – It is often requested that a company maintain insurance that is satisfactory to the lender. Asset collateral is protected by insurance and is expected to be managed by the borrower.

‘Negative’ Covenants

Negative covenants generally limit or prohibit the borrower from doing something that would or could be detrimental to the lender. They can be financial or non-financial in nature, but for the purposes of this article, we will address financial covenants in a separate section below. Typical negative covenants strive to limit or prohibit the following activities:

1. Transactions with Affiliates – This term limits the amount of related-party transactions that the borrower can incur to protect the original intent of the use of proceeds and reduce value leakage to third party entities.
2. Asset Sales – This covenant establishes a limit on the amount of assets a borrower can sell, transfer or lease in a year. This term exists to protect the core assets within the obligor group to maintain the integrity and value of the entity being financed.
3. Most Favored Lender – Often adopted when a borrower is establishing its first loan, or when at a particular inflection point in its growth strategy, this term automatically drafts any covenant that may be more restrictive than what was included in the referenced loan documents.

Financial Covenants

Financial covenants measure the financial position of the company against its debt obligations (although tested most frequently on a quarterly basis, it is common for borrowers to maintain compliance with these covenants ‘at all times’). These ratios assist a lender in understanding the operating health of a borrower and provide an early indication if changes in performance merit a deeper review. The following list includes the most common financial ratios that borrowers are often asked to maintain. Many involve the relationship between Earning Before Interest, Taxes, Depreciation and Amortization (‘EBITDA’) as well as debt levels.

1. Senior/Total Debt to EBITDA – The ratio of senior or total debt to EBITDA cannot exceed an agreed upon ratio for specified periods of time. Often called a ‘leverage ratio,’ this is the most common covenant within the middle market.  Leverage covenants vary by the volatility of the business but often have a beginning range of 2.0x – 3.0x.
2. Fixed Charge Coverage – The ratio of EBITDA to the sum of (i) interest expense, (ii) required principal payments, (iii) capital expenditures, (iv) operating lease and rent payments as well as (v) any management fees cannot be less than an agreed upon ratio for specified periods of time.
3. Debt to Capitalization – Also known as ‘gearing,’ this is a balance sheet test that measures the ratio of debt to a company’s total capitalization (i.e. the sum of debt and book equity value).‍
4. Minimum Net Worth – This covenant sets a minimum absolute equity book value the company must maintain (it can occasionally be expressed as a percentage of closing book value).  For highly acquisitive companies, the covenant can be varied to specify Tangible Net Worth, which excludes intangible assets like goodwill.

A corporate borrower can expect to be required to maintain up to three of these financial covenants within any loan agreement (typically a leverage ratio, debt service coverage, and balance sheet covenant), that are intended to work in concert and be set at levels appropriate for the borrower’s sector, company-specific needs/risks and transaction circumstances.

Financial Covenants for Specific Types of Companies

Here are several common types of companies and the example covenants each could receive:

Covenants may feel onerous at times. However, they are in place to help frame a conversation between the lender and borrower, and potentially provide an early indication that changes need to be made either within the company or credit agreement, supporting the long-term success of both the lender and borrower.