What are covenants?
Covenants are special rules that are part of some loan agreements and bond contracts. They’re promises that the borrower makes to the lender. The borrower has to follow these rules, or else there can be big consequences.
There are two main types of covenants:
- Affirmative covenants: These are things the borrower promises they will do. Like paying back the money on time and keeping enough insurance.
- Negative or restrictive covenants: These are things the borrower promises not to do. Like selling important company property, taking on too much new debt, or letting the company’s finances get really bad.
If a borrower breaks one of these promises, it’s called violating the covenant. And that’s a big deal. It means the lender can demand all their money back right away, even if the loan wasn’t supposed to be paid back yet.
Why do lenders want covenants?
Lenders put covenants in loan contracts to protect themselves. They’re basically a way to keep an eye on the borrower and make sure they’re not doing anything too risky that could make it hard for them to pay the money back.
Covenants give lenders more control. If the borrower starts having financial trouble, covenants give the lender a heads up. And if things get really bad, the lender can take action before it’s too late and their money is gone for good.
Common types of covenants
There are lots of different covenants out there. What exact covenants are included depends on the specific loan and the lender. But some common ones are:
Restricted retained earnings covenant
This type of covenant puts a limit on how much the company can pay out in dividends. Dividends are payments the company makes to its shareholders.
If the company has been losing money, this covenant might say they can’t pay any dividends at all. The idea is to stop the company from giving away money it might need later to pay back the loan.
Net tangible assets covenant
Tangible assets are things the company owns that you can touch, like buildings, equipment, and inventory. Intangible assets are things like patents or goodwill that don’t physically exist.
A net tangible assets covenant says the company has to keep their tangible assets above a certain level. If they fall below that level, the covenant puts limits on what the company can do, like making new investments, paying dividends, or taking on new debt.
Working capital covenant
Working capital is the money the company has available for day-to-day operations. It’s calculated by subtracting current liabilities from current assets.
A working capital covenant is triggered if the company’s working capital falls too low. It restricts the company’s ability to make certain financial moves that could put the lender’s money at risk.
Leverage covenant
Leverage refers to how much debt the company has compared to its equity. A company with a lot of debt is considered highly leveraged.
A leverage covenant puts a cap on how much new debt the company can take on. If the company’s debt-to-equity ratio gets too high, meaning they have too much debt, they won’t be allowed to borrow any more money.
What happens when a covenant is violated?
If a borrower violates a covenant, it’s a breach of contract. The consequences can be severe:
- The loan or bond could be “accelerated.” That means the full amount becomes due immediately, even if the original agreement said the borrower had more time to pay.
- The lender can charge a higher interest rate as a penalty.
- The lender might force the company to sell assets to pay back the debt.
- In the worst case, the lender could force the company into bankruptcy.
Negotiating covenants
Because covenants can be so strict and the consequences so serious, borrowers often try to negotiate them before signing the loan agreement. They might try to get the lender to agree to less restrictive covenants, or to allow for some wiggle room before a covenant is considered violated.
For example, instead of a leverage covenant that gets triggered as soon as the debt-to-equity ratio goes above a certain point, the borrower might negotiate a covenant that allows that ratio to be high for a certain period of time before it counts as a violation.
The strength of the borrower’s negotiating position depends on things like their credit rating, cash flow, and general financial health. A financially strong borrower will likely be able to get more lenient covenants than a borrower that looks risky to the lender.
Covenants protect lenders
At the end of the day, covenants are there to protect the lender. They’re a tool lenders use to monitor borrowers and to step in if the borrower is doing something that makes it less likely they’ll be able to pay back the loan.
For borrowers, covenants can feel like a burden. They limit the company’s flexibility and can trigger harsh penalties if violated. But for lenders, covenants are a key part of managing risk. They’re a way to try to make sure they’ll get their money back, even if the borrower runs into trouble.
Understanding covenants is important for anyone involved in corporate finance. Whether you’re a borrower trying to negotiate a loan or a lender trying to protect your investment, covenants play a crucial role in the lending process. They’re complex and can have big implications, so it’s important to scrutinize them carefully before signing on the dotted line.
