Loan agreements generally include legal requirements, or covenants, that govern borrower behavior through the life of the loan. The loan covenant package theoretically sets the barrier in the Black–Cox Model and helps to create value for the lender in addition to regular payments of interest. The value created likely takes the form of higher recovery rates should default occur, or additional lender income through interest‐rate resets or fees charged by the lender to waive covenant violations. This chapter provides an overview of a typical loan agreement and catalogs the more common loan covenants.
Direct loans are governed by lengthy agreements between the borrower and lender, generally structured as follows:
While the level and structure of interest payments found in the loan commitment section of the agreement represents the clear majority of the return on direct loans, covenant protection itself has value that can be theoretically measured by the Black–Cox model.
Covenants, and financial covenants in particular, are designed to protect the financial condition of the borrower for purposes of repaying the lender in full through controls on the borrower's income statement and balance sheet. These covenants are put forth in the loan indenture and monitored by the Agent, who is usually the lead lender.
Covenants are generally divided into affirmative covenants and negative covenants.
A list of affirmative covenants would likely include:
A longer list of negative covenants would likely include:
The financial covenants described in (i) above generally fall into two camps, maintenance and incurrence. Maintenance covenants are stricter compared to incurrence covenants, requiring the borrower to continually satisfy a financial test. Incurrence covenants instead require application of a financial test only upon a corporate action, such as new debt is incurred. For example, a requirement that the borrower's debt not exceed a percentage of EBITDA is a common covenant. A maintenance covenant involving EBITDA might be very valuable to the lender and costly to the borrower given year‐to‐year potential volatility in EBITDA, particularly in cyclical industries. On the other hand, an incurrence covenant covering leverage would only be violated if the borrower were to exceed the covenant level via the incurrence of additional indebtedness. If the covenant level was exceeded solely because the borrower's EBITDA declined, the borrower would not be in breach of the covenant. Consequently, differentiating the application of maintenance and incurrence tests becomes important in interpreting the strength of any covenant. Private direct loans typically make use of maintenance covenants, while publicly traded debt, such as high‐yield bonds and some broadly syndicated loans, often only includes incurrence covenants. This difference makes theoretical sense given the relatively less liquid nature of direct loans.
Definitions are another important dimension in understanding covenants. For example, EBITDA plays a central role in many covenants, but the definition of EBITDA can itself become an important part of lender protection. Late in a credit cycle when lenders are competing more aggressively for deals, credit terms generally favor borrowers, and it is not uncommon for the definition of EBITDA in the loan agreement to expand and include add‐backs, such as expected reduction in operating costs and capital expenditures, or expected improvements in sales that make the borrower look more creditworthy. Ideally, lenders should push for standard generally accepted accounting principals (GAAP) definitions that are grounded in current operating performance. Otherwise, covenants no longer have any meaning. In addition, financial covenants are typically set at a cushion to the borrower's actual financial condition. For example, if the borrower's actual senior leverage (senior debt as a multiple of trailing 12‐month EBITDA) is 4.0 times at the initiation of the loan, the covenant level might be set at a modest cushion, such as 4.25 times. As the market for direct loans becomes more competitive, lenders will compete for deals by offering wider cushions. Similar to the use of add‐backs, these covenant cushions make financial covenants less impactful.
Covenant lite is a term often used to describe loan agreements where covenants are either watered down or eliminated, and a condition often seen later in a business cycle when credit is abundant, and borrowers have the upper hand in loan negotiations. The Black–Cox model helps measure the significant cost of covenant lite loan agreements, particularly for unitranche and second‐lien loans. Lenders often note that covenants don't enhance the return on an otherwise bad deal. However, well‐constructed covenants are important in that they give the lender an early seat at the table in the event the borrower's financial condition declines, and permit the lenders to restructure their loan packages to improve their position as creditors, including raising interest rates and fees, and accelerating their ability to force a company restructuring before the value of their collateral declines beyond recovery.