What is a “Covenant Breach”?
A breach of covenant is the violation of an agreement or promise made in a written contract. The covenants in a loan agreement are principally divided into three categories; information covenants, restrictive covenants and financial covenants.
Most covenant breaches relate to financial covenants. A typical financial covenant is when a borrowing company agrees to stay above or below a pre-agreed financial ratio such as EBITDA based leverage, interest coverage ratio, debt to equity ratio or a cash flow based ratio.
Hence, covenants allow lenders to monitor the financial position of a borrower. A breach of covenant is typically not just a warning signal but a powerful indicator of the deteriorating financial health of a borrower with potentially serious consequences.
Key Learning Points
- A breach of covenant is the violation of an agreement or promise made in a written and legally enforceable loan agreement/contract
- A company could face a breach of information, restrictive or financial covenant
- A breach of covenant typically occurs when a borrower fails to maintain a certain financial covenant such as EBITDA based leverage or interest cover
- The breach can result in serious repercussions to the borrower and in a worst case scenario trigger bankruptcy, however the specific consequences need to be determined on a case-by-case basis
- If in breach, the lender may opt to waive the covenant, on a temporary, permanent or conditional basis
Typical Breaches of Covenants
The wide range of covenants means that there could be many different types of covenant breaches:
Typical Breach of Information Covenant
The most common information covenant is the borrower’s obligation to file annual reports and other relevant documents in a timely, regular manner. A late filing of relevant financials can make credit analysis conducted by the lender more difficult and less effective. However changes in accounting regulations, delays in auditing and other scenarios can result in a breach of this covenant, which is typically handled via an unconditional waiver.
Typical Breach of a Restrictive Covenant
A typical restrictive covenant is the borrower’s limitation to further increase debt. For highly leveraged companies, this covenant can help to avoid additional borrowing. However, in a difficult economic situation, the lender may agree to a conditional waiver (if it helped resolve a short-term credit squeeze for example), and allow the borrower to increase debt while forcing it to refinance at a higher interest rate.
Typical Breach of a Financial Covenant
Most covenant breaches are in relation to financial covenants. In many cases, the lender may require the borrower to maintain a certain leverage or interest cover. These covenants are called maintenance covenants. These two are the most frequently used financial covenants in debt documentation.
EBITDA based leverage = Gross or Net Debt / EBITDA
EBITDA based interest cover= EBITDA / Gross or Net Interest
Breaching a financial covenant is classified as a serious breach and the lender will look carefully at how to cure the covenant breach, typically under the threat of a technical default.
Conclusion: Consequences of a Breach of Covenant
A breach of covenant is a serious situation and in a worst case scenario can trigger a technical default. However, as the specific consequences of a covenant breach are different for any borrower, it is essential to understand and analyze the breach on a case-by-case basis. Based on the case specific analysis, the creditor decides the most suitable consequences of the breach, which can also be to waive the violations. The consequences of a breach of covenant can generally include the following alternatives:
- A penalty or fee charged to the debtor by the creditor
- An increase in the interest rate of the bond or loan
- An increase in the collateral
- Termination of the debt agreement
- Waiving the violation without important consequences
Example: Breach of Covenant
Please calculate if the following company is currently is breach of its EBITDA based leverage covenant:
|Consolidated Senior Debt to EBITDA Ratio: Maintain at all times a Senior Debt to EBITDA Ratio set forth in the range below opposite the applicable period|
|6/30/2020 through 9/29/2020||3.75 to 1.5|
|9/30/2020 through 12/31/2020||4.25 to 1.5|
|12/31/2020 through 3/30/2021||4.5 to 1.5|
|3/31/2020 and thereafter||2.0 to 1.5|
|EBITDA Interest Cover: Maintain at all times an Interest Cover ratio set forth in the range below opposite the applicable period|
|6/30/2020 through 9/29/2020||7.0 to 10.0|
|9/30/2020 through 12/31/2020||5.0 to 9.0|
|12/31/2020 through 3/30/2021||3.5 to 7.5|
|3/31/2020 and thereafter||8.5 to 12.0|
|Assume we are now post 31 March 2021 with the company’s current financials below|
|Balance Sheet extract|
|Cash and Cash Equivalents||1,275.0|
|Long term Financial Investments||750.0|
|Revolving Credit Facility||550.0|
|Senior Syndicated Loans||1,200.0|
|Second Lien Senior Debt including ST portion||1,750.0|
|Income Statement / CFS Extract|
|Restructuring charge in operating profit||197.0|
|Gain on sale of division above EBIT||126.0|
|Depreciation & Amortization||230.0|
|Gross interest expense||102.0|
|Net Interest Income||68.0|
|Total Senior Debt||2,950.0|
|Total Senior Debt/EBITDA||3.4||BREACH OF COVENANT|
|Current interest cover|
|Gross interest expense||102.0|
|Total Senior Debt/EBITDA||8.6||COVENANT MAINTAINED|
|The company is currently in breach of its leverage covenant but not its interest cover.|
|The covenant package suggests that the company was scheduled to significantly delever during the time when Corona started.|
|Based on the current leverage it looks as if the company did not manage to delever according to plan and will need to waive and renegotiate its current covenant package.|