How to approach a Financial Covenant even if you are unfamiliar with them

So, who sees the title of an article incorporating the phrase ‘financial covenants’ and doesn’t immediately scroll past it?

There are probably thousands of articles out there about financial covenants; so why read this one? A very good question…

I want to focus upon some of the softer elements to covenants and what to do when you’re unfamiliar or worried about them. Why? Because I consistently hear from clients, prospective clients and professional contacts that the uncertainty of the budget on October 30th is creating a distinct lack of confidence and worry about the immediate future. Recent articles like the one I read with interest in This is Money back up the anecdotal evidence I’m hearing all around me.

What has all this got to do with covenants? Well, first the technical part: covenants are legally binding promises or agreements a borrower enters into with a lender which are financial in nature. There are too many different types of covenants to cover off here, and they are different for different types of lending e.g. minimum Debt Service Cover for cash flow loans or maximum Loan to Value on property loans.

Instead, I’m going to focus on two areas:

1. Lenders’ thinking behind setting covenants
2. Borrowers’ options if they are worried about their covenants
    

1. Lenders' Thinking:
 

Most lenders do not want to enforce covenants. Yes, you heard me right! The vast majority of the time it’s not in a lender’s best interests to do so, as instead they could:

• Renegotiate on more remunerative terms
• Give the borrower a period of time to move their borrowing away or pay it off, sometimes whilst charging an increased rate of return
• Request an equity introduction to remedy the covenant breach

Lenders will also state that covenants aren’t supposed to trip you up, or have the shareholders and directors awake at night. The key to setting good covenants that can 1) provide a safety net and early warning system for lenders, and, 2) allow businesses to thrive and trade as they wish to, is to have a constructive, two-sided discussion with the lenders during the pre-lending process.

Aah yes, I hear you say, but what if we do all of that and then things change, such as a pandemic or high and fast inflation, to use recent examples. Well, this is where communication is key as lenders don’t like surprises or uncertainty.

Their response is also less straight-forward than one might assume, and it depends on factors such as how they’re funded (especially alternative lenders and Private Credit), the different drivers for a return and/or stage of the fund, alongside considerations of how their complete portfolio is performing. Not all these factors will be visible to you, however, professional advisors are likely to be aware of the drivers behind the lender’s stance.
 

2. Borrowers' Options:
 

There are a number of pro-active approaches you can take in this scenario, for example:

• Request a meeting with the lender
• Produce strategic information that shows how the situation will be rectified, which will differ according to the covenant(s) in play
• Have a number of scenarios, so Plans A, B and C. Maybe even a Plan D…
• Be willing to listen and work collaboratively with the lender

One of the key decisions is whether or not you should consider moving the lending to a different provider who might be more expensive (not always) but would offer more freedom than the existing situation. This is where a good professional advisor will be able to help. They can help you prepare the information required to go out to market, advise you on different strategies for different lenders, the nuances of each offer and which would best suit your business now and into the future.

The very good advisors will also help to negotiate with the existing lender, which tends to give the lender confidence that they will be re-paid soon, which in turn often leads them to be more lenient. 

So, if you’ve managed to get this far in the article without clicking away (or falling asleep!) I would summarise the key points above as:

• Covenants can be scary, but they shouldn’t be designed to catch you out
• Communicate, communicate, communicate!
• If you’re worried, speak to a professional advisor who will be able to help you consider multiple options