Covenant

Lenders do not just hand over money and hope for the best. They write conditions into the loan agreement or the NCD trust deed that the borrower must follow for the life of the loan. Breaking one gives the lender the right to demand early repayment or to renegotiate on its own terms.

Three kinds of covenant

• Financial covenants set limits on ratios, such as net debt to EBITDA of no more than 4.5 times, interest coverage of at least 2.5 times, a minimum DSCR in project finance, or a minimum net worth.
• Affirmative covenants are things the borrower must do: keep adequate insurance, send quarterly financial statements, tell lenders about material adverse changes and keep key licences.
• Negative covenants are things the borrower cannot do without consent, such as borrowing more above a threshold, selling major assets, paying dividends while below a leverage or coverage threshold, making large acquisitions or changing its business.

Maintenance and incurrence tests

A maintenance covenant is tested regularly, usually every quarter, so the company must stay within the limit at all times. An incurrence covenant is triggered only when the company does something, such as taking on more debt. A company with only incurrence covenants has far more room to move. Covenants in India have generally been tighter than the covenant-lite deals seen in global leveraged buyout markets, especially for bank loans.

What happens on a breach

A breach does not usually mean immediate default. Lenders may waive it, often for a fee, or reset the covenants with a higher interest margin or more collateral. In the worst case they accelerate the loan and declare it immediately due. Even a waiver shifts power to the lenders, which is bad news for shareholders.

How to measure headroom

Headroom is the distance between where a ratio is today and where the covenant would be breached. For a maximum leverage covenant, the useful question is how far EBITDA can fall before the limit is crossed. The formula above answers it.

Where to find them

Covenants sit in the credit agreement or the debenture trust deed. Annual reports sometimes mention breaches or waivers in the notes on borrowings.

Common mistakes

• Treating maintenance and incurrence covenants as the same thing.
• Checking headroom only in the base case. Test it under a realistic downturn.
• Assuming a breach means default. It usually means negotiation, on the lenders' terms.
• Forgetting rating triggers. Some loan agreements speed up repayment after a downgrade.

Questions investors ask

What is covenant headroom? How much a company's numbers can worsen before a covenant is breached, usually stated as the fall in EBITDA the covenant can absorb.

What is a covenant-lite loan? A loan with only incurrence covenants and no regular maintenance tests, which gives the borrower more freedom and the lender less warning.