Covenants and triggers
Intuition
When a lender extends a large loan, they don't just hand over the money and hope for the best. They impose contractual restrictions on the borrower, called covenants, to protect themselves. These covenants define rules the borrower must follow throughout the life of the loan. Violating them gives the lender the right to demand early repayment or take control of the situation.
Think of covenants as a pre-agreed contract that says: "we'll lend you money, but if your financial health deteriorates beyond these specific thresholds, we have the right to intervene, before you actually default on a payment." This gives lenders early warning and recourse, reducing their loss in a deteriorating credit.
For equity analysts, monitoring covenant headroom is crucial. A company approaching a covenant breach is under significant pressure, it may be forced to sell assets, raise dilutive equity, or renegotiate terms that benefit lenders at the expense of shareholders.
Mechanics
Types of covenants:
Financial Covenants (quantitative)
- Net Debt/EBITDA ≤ X× (maintenance test, typically quarterly): e.g., "Net Debt/EBITDA shall not exceed 4.5×"
- Interest Coverage ≥ X× (EBIT/Interest): e.g., "ICR shall be no less than 2.5×"
- DSCR ≥ X×: Used in project finance
- Net Worth ≥ ₹X Cr: Ensures minimum equity cushion
Affirmative Covenants (things borrower must do)
- Maintain adequate insurance
- Provide quarterly financial statements
- Notify lenders of material adverse changes
- Maintain key regulatory licences
Negative Covenants (things borrower cannot do without lender consent)
- Restrict additional borrowings above a threshold
- Restrict asset sales above a threshold (negative pledge)
- Restrict dividend payments if below leverage/coverage thresholds
- Restrict acquisitions above a certain size
- Restrict change of business
What happens on breach:
- Waiver: Lenders waive the breach (often with a fee)
- Renegotiation: Covenants are reset, often with tighter margins
- Acceleration: Lenders declare the loan immediately due and payable
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