VideoWhat's more, the lack of liquidity in markets takes away some of banks' leverage. If a lender did seize a company's assets, it could have trouble selling them. "Nothing is off the negotiating table," says Vanessa Spiro, a partner in banking and finance at Jones Day. "That's the most interesting part of this downturn."
Still, if a company is going to trip a covenant, the CFO should give the bank plenty of warning. Borrowers need to be transparent with their lenders and explain why they're missing projections, says Mack, as well as give lenders time to process the information. The amount of lead time depends on the seriousness of the breach. Nine months to a year is not unheard of. At minimum, give the lending group a couple of weeks, advises Mack.
There's no certainty, of course, that a bank will reward a company for giving early notice of a potential covenant violation. Even if the violation is forecast a year ahead and the company has a strong balance sheet and cash flow, say CFOs, lenders are still ratcheting up rates and demanding an upfront fee. That's especially true if a loan is priced below market.
Take the case of chemicals maker Huntsman. Anticipating a long global recession, the company recently sought relaxation of a maintenance covenant in its $650 million revolver, despite not being in violation. The lenders agreed to increase the loan's senior secured leverage ratio for a year starting in June, but Huntsman had to pay 50 basis points and a 225 basis points increase in the LIBOR spread.
A Margin for Error
If a breach is a minor one — a mere "foot-fault," as Credit Suisse's Moran says — the bank may waive it and await the business's recovery for a quarter or two. Or it could grant a temporary forbearance. After all, as much as lenders like financial covenants, they also want to deploy capital.
A few years ago, Ed Cordell, now vice president of finance at Given Imaging, a medical-device maker, took over as CFO of a highly leveraged LBO company. The retail-equipment maker had already tripped covenants, but the CEO thought it could work with the banks to negotiate amendments within six months. The forecasted revenue growth in the company's three-year plan never materialized, however, causing the company to be plagued with covenant problems for two years. Still, the banks didn't call the loan or seize assets.
"Sometimes a bank will ride it out," says Cordell. "Our banks didn't want to incur the legal cost of amending the covenants until they got a plan that was achievable." Based in the United Kingdom and France, the banks also were loath to take over the operations of a U.S. company.
Looking back, Cordell wishes he had scrutinized the three-year plan more closely. "When you go in with an operating plan, you have to have a high degree of confidence you can hit it," he says, "so that the bank doesn't set the covenants without room for execution error."
"We want to give borrowers enough cushion to run their businesses," says Moran. That cushion in financial ratios is usually 15% to 20% below the projection. If a CFO says he can produce $100 million EBITDA, the covenant shouldn't be much above $80 million. But if a company habitually misses its covenants and comes back two and three times for a reset, "a fatigue factor sets in," Moran says. "Then we start setting the covenants tighter."
Make New Friends
For a company with cash flow and liquidity, it's possible to push back against the bank's offer, says Walenta. Even if the company doesn't win, it does get its objections on record. If a company has to play ball with its existing syndicate, it should at least "make them feel a little pain in the negotiation," Walenta says — especially if the lenders' decreased appetite for risk is one of the drivers of an amendment. "Make the banks remember that when the world returns to normal, you want to renegotiate [the agreement]."
Don't be too adversarial, though. Communication is what's critical, on both sides, says KeyBank's Mack. "The more you know each other, the less of a surprise it is going to be. That creates a much stronger relationship, and allows for more flexibility."
Of course, that assumes the lenders want a relationship. "Are there aggressive hedge funds, which will seek to maximize yield, or relationship commercial banks that would be more reasonable?" asks Dana Klein, managing director in syndicated-loan capital markets at Credit Suisse. Some investors look forward to a covenant default so they can raise interest rates, Moran says. That causes the loan to trade better and increases the return to investors.
Avoiding those lenders, and building ties to syndicate members other than the loan administrator, are advisable when a facility is first signed. By the time a covenant is tripped, it's too late. "This is exactly the environment where you may regret being with a syndicate you have no history with," Walenta says. "If you've been much more transactional in your dealings with banks, you may find that you don't have as many friends in the banking world as you thought."
Vincent Ryan is a senior editor at CFO.
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