When Loan Covenant Talks Stall

Two attorneys counsel borrowers on how to break an impasse in loan covenant negotiations.
Katie Kuehner-HebertMarch 24, 2015
When Loan Covenant Talks Stall

While banks are eager to lend to quality businesses and are generally easing terms, they’re still requiring basic financial covenants. So what happens if your company is negotiating covenants with a lender and the talks appear to be heading toward a stalemate?

Two Australian attorneys have some simple tips that are just relevant in the United States as Down Under.

In a Mondaq post, Rebecca Field, partner, and Simon Schuler, senior associate at Corrs Chambers Westgarth, say that a lender and a borrower should agree on the most suitable ratios that the borrower needs to maintain to avoid default, depending on the company’s specific credit risk.

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Common ratios used in covenants are the loan-to-value ratio (LVR), which measures the ratio between the loan amount to the value of the financed asset, and the income-contingent repayment (ICR) ratio, which reflects how many times the income of the borrower can cover the interest expenses during a certain period.

The ICR is particularly suited to real estate. “While a strict ICR may be suitable for an investor who deals with established properties, it is most likely not suitable for a property developer who might have extended periods of no or very low cash-flow,” the attorneys write.

“If the lender must insist on using a certain ratio, the solution may be as simple as testing the ICR only yearly instead of quarterly thus giving the borrower sufficient time to improve its cash flow.”

The two parties could also agree that any breaches of the covenant would only result in the borrower having to provide cash collateral. That way, the lender has less cash-flow risk and the borrower is reassured that the funding under the line of credit will remain available.

“The parties could also agree on a honeymoon period during which certain covenants can be breached or on a so-called ‘Mulligan’ clause – a provision according to which only the second (or third) consecutive breach of a financial covenant bears consequences,” the attorneys write.

Another way to avoid a stalemate would be to modify some financial covenants, such as referring to “earnings before interest and tax,” or EBIT, instead of “earnings before interest, tax, depreciation and amortization” or EBITDA, when calculating the ICR, or referring to debt service — which includes fees — instead of interest.

This “might do the trick to avoid a stalemate and lead to a satisfying outcome of the negotiations for both parties,” the attorneys say.

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