If you look to improve the commercial lending customer experience, after the delivery of the term sheet, loan approval and explanation of documentation, walking borrower’s through financial covenants is another material event that impacts a borrower’s view and emotion around a bank’s brand. As we interview banks and borrowers that have the best rated customer commercial lending experience, it seems that this is an area many banks can improve on. In this post, we’ll consider which financial covenants are important for commercial lenders to understand and some of the pitfalls in their use. The goal is to better equip community bank lenders with the tools to not only be more effective lenders, but to create a better customer experience.
Why Educating the Borrower About Covenants Is Important
Financial covenants are important for commercial lenders because they are not only a consideration in the initial underwriting of credit but they are also a marketing consideration in term sheets and commitments. At a minimum, covenants are often an important topic of lender/borrower negotiation in many transactions, thus having your lending team able to deftly handle push back and discussions are mandatory. The more your lenders understand the structure, options and purpose of each covenant, the more successful they will be at arriving at a suitable solution.
Further, taking the time to explain covenants not only makes sure everyone is educated and on the same page, but underscores the importance of maintaining covenant compliance. This helps the quality of credit over the life of the loan.
While most banks handle the above well, we point out the one best practice aspect that few banks take advantage of. While no one will argue the main purpose of financial covenants is to protect the lender, insightful lenders also understand that financial covenants can help the borrower in certain circumstances. Having covenant protection allows for faster resolution of credit issues and a better outcome for both lender and borrower. Financial covenants help create financial transparency that helps all parties. Banks would be served well to take the extra time to have their lenders frame the covenant discussion around how covenants benefit the borrower. Doing this can set your bank apart, as few institutions take the time to explain the details.
Categories of Financial Covenants
Financial covenants are used to monitor the borrower’s business, and evaluate the ability of the borrower to repay debt. However, the most important aspect of financial covenants is the power that it gives the lender to remedy problems in the borrower’s business – an early warning system that gets lender and borrower to the negotiation table.
Financial covenants typically focus on one of four categories of the borrower’s financial condition, as follows:
- Cash flow. These types of covenants attempt to measure excess cash generated by the business to service debt. The proxy for cash flow for almost all commercial transactions is EBITDA, although in real estate transactions NOI is common.
- Leverage. The leverage of the borrower is the ratio of debt outstanding compared to cash flow. The amount of leverage a lender will find acceptable will vary based on the business cycle, quality (predictability) of cash flow, projected prospects for the business, and the quality of secondary form of repayment.
- Liquidity. The liquidity of the borrower is comprised of the following (in descending order of importance): cash on hand, marketable securities, receivables, and inventory. These covenants are typically balance sheet ratios measured at a point in time versus over a period.
- Net Worth. This is the measure of assets minus liability and is the primary measure of liquidation value. Like liquidity measures, net worth is also a measure at a point in time versus over a period.
Cash Flow Covenants
EBITDA stands for earnings before interest, taxes, depreciation and amortization and is used to calculate how much debt a company can support. EBITDA is typically used as a proxy for free cash flow. However, EBITDA is not the same as free cash flow available to service debt. EBITDA and free cash flow can vary substantially.
There are two main reasons why free cash flow varies from EBITDA, even if EBITDA is very tightly defined by the lender. First, EBITDA does not measure cash consumed or provided in working capital management. For example, high growth companies may show high EBITDA but have no free cash flow from operations because of growth in inventory or account receivables. Second, EBITDA does not measure required or discretionary capex. Therefore, companies that require substantial maintenance capex may have high EBITDA but no free cash flow.
Nonetheless, we rarely see commercial loans where lenders have defined free cash flow other than through EBITDA.
The most common leverage ratio is debt to EBITDA. In real estate finance and for stable utility companies transactions, debt to EBITDA can be as high as 8X or more. For lenders that want to see a real estate leverage calculator, please go HERE . In low levered C&I loans debt to EBITDA is generally below 4X. For stable C&I transactions where the obligor is a market leader in a stable industry, generally accepted debt to EBITDA can reach 6X.
Other measures of leverage include interest coverage ratio (EBITDA divided by interest payments), debt service coverage ratio (EBITDA divided by P & I payments) or fixed charge coverage ratio (EBITDA divided by (P & I payments plus dividend and management, consulting or other fixed costs like required capex)). Leverage ratios are typically measured on trailing four quarters to eliminate seasonal variability.
Liquidity covenants measure cash resources of the borrower. Some typical covenants include minimum cash on hand, working capital ratio (current assets divided by current liabilities), or quick ratio (ratio of current assets minus inventories, divided by current liabilities). Borrowers do not immediately default on obligations to pay if cash flow generation is disrupted, or leverage increases, or net worth drops, however, borrowers stop making loan payments as soon as liquidity disappears.
If liquidity is such an important driver of loan payment default why do more lenders not use liquidity covenants? Unfortunately, liquidity is fungible – a positive because cash can be used for any purpose, but a negative because liquidity measured as sufficient today can disappear tomorrow. The best way to test liquidity covenants is frequently, preferably daily. This can only be done if the borrower maintains all accounts with the lender and the lender has a global view of the borrower’s business (essentially, this would amount to live reporting of the complete cash flow statement of the borrower).
Net worth tests are common for community banks. The concept requires the measure of total assets versus total liabilities. Common covenants include minimum net worth, debt to capital, or debt to assets.
The net worth category of covenants is ripe for misinterpretation and lender problems. First these covenants are maintenance covenants and are measured on a balance sheet. That means that the covenant applies at a specific date, and a month later the covenant ratio can be substantially different. Second, problems arise when market values do not match GAAP values. Most covenants are measured according to GAAP, however, the discrepancy between GAAP and market value can be substantial. Tangible assets may have substantial market value which is not captured in GAAP – for example, real estate improvements. Conversely intangible assets (such as patents, copyrights, distribution agreements and marketing rights) can have tremendous value but may be subtracted by the lender for covenant purposes.
Lenders should be comfortable understanding the four areas of financial covenants and which covenant may be appropriate based on the size of the loan, industry, amount of leverage and sophistication of lender and borrower. Even if maintenance of financial covenants is not expressly required in the loan documents, as is often the case in smaller commercial transactions, the formulation and testing of the covenants discussed above is an integral part of the underwriting process that successful lenders should understand.
Submitted by Chris Nichols on June 02, 2016