No matter what your definition of a six pack is, competitive pressure must be erasing memories at many banks, as it was only five short years ago that the presence of tight covenants allowed many banks to work out loans and salvage principal. Given the increase in loan competition, loan covenants are now more important than ever as borrowers could be under more credit pressure with potentially higher costs and lower collateral values. To better monitor the impact of rising rates on credit, having a set of proven covenants can help offset some of this risk.
Covenants help partially solve the asymmetrical information problem that results in the borrower having better information than the bank. A proper set of loan covenants, we have found, can reduce the probability of default, the loss given default and the net exposure at default by a significant amount for commercial borrowers. The net result is an expected loss rate of almost 20% less with a set of strong covenants than without. A large part of this expected loss reduction is the fact that covenants give the lender an average of seven or more months of early warning between the time the covenants are tripped and the time a delinquency occurs.
We looked at research covering more than 7,200 loans (all three years or longer in remaining maturity) from more than 2,800 unique borrowers since 1995. While covenant sets vary by borrower and bank, here is our recommendation (internally called the “Six Pack”), in order of impact on expected loss that we would always attempt to get:
- Timely financial information (monthly preferred, quarterly at worst) – for small business borrowers, insistence (and an adjustment to loan pricing) of timely financial data or reports is the biggest thing a lender can do to establish early warning thresholds and covenant monitoring;
- Cash flow (debt service ratio);
- Leverage (senior and total debt/EBITDA);
- Liquidity (current ratio);
- Collateral value (loan-to-value or net worth); and,
- Cash control - ability to use proceeds from asset sale/debt issuance and the ability to control cash out in the form of bonus, dividend restrictions or similar are important.
In addition to the Six Pack, there are a variety of restrictive and negative covenants that are important, but we don’t have quantitative evidence as of yet. Items like insurance are obviously mandatory, while covenants like key man insurance are a little murkier. Further, negative covenants also play an important role but are equally hard to quantify.
Since borrowers tend to be more price sensitive than covenant sensitive, if you have to compete on price, then including important loan covenants can not only offset the lower pricing, but can actually result in a higher risk-adjusted return by reducing losses and potentially lowering reserves. If you have to lower your loan pricing, insisting on some of the above-mentioned covenants will help relieve some of the current lending anxiety that is going around.
Submitted by Chris Nichols on November 26, 2014