Financial covenants are the lender’s early warning system. They are designed to monitor a borrower’s financial health throughout the life of a facility and identify signs of financial stress before they develop into a more significant credit concern. Understanding how financial covenants operate and the consequences of breaching them is essential for any borrower entering into a financing arrangement.
Put simply, if a borrower’s financial performance falls below agreed thresholds, lenders want visibility of that at an early stage. For borrowers, financial covenants are more than just monitoring tools. They are heavily negotiated provisions that can directly affect operational flexibility and, if breached, may trigger an event of default.
It is therefore important for borrowers to ensure that covenant levels are set at realistic and sustainable levels, with sufficient headroom to accommodate fluctuations in trading performance and changing market conditions. Borrowers should also consider future growth plans, capital expenditure requirements, acquisition strategies and broader business objectives when negotiating covenant levels, as these factors may affect compliance throughout the life of the facility. Careful financial forecasting and scenario planning can help identify potential pressure points early and ensure that covenant packages remain appropriate as the business evolves.
Careful negotiation and legal advice at the outset can help minimise the risk of technical breaches and reduce the need for waiver or amendment discussions later in the life of the facility.
What Are Financial Covenants in a Facility Agreement?
Financial covenants are periodic financial tests included in a facility agreement. They require a borrower to maintain agreed levels of financial performance throughout the life of the loan.
From a lender’s perspective, financial covenants are a key monitoring tool, enabling it to identify signs of financial deterioration at an early stage and assess whether the borrower remains capable of servicing and repaying its debt.
Typical financial covenants include:
- Loan-to-Value Ratio (LTV) – measures the value of the secured assets against the amount of debt outstanding.
- Minimum Cash Requirement – requires the borrower to maintain a specified level of cash or liquidity.
- Minimum EBITDA – requires the borrower to generate a minimum level of earnings before interest, tax, depreciation and amortisation.
- Leverage Ratio – measures the borrower’s level of indebtedness relative to its earnings.
- Interest Cover Ratio – measures the borrower’s ability to meet its interest payment obligations.
The purpose is simple, ensure that the business remains financially stable and capable of meeting its repayment obligations.
Cure Rights for Financial Covenant Breaches
A covenant breach does not always result in an immediate event of default. Many facility agreements contain cure rights, which allow additional funding to be injected into the business following a failed covenant test in order to restore compliance.
The most common form of cure right is an equity cure, although some lenders may also permit subordinated debt injection cures. The availability and scope of these rights are often heavily negotiated and can provide borrowers with valuable flexibility during periods of financial underperformance.
What Is an Equity Cure Right?
An equity cure right allows shareholders to inject new equity into the borrower or, in some structures, another member of the group following a failed financial covenant test. Subject to the terms of the facility agreement, the cure amount is then taken into account for the purposes of the relevant covenant calculation.
Depending on the drafting, the injected funds may be deemed to increase EBITDA, reduce net debt or otherwise improve the covenant calculation used for the relevant testing period.
The effect is to enable the borrower to remedy a covenant breach and avoid what might otherwise become an event of default.
Equity cures are generally attractive to lenders because the additional funds are introduced as equity rather than debt, strengthening the borrower’s balance sheet without increasing leverage.
From a borrower’s perspective, key negotiation points include:
- the number of cures permitted during the life of the facility;
- any restrictions on cures in consecutive testing periods;
- the period within which the cure must be exercised; and
- how the cure amount is applied when recalculating covenant compliance.
Debt Injection Cures and Subordinated Shareholder Loans
Borrowers should also consider/negotiate whether the facility agreement permits covenant breaches to be cured through the injection of subordinated shareholder debt rather than equity.
Unlike an equity cure, a debt injection does not involve shareholders subscribing for additional shares. Instead, funds are advanced to the borrower by way of a loan, typically on terms that are subordinated to the senior lender and subject to restrictions on repayment.
From the borrower’s perspective, this can be an attractive alternative because it allows additional funding to be introduced without diluting existing shareholders’ interests.
However, debt injection cures are generally less attractive to lenders because they increase the borrower’s indebtedness rather than strengthening its equity base. For that reason, lenders may impose tighter restrictions on debt injection cures, limit how they are applied for covenant testing purposes, or refuse to allow them altogether.
Borrowers should therefore carefully assess whether the facility agreement permits only equity cures, both equity and debt injection cures, or neither. The ability to inject subordinated debt rather than equity can provide valuable flexibility where shareholders are reluctant to dilute their ownership interests.
What Happens When a Financial Covenant Is Breached?
If a financial covenant breach cannot be cured and the lenders are unwilling to waive the default, the consequences can be severe. Depending on the terms of the facility agreement, lenders may be entitled to:
- accelerate the debt;
- demand immediate repayment;
- charge default interest;
- enforce security; and/or
- trigger cross-default provisions under other financing arrangements.
What begins as a failed covenant test can quickly develop into a wider liquidity and refinancing issue for the borrower.
Practical tips for borrowers
- Monitor covenant compliance regularly -maintain up-to-date financial information and test compliance well in advance of scheduled testing dates. Early identification of potential issues provides time to take corrective action.
- Maintain sufficient headroom – when negotiating financial covenants, seek covenant levels that reflect realistic business performance and provide adequate flexibility to accommodate market fluctuations and unforeseen events.
- Negotiate cure rights early – consider the availability and scope of both equity cure rights and debt injection cures during negotiations, ideally before heads of terms are agreed.
- Strengthen financial management processes -robust forecasting, cashflow management and financial reporting procedures can help identify risks at an early stage and support ongoing compliance.
- Take legal advice – financial covenants are often among the most heavily negotiated provisions in a facility agreement. Borrowers should understand how covenants are calculated, what adjustments are permitted, what cure rights are available and the consequences of any breach.
Financial covenants are far more than periodic financial tests. They are a key risk management tool for lenders and a critical area of negotiation for borrowers. Understanding how covenants operate, what cure rights are available and the differences between equity cures and debt injection cures can help borrowers manage their financing arrangements more effectively and reduce the risk of unnecessary defaults.
If you would like advice on any aspect of a facility agreement, refinancing, covenant compliance or financing transaction, please contact us.
