In today’s competitive lending market, as well as competing on price, lenders must show flexibility when negotiating financial covenants.
There is a natural tension between what borrowers and lenders both want. Borrowers want flexible and loose financial covenants while lenders aim for restrictive and watertight terms. The outcome is that negotiations often end in a stalemate.
Successfully negotiating financial covenants often requires some thinking “outside the box” to find a solution that meets the interests of both lender and borrower.
In the financial covenant provisions, a borrower covenants with the lender to maintain a certain ratio between obligations under the loan and key figures derived from financial data such as the borrower’s balance sheet.
Common financial ratios include the LVR which measures the ratio between the loan amount to the value of the financed asset and the ICR, which reflects how many times the income of the borrower can cover the interest expenses during a certain period.
So, what can be done if there is a stalemate? Here are five quick tips to break a deadlock.
- Firstly, the parties should be clear about the most suitable financial covenant to cover the specific credit risk of the borrower. 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.
- 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.
- Borrowers often push back on restrictive covenants because they fear the harsh consequences of a default. However, a restrictive covenant which at first glance seems harsh, may be acceptable if its breach “only” results in the requirement to provide cash collateral. In this way, the cash-flow risk for the lender is managed while the borrower has certainty that the funds provided under the loan remain available.
- The parties could also agree on a honeymoon period during which certain covenants can be breached or on so-called “Mulligan” – a provision according to which only the second (or third) consecutive breach of a financial covenant bears consequences.
- Finally, modifying some financial covenants such as referring to EBIT instead of EBITDA when calculating the ICR or referring to debt service (which includes fees) instead of interest might do the trick to avoid a stalemate and lead to a satisfying outcome of the negotiations for both parties.