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Importance and management of financial covenants

2008

The crisis on the financial markets has led once again to increased risk awareness among banks: Company-specific interest markups on loans have risen since and stipulations for borrowers have become stricter. Financial covenants (financial indicators of the borrowing company) are seeing a comeback as a creditor protection tool, especially in the case of SME financing. They help banks recognize possible defaults early on and take counteraction. These covenants can be tailored to fit the individual borrower. Of key importance are earnings and liquidity indicators; these are checked quarterly. If obligations are violated, this often leads to higher interest payments and the participation of an external consultant. These are the findings of Roland Berger's "Bedeutung und Management von Financial Covenants" ("Importance and management of financial covenants") study. The study involved interviewing 100 executives from more than 20 German banks, including the four major German banks as well as the leading public-sector and cooperative banks.

"Financial covenants are back," announces Roland Berger Partner Dr. Sascha Haghani. Until recently, many banks refrained from using such creditor protection mechanisms or formulated them very loosely ("covenant lite"). For instance, covenant lite loans accounted for 35% of all loans in the US in 2007. As a result of the financial crisis that erupted in fall 2007, banks are going back to stipulating stricter terms and conditions.

Financial covenants – Early-warning and control mechanisms

Financial covenants represent an important subgroup of creditor protection provisions for loan extensions and can also be classified as capital structure covenants. These address the borrower's financial situation and obligate the borrower to comply with specific equity, debt, earnings or liquidity ratios during the term of the loan.

Key financial covenants are earnings and cashflow indicators, especially EBITDA interest cover and debt service cover ratio. The importance of these creditor protection provisions depends on the likelihood of loan default: 42% of the interviewees stated that such provisions are used for 75% of their subordinated loan and for 65% of their mezzanine financing facilities. Two-thirds of the banks tailor the covenants to the individual borrower. The type and extent of the provisions are typically governed by the underlying financing instrument as well as the borrowing company's business model and the industry it operates in. Only 34% of the survey participants feel that using standardized covenants is a sound approach.

Five steps to success: Optimally defining financial covenants

Roland Berger Strategy Consultants recommends a five-step approach to optimally adjust financial covenants to fit the borrowing company:

  1. Analyze the industry and market: Key factors include corporate and industry-specific seasonal fluctuations or lifecycle phases
  2. Examine the business plan: It is important to take a look at the company's business forecast and possible risks if the situation develops differently
  3. Set up a repayment plan: The borrower's debt serving abilities must be clarified prior to any emergencies
  4. Determine the "downside case": Even if things develop unfavorably, the borrower should still be able to service interest and principal
  5. Define individual covenants: The final covenants should be defined only after carrying out the aforementioned steps

Less growth due to more restrictive lending

38% of the interviewees feel that financial covenants only have a marginal effect, 44% a moderate effect, while 18% believe these have a major effect on the borrower's scope for action.

However, banks' more restrictive lending policies could slow down growth in Germany. "Bank loans in Germany remain the main source of financing, especially for small and medium-sized companies," says Haghani. "German SMEs will be hit especially hard should the terms and conditions for obtaining a loan become even stricter."

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