Increasing spotlight on covenants

Date 11 March 2024

Type Investment Banking

Borrowers are facing a number of well-documented challenges – low to flat economic growth, inflationary pressures, heightened interest rates, reduced labour supply, to name a few. The majority of companies are impacted to some degree by these macro pressures and this has increased the focus on covenants, both in respect of existing covenant structures that may not be fit-for-purpose and for new debt facilities to ensure that borrowers have the right covenant structure.

When agreeing covenants, whilst negotiating a sufficiently low growth banking case to set the covenants off is important, there are also a number of other important considerations. The first debate should be around the use of a gross or net leverage test. Sponsors may have a house view but, at a simplistic level, a gross covenant is simpler (one numerator) and underperformance is not subject of a ‘double-hit’. However, a gross covenant is closer to an EBITDA test with less ability to manage period-ends and a net covenant should be considered where the business can utilise specific cash levers (typically working capital-based).

Beyond this, the next level of detail has become increasingly important and detailed covenant definitions should be considered ahead of mandating a lender. A deep understanding of the business and the impact of future activities should be translated into tailored definitions and flexible caps (or, in some cases, no caps) in respect of add-backs for the purpose of calculating Adjusted EBITDA for covenant calculations (i.e. exceptional and cost savings / synergies).

The Debt Advisory Team at Alantra has relevant current experience of these very situations and are keen to bring the benefit of that insight to your projects. Do get in touch if you would like to discuss further.