When you raise debt you agree to more than repayment. You also agree to a set of promises about how you will run the business while the money is outstanding. These are covenants, and they matter as much as the coupon.
What a covenant is
A covenant is a condition in the loan documents that you undertake to keep. If you breach one, the investor or trustee usually gains rights they did not have before: to demand information, to charge default interest, or in serious cases to call the debt in early.
Covenants exist because debt investors do not share in the upside. Their protection is the promise that the business will stay within agreed limits.
The common types
Information covenants require you to provide accounts, management figures and notice of material events on a set timetable. They are the easiest to keep and the most often missed.
Negative covenants stop you doing certain things without consent: taking on more debt, granting security over the same assets, selling key assets, or paying dividends while the notes are outstanding.
Financial covenants set measurable tests, such as a minimum level of cash, a maximum ratio of debt to earnings, or a minimum ratio of earnings to interest. They are more common in larger bond issues than in smaller loan notes.
Negotiating them
Covenants are negotiable, and the time to negotiate is before you sign.
- Test them against your plan. Run your forecast, including a downside case, through every financial covenant. If the downside breaches, the covenant is too tight.
- Ask for headroom. A test you pass only if everything goes to plan is a trap.
- Build in cure rights. A short period to fix a breach, or the ability to cure with fresh equity, turns a crisis into an inconvenience.
- Keep reporting realistic. Promise the information you can actually produce on time.
Why investors care
Well-drafted covenants make a note easier to sell. They show investors that the issuer has thought about downside risk and accepted sensible limits. Covenants that are either absent or impossible to meet both send the wrong signal.
The goal is a set of promises that protect investors without putting the business at risk of a technical default in an ordinary bad quarter.
Mark Johnson is a Director of BDM Wealth Management, which introduces capital raising opportunities across bonds, loan notes, IPOs and SEIS/EIS. To discuss a raise, get in touch.
BDM Wealth Management is an introduction business and is not regulated. This article is general information, not financial, tax or legal advice, and does not constitute an offer or invitation to invest. Capital is at risk and you may get back less than you invest. For high-net-worth and sophisticated investors only. Take independent professional advice before making any investment decision.