Once upon a time Loan Agreements for most businesses below ‘Corporate level’ were straightforward documents, so actually drawing down the loan once agreed was relatively quick (subject to any additional security documentation).
The years post ‘Credit Crunch’ revealed how bank’s documentation had become more complex with ‘Terms & Conditions’ documents (now separate chunky documents available by download) not easily read and digested by borrowers. Most relevant was the inclusion of ‘Covenants’ which would have previously only been included with loans for larger ‘Corporate’ borrowers.
Covenants are of course ‘rules’ which the bank set as criteria for the loan to be continued on the agreed and committed terms. Most common examples are:
- ‘Loan to Value’ covenants (used where property or other assets are used as security with a threshold set to ensure that there is sufficient headroom between the amount of the debt and the value of the security).
- Cash generation covenants (used to ensure that the business is generating sufficient tangible revenue to cover the loan repayments). The measures might be expressed as simple ‘net profits’ or EBITDA but might have bespoke calculations tailored to the business.
- Production of financial information. At a simple level this will cover the need for timely production and sharing of year-end figures but it can include the submission of regular management information to tight deadlines.
- Negative Pledges. These are ‘assurances’ made by a borrower that they will NOT do certain things – so for example they will not charge unencumbered assets to another lender.
Surprising as it sounds a number of borrowers have found that they had covenants that they claimed that they didn’t know about or had forgotten existed. This can come about because:
- When covenants get put in place the lenders usually build in ‘headroom’ so that a breach is unlikely in the short term.
- Most loans are then reducing with capital repayments so normally you would expect that gap to widen and be even less of a consideration.
- Communication gaps: lenders might ‘make light’ of the covenants during negotiations and borrowers have a natural tendency to ‘hear what they want to hear’ (when what they want is the loan).
- Documentation problems – either complexity or poor retention on the borrower’s part.
During stable times covenants tend to be passive instruments and don’t cause issues, however the banking crisis educated a lot of businesses about the risks they involved. For all the reasons we know about the banks were forced to try to ‘shed’ loans that were losing them money but with facilities committed the only way that they could do that was to target loans where covenants had been breached.
Once they could prove that was the case the original commitment could be undone and the loan either re-priced or re-structured – or the borrower encouraged to bank elsewhere.
The lessons learnt during the last few years should ensure that businesses take time and care to understand covenants and be prepared to negotiate on them. They should also be constantly aware of them and how they could be affected by decisions made about the business.
The reasons that Accountants should be consulted becomes clear when you consider how they work with businesses on financial decisions, so for example:
- Level of drawings and dividends. These decisions are often tax driven but they could impact on a loan covenant that dictates a certain level of retained cash in the year-end figures. Sometimes a covenant might also restrict dividend levels.
- Revaluation of assets. These are typically normal depreciation write-downs of course but there could be technical or tactical reasons for revaluing an asset (particularly an intangible asset) and the impact on a ‘loan to value’ type covenant should be considered.
- Capability to produce management information. A covenant might dictate the submission of management figures in a certain format. Where the accountant supports the business closely in this area they need to know about it and be involved.
A challenge: how many accountants and businesses have this discussion either when a loan is negotiated or on an annual basis?