With more specialised financial products these days and with more competition between financiers, we tend to see that financiers are more focused on mechanisms and early warning systems to ensure repayment of facilities through the introduction of covenants in addition to security than to finance against security only. The days of security lending only on sizable loans are over, financiers want to have certainty regarding cash flow.
A debt covenant or more specifically, a financial or banking covenant is a solemn agreement between a lender and a borrower; whereby the borrower is required to either engage or refrain from a specific action.
The factors which play a large role in determining the scope of a covenant are (i) the degree of the risk undertaken by the lender; (ii) the nature of the borrower; and (iii) whether the loan is a secured or an unsecured loan.
The main purpose of a covenant, for an unsecured loan, is to provide more security to the lender; and although this might appear as if the covenants are obstacles creating a burden and a restriction on the borrower during its term, it is of extreme necessity in order to monitor the condition of the borrower and the terms of the loan.
The functions of these covenants, especially in an unsecured loan, is not to restrict the borrower of its day to day activities but to rather instil in the lender the surety that the borrower will not act recklessly or partake in activities that might put the loan and the lender at risk.
Some of these functions might include that the borrower refrain from international activities without obtaining the written consent of the lender, the pari passu clause the restriction of extending any funds to any third parties, restrictions on its capital expenditure, refraining from disposing of its assets without obtaining the written consent of the lender, the borrower must remain within specific financial ratios at all times, or is restricted to undergo a substantial change in its business, the borrower might be obligated to make available to the lender financial information upon request, and further, the borrower might be restricted to incur any other debt or liabilities during the course of the loan period.
The moment the lender extends capital to the borrower, the lender acquires an interest in the preservation of that capital. Therefore one might suggest that the lender, although in silence, extends a hand of management when it comes to the operations of the business in order to protect the loan granted.
In the article Is the Borrower in Default? Sometimes It’s Hard to Tell by the Lending Report the point was raised that if covenants are not clear and action to comply therewith measurable it can lead to default under the loan.
In conclusion it must also be noted that the wording of covenants must done on such a basis that it is clear and measurable. Lenders and borrowers must spent time in negotiating covenants so that it is measurable by the lender and manageable by the borrower. The best is to put on the test with available data to ensure everybody is on the same page.