An overview of covenants in large bank loans

RMA Journal, The, March, 2002 by John K. Paglia

As important as covenants are in managing lending risks, they are generally not at the top of the lender's knowledge base. Survey results offer information on the breadth and frequency of covenants as they appear on large bank loans.

It's not until the car won't stop that we remember we meant to have the brakes checked. And it's not until rough economic times that we seem to remember the saying, "Bad loans are made during good times." That's when we rediscover covenants, a loan's bank-installed automatic braking system.

Covenants--contractual restrictions placed on a borrower--are back in vogue as an important facet in banks' risk management programs. These contracting devices set minimum standards for a borrower's future conduct and performance and typically accelerate the maturity of the loan in the event of a violation. Loan covenants also can reduce the borrower's costs of debt, thereby being a good thing for both borrower and lender. Yet a lack of knowledge persists.

The number and the severity of restrictions in the covenant package increase in proportion to a borrower's financial risk. Agreements with strong, large companies usually have, at most, a few standard covenants attached. Agreements with highly leveraged or otherwise riskier borrowers, on the other hand, are often much more complex and contain many nonstandard covenants.

Features of Covenants

Covenants provide an important mechanism for addressing bondholder-stockholder conflicts, altering the relationship in two fundamental ways:

1. Violation of covenants gives bondholders an opportunity to intervene--through forced bankruptcy, a renegotiated restructuring, or the imposition of additional constraints. In this context, covenants serve the ex post role of permitting bondholders to intervene after the consequences of the firm's strategies have been revealed.

2. Covenants also play an ex ante role by restricting the ability of stockholders to engage in strategies designed to expropriate wealth from bondholders or in actions that generally are detrimental to bondholders. Contracting is not a zero-sum game, and covenants can increase a firm's value relative to that of a covenant-free debt contract by providing incentives to shareholders not to engage in exploitative behavior. (1)

There are two broad classifications of covenants: affirmative and negative covenants.

Affirmative covenants require a borrower to meet certain standards such as discharging contractual obligations and providing information at regular intervals. Thc affirmative covenants arc usually standard boilerplate documents that require the borrower to pay the bank interest and fees, maintain its business, pay taxes, and so forth.

Negative covenants restrain the borrower from such actions as spending more than a specified amount on capital expenditures or increasing dividend payments, or they stipulate that measurable financial variables must satisfy certain minimums. Covenants related to financial variables are called financial covenants, and these can be either maintenance covenants or incurrence covenants. With maintenance covenants, the criteria set forth in the covenants must be met on a regular basis. With incurrence covenants, the criteria must be met at the time of a prespecified event, such as the firm making an acquisition or incurring additional debt.

There are many types of covenants and each is written to reduce some risk to the bank. Using a sample of large bank loans, this article classifies each covenant type and reports on its frequency. The sample of 238 loans made from 1992 to 1994 is taken from TearSheets, a product provided by the Loan Pricing Corporation (LPC) that includes detailed covenant information on high-profile bank loans. The sample represents single-facility deals, which are important in isolating the covenant attachment decision to one particular "deal." (2)

The average loan size is $431 million and the median size is $200 million. The average asset size of firms in the sample is $2,322 million. Of the 238 TearSheet loans examined, 171 (71.9%) are to publicly traded companies and 162 (68.1%) have public debt outstanding. Most of the loans in the sample are syndicated; the average number of lenders per loan is 12.3. Sixty-two different banks serve as lead agent in the 238-loan sample. The average maturity of the loan sample is 47.44 months. All of the loans in the sample are senior. The majority of the loans are revolving credits (90.8%).

Loan Covenants

The loan covenants were classified largely in accordance with the covenant classes identified by Gilson and Warner. (3) The covenant classes represented Include:

* Operating activity.

* Investment expenditure.

* Asset sale.

* Cash payout.

* Financing.

* Reporting and disclosure.

* Preservation of collateral/seniority.

* Management, control, and owners hip.

* Financial.

Operating activity--restrict, in some fashion, the daily operations of the firm. Operating activity covenants were found in 96.6% of the 238-loan sample. The average number of such covenants per loan was 4.42.