Borrowers: Are you in danger of
breaching your banking covenants?
JANUARY 2009
One does not have to look very far these days to see headlines painting a gloomy
picture about the current economic climate. In the property and retail press
particularly, it is becoming a regular occurrence to read about the dramatic
downturn in customer spending and the substantial falls in property prices.
Some of the statistics are particularly worrying:
- Jones Lang LaSalle expects the amount spent on UK commercial property
this year to be £21 billion – a substantial 55% lower than in 2007. It also
forecasts that this will bring the market back to 2000 trading levels.
- RICS states that commercial property prices in dollar terms have fallen over
50% from the June 2007 peak.
- According to RICS experts and the IPD index, commercial property values
could fall by a further 25% over the next two years.
As a result of the current economic climate, borrowers are becoming increasingly
concerned about the likelihood of breaching the covenants in their loan
documentation. These covenants, known as banking covenants, place obligations
on the borrower to operate within certain parameters and enable the lender to
review at regular intervals the borrower’s ability to repay the loan. They also
highlight at an early stage any areas of concern.
Banking covenants explained
They consist of three main areas:
- Information covenants – covenants to ensure the regular provision of
information (business and financial) to the lender
- Non-financial covenants – obligations to maintain the assets, such as keep
the property in good repair and not assign or underlet the property, save in
accordance with specified conditions
- Financial covenants - agreements by a borrower to meet certain defined
financial performance measures, such as loan to value ratios, net worth
and interest cover covenants. These are the covenants that borrowers
are most likely to breach in the current market and are as follows:
Loan to value ratio
The most common of these is the Loan to Value (“LTV”) covenant. This is the
comparison between the value of the property and the amount of debt against that
property, expressed as a percentage. The loan documentation usually contains a
covenant that the borrower will not permit the LTV ratio to exceed a specified
percentage, which can sometimes be as high as 85%. It will also provide for
valuations of the property to be done on a regular basis to enable the lender to
monitor the ratio.
As property values plummet, borrowers are witnessing sharp increases in their LTV
ratios. As a result, many are at risk of breaching this particular banking covenant.
The situation is exacerbated by increasing levels of debt as a result of struggling
sales and general worsening economic conditions.
Net worth
The net worth is the value of a borrower’s net assets less its liabilities. A lender
will usually require that a borrower covenants to maintain this at a minimum level.
Borrowers may be at risk of breaching this covenant due to the increasing levels of
debt and a decrease in their net assets.
Interest cover
Interest cover measures the adequacy of a borrower’s earnings before interest and
taxes (“EBIT”) relative to the interest payments on its debts. The loan
documentation will usually provide for the interest cover to be calculated at regular
intervals (by dividing the EBIT figure by the interest payable for the same period)
and the borrower will usually be required to keep the figure above a certain level.
The higher the figure, the greater the likelihood that the borrower will be able to
continue to maintain the debt in the future, thus a lower risk for the lender. The
lower the figure, the more likely it is that the borrower will have problems meeting
interest payments.
Breach of covenant?
The consequences of breaching one or more of the banking covenants vary,
depending on the lender, and can include the following:
- As a breach of covenant is a default, the lender can demand immediate
repayment of the loan
- If it decides not to call in the loan, it will usually require the loan
documentation to be renegotiated on terms significantly less favourable to
the borrower, including higher interest rates and perhaps substantial fees
- Some loan documentation may require the borrower to provide a deposit
as further security in the event of a breach of the LTV ratio, thus increasing
the financial burden of the borrower
There are, however, indications that lenders are becoming more willing to
renegotiate the documentation instead of calling in the loans, given that they will
want to limit their bad debts as much as possible. It is of course in their interests
to agree a solution that will work for both parties.
Take action sooner rather than later
It is therefore important to take action well in advance to avoid any such breach,
particularly as the options available to a borrower may be greatly reduced or
perhaps disappear altogether once the covenant has been breached. As mentioned
above, if the lender agrees to renegotiate following a breach, it will be on terms
significantly less favourable to the borrower. Approaching the lender well in
advance means that the borrower can renegotiate on more equal terms and, if that
proves unsuccessful, explore alternative financial solutions where possible. Some
options might include:
- Agree a new loan to value ratio with the lender. Generally, lenders should
be willing to work with borrowers to find an acceptable compromise
- Replace or alter the interest cover covenant or relax/reduce the minimum
net worth covenant
- Explore alternative finance solutions and structures
- Sell assets in order to pay off debts
- Arrange for cuts to dividends or decide not to pay at all
- Above all, approach the lender or seek advice now
If you would like further information on the content of this newsletter please
contact Michael Collins on 0207 404 0606 or mcollins@gdlaw.co.uk.
This is a guide for general information and interest and should not be relied upon as providing specific legal advice. |
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