Covenants and Financial Modeling

Introduction

What are Financial Covenants?

• Contractual provisions in credit agreements
• That require borrowers to maintain specified financial metrics
• Or restrict certain actions

Introduction

What is Covenant Modeling?

• Involves projecting financial performance
• Calculating covenant ratios, and assessing compliance headroom
• Under various scenarios to ensure sustainable capital structures and avoid technical defaults

Covenant Categories

Maintenance Covenants:

• Require borrowers to maintain financial ratios within specified ranges
• Tested periodically (typically quarterly)
• Breaches constitute immediate events of default unless cured or waived

Covenant Categories

Incurrence Covenants:

• Restrict specific actions (incurring debt, making acquisitions, paying dividends)
• Unless certain conditions are satisfied at the time of the action
• Common in high-yield bonds and covenant-lite structures

Covenant Categories

Negative Covenants:

• Prohibit or limit certain activities including additional debt, liens, asset sales
• Investments, and related party transactions
• Protecting lender interests by preventing value leakage or risk increases

Covenant Categories

Affirmative Covenants:

• Require specific actions such as maintaining insurance
• Providing financial statements, preserving corporate existence
• And complying with laws, ensuring ongoing transparency and business continuity

Covenant Categories

Financial Reporting Covenants:

• Obligate delivery of financial statements, compliance certificates
• Budgets, and other information
• Enabling lenders to monitor performance and covenant compliance

Common Financial Covenants

Total Leverage Ratio:

• Most prevalent financial covenant
• Calculated as total debt divided by EBITDA
• Maximum permitted ratios typically ranging from 3.5x to 6.5x depending on credit quality and industry

Common Financial Covenants

Senior Leverage Ratio:

• Similar to total leverage but includes only senior secured debt in the numerator
• Protecting senior lenders by limiting total debt layers
• Senior leverage limits typically run 0.5x to 1.5x below total leverage limits

Common Financial Covenants

Interest Coverage Ratio:

• EBITDA divided by interest expense
• Ensuring sufficient cash generation to service debt
• Minimum coverage typically ranges from 2.0x to 4.0x, with higher requirements for weaker credits

Common Financial Covenants

Fixed Charge Coverage Ratio:

• More comprehensive than interest coverage
• Including principal amortization, capital expenditures, taxes, and sometimes rent in fixed charges
• Minimum requirements typically range from 1.1x to 1.5x

Common Financial Covenants

Debt Service Coverage Ratio:

• Cash flow available for debt service divided by required principal and interest payments
• Common in project finance and real estate lending
• Typically requiring minimums of 1.2x to 1.5x

Common Financial Covenants

Minimum EBITDA or Liquidity:

• Absolute dollar requirements ensuring minimum earnings or cash levels
• Protecting against severe deterioration
• Regardless of leverage ratios

Covenant Calculation Mechanics

EBITDA Adjustments:

• Credit agreements define EBITDA specifically
• Typically starting with net income and adding back interest, taxes, depreciation, and amortization
• Then permitting additional adjustments for non-recurring items, restructuring costs, synergies

Covenant Calculation Mechanics

Permitted Add-Backs:

• Common adjustments include non-cash charges (stock compensation, write-downs)
• One-time costs (transaction fees, severance)
• Expected synergies from acquisitions (often capped at 10-20% of pro forma EBITDA)

Covenant Calculation Mechanics

Pro Forma Adjustments:

• Acquisitions and divestitures receive pro forma treatment
• Calculating ratios as if transactions occurred at the period start
• Including full-period EBITDA for acquisitions and excluding divested business EBITDA

Covenant Calculation Mechanics

Debt Definitions:

• Total debt typically includes all borrowed money, capital leases
• And sometimes certain off-balance sheet obligations
• While excluding items like deferred taxes, pension obligations, or other non-debt liabilities

Covenant Calculation Mechanics

Netting and Excluding Items:

• Some definitions permit netting unrestricted cash against debt
• Or excluding certain permitted debt categories
• Like subordinated debt, intercompany balances, or working capital facilities up to specified amounts

Covenant Calculation Mechanics

Testing Periods:

• Most covenants test on trailing twelve-month (TTM) or last twelve-month (LTM) bases
• Calculating EBITDA over the four most recent fiscal quarters
• Rather than annualizing single quarters

Covenant Modeling Fundamentals

Base Case Projections:

• Start with management's most realistic forecast
• Incorporating known business trends, seasonal patterns, market conditions
• Representing the expected scenario rather than aspirational targets

Covenant Modeling Fundamentals

Historical Analysis:

• Review historical covenant compliance
• Calculating actual ratios over past periods
• To understand trends, seasonal variations, and relationships between operational metrics and covenant calculations

Covenant Modeling Fundamentals

Quarterly Granularity:

• Model financial performance and covenant calculations quarterly rather than annually
• Capturing seasonal fluctuations
• And identifying specific quarters where covenant stress may occur

Covenant Modeling Fundamentals

EBITDA Build-Up:

• Project revenue, cost of goods sold, operating expenses
• And other components building to EBITDA
• Then apply permitted add-backs consistently with credit agreement definitions

Covenant Modeling Fundamentals

Debt Schedule:

• Maintain detailed debt schedules tracking principal outstanding
• Draws and repayments, amortization, and interest calculations
• For all facilities, ensuring accurate leverage denominator calculations

Covenant Modeling Fundamentals

Working Capital Impacts:

• Model accounts receivable, inventory, and payables
• To project cash flow and potential revolver draws
• As working capital swings significantly impact net debt and availability

Headroom and Cushion Analysis

Compliance Cushion:

• Calculate the difference between actual or projected covenant levels and maximum permitted levels
• Expressing as absolute difference or percentage buffer
• Minimum cushions of 10-15% provide safety margins

Headroom and Cushion Analysis

Stress Testing:

• Model downside scenarios including revenue declines, margin compression
• Working capital deterioration, or capital expenditure increases
• To assess covenant resilience under adverse conditions

Headroom and Cushion Analysis

Quarterly Phasing:

• Identify quarters with tightest covenant compliance
• Often Q1 or Q4 due to seasonal patterns
• Ensuring sufficient cushions during these vulnerable periods

Headroom and Cushion Analysis

Covenant Triggers:

• Determine the level of performance deterioration that would trigger covenant breaches
• Calculating required EBITDA declines or debt increases
• That would consume available headroom

Headroom and Cushion Analysis

Margin of Safety:

• Maintain cushions accommodating unexpected events, timing differences, or calculation disputes
• Recognizing that technical breaches trigger default consequences
• Even when fundamental business health remains solid

Common Modeling Pitfalls

Definition Mismatches:

• Failing to apply credit agreement EBITDA definitions precisely
• Including omitting permitted add-backs or including non-permitted adjustments
• Creating inaccurate covenant calculations

Common Modeling Pitfalls

Pro Forma Errors:

• Incorrectly calculating pro forma effects of acquisitions or divestitures
• Failing to adjust for synergies within permitted limits
• Or missing required adjustments for purchase accounting

Common Modeling Pitfalls

Timing Issues:

• Misaligning testing dates, using incorrect quarters for TTM calculations
• Or applying covenant levels that change over time
• Based on step-downs or amendments

Common Modeling Pitfalls

Interest Calculations:

• Oversimplifying interest expense calculations
• Failing to capture SOFR changes, neglecting PIK interest accruals
• Or missing commitment fees on undrawn facilities

Common Modeling Pitfalls

Working Capital Dynamics:

• Underestimating seasonal working capital needs
• Failing to model revolver draws during inventory builds
• Or not considering cash conversion timing in debt balances

Common Modeling Pitfalls

Add-Back Limitations:

• Exceeding caps on specific add-backs
• Applying synergy adjustments beyond permitted timeframes
• Or including non-recurring items that credit agreements don't permit

Scenario Analysis and Sensitivity

Downside Cases:

• Model scenarios with 10-20% revenue declines
• Margin compression, or operational challenges
• To assess covenant resilience and identify potential breach triggers

Scenario Analysis and Sensitivity

Seasonal Sensitivity:

• Understand which quarters face greatest covenant pressure
• Due to seasonal working capital requirements
• Inventory builds, or collection timing

Scenario Analysis and Sensitivity

Acquisition Impact:

• Model pro forma effects of potential acquisitions on leverage ratios
• Ensuring sufficient headroom exists for contemplated M&A activity
• Within covenant constraints

Scenario Analysis and Sensitivity

Interest Rate Sensitivity:

• For floating-rate debt, assess covenant impacts from SOFR increases
• Modeling 100-200 basis point rate increases
• To understand interest coverage vulnerability

Scenario Analysis and Sensitivity

EBITDA Sensitivity Tables:

• Create tables showing covenant compliance across ranges of EBITDA performance
• E.g., 90%, 95%, 100%, 105% of base case
• And debt levels

Scenario Analysis and Sensitivity

Mitigation Strategies:

• Identify potential actions to prevent or cure breaches
• Including cost reductions, working capital improvements
• Asset sales, or equity contributions

Step-Downs and Ratchets

Step-Down Provisions:

• Many facilities include leverage covenants that decrease over time
• E.g., 5.0x in year one, 4.5x in year two, 4.0x thereafter
• Requiring improving credit metrics as loans mature

Step-Downs and Ratchets

Performance Ratchets:

• Some covenants adjust based on credit ratings or other metrics
• Tightening if performance deteriorates
• Or relaxing if metrics improve beyond thresholds

Step-Downs and Ratchets

Modeling Step-Downs:

• Ensure models apply correct covenant levels for each testing period
• Flagging transitions where requirements tighten
• And ensuring adequate cushions during step-down quarters

Step-Downs and Ratchets

Amendment Opportunities:

• When approaching step-downs with insufficient headroom
• Consider timing amendment requests before new levels take effect
• Rather than waiting for imminent breaches

Covenant-Lite Structures

Incurrence vs. Maintenance:

• Cov-lite facilities replace quarterly maintenance tests
• With incurrence covenants restricting actions
• Only when leverage exceeds thresholds at the time of proposed actions

Covenant-Lite Structures

Modeling Differences:

• Incurrence covenants require modeling specific transaction scenarios
• (acquisitions, dividends, debt issuances)
• To determine if leverage tests permit contemplated actions

Covenant-Lite Structures

Ratio Testing:

• Calculate pro forma leverage including proposed transaction effects
• Ensuring post-transaction ratios satisfy incurrence test requirements
• Typically 4.5x to 6.0x depending on covenant

Covenant-Lite Structures

Growth Baskets:

• Many cov-lite facilities include alternative baskets
• Permitting actions regardless of ratio compliance up to specified dollar amounts
• Requiring tracking of basket utilization

Covenant-Lite Structures

Springing Covenants:

• Some cov-lite facilities include maintenance covenants that "spring" into effect
• When revolving credit utilization exceeds thresholds
• Typically 30-40% of commitments

Compliance Certificates and Reporting

Certificate Components:

• Compliance certificates attest to covenant compliance
• Provide detailed calculations, list exceptions or defaults
• And confirm representations and warranties remain accurate

Compliance Certificates and Reporting

Calculation Details:

• Support covenant calculations with detailed schedules
• Showing EBITDA build-ups, debt component listings
• Add-back details, and pro forma adjustments with supporting documentation

Compliance Certificates and Reporting

Definition Adherence:

• Apply credit agreement definitions precisely
• Including specific add-back caps, permitted debt categories
• And calculation methodologies exactly as documented

Compliance Certificates and Reporting

Timing Requirements:

• Submit certificates within specified periods after quarter or year-end
• Typically 45 days for quarters, 90 days for year-end
• With late submissions potentially constituting defaults

Compliance Certificates and Reporting

Amendment Tracking:

• Maintain detailed records of all amendments, waivers, or modifications
• Affecting covenant definitions, levels, or testing dates
• Ensuring current requirements are applied

Amendment and Waiver Strategies

Proactive Amendments:

• Approach lenders early when projections indicate potential future breaches
• As advance notice and good-faith engagement
• Typically result in more favorable amendment terms than crisis negotiations

Amendment and Waiver Strategies

Covenant Relief Types:

• Amendments may increase permitted leverage levels, reduce coverage requirements
• Modify EBITDA definitions to permit additional add-backs
• Or defer step-downs

Amendment and Waiver Strategies

Amendment Costs:

• Lenders typically charge consent fees (25-75 basis points on commitments)
• Amendment fees, or require pricing increases
• Typically 25-50 basis point margin step-ups as compensation

Amendment and Waiver Strategies

Equity Cures:

• Some facilities permit equity contributions to cure covenant breaches
• Or be added to EBITDA for calculation purposes
• Providing breach remediation without requiring amendments

Amendment and Waiver Strategies

Strategic Timing:

• Consider amending during strong performance periods
• When negotiating leverage improves
• Rather than waiting until deterioration weakens borrower positioning

Best Practices for Borrowers

Conservative Projections:

• Model conservatively with realistic assumptions rather than aggressive targets
• Ensuring compliance even if performance slightly underperforms expectations

Best Practices for Borrowers

Continuous Monitoring:

• Track covenant metrics monthly or more frequently
• Despite quarterly testing
• Enabling early identification of developing compliance risks

Best Practices for Borrowers

Scenario Planning:

• Maintain updated scenarios reflecting business changes
• Market conditions, and strategic initiatives
• Recalculating covenant impacts as circumstances evolve

Best Practices for Borrowers

Maintain Documentation:

• Keep detailed support for all covenant calculations
• EBITDA add-backs, and pro forma adjustments
• Facilitating certificate preparation and lender discussions

Best Practices for Borrowers

Relationship Management:

• Communicate proactively with lenders about business performance
• Covenant trends, and potential issues
• Building trust that facilitates constructive amendment discussions if needed

Best Practices for Borrowers

Cushion Discipline:

• Establish internal thresholds tighter than covenant requirements
• Triggering management action when approaching cushion limits
• Rather than waiting for imminent breaches

Best Practices for Lenders

Underwriting Discipline:

• Set covenant levels during underwriting providing adequate cushions
• Typically 15-25%
• Accommodating normal business volatility without requiring frequent amendments

Best Practices for Lenders

Definition Precision:

• Draft covenant definitions clearly and completely
• Specifying permitted add-backs with caps, pro forma adjustment rules
• And calculation methodologies preventing ambiguity

Best Practices for Lenders

Ongoing Monitoring:

• Review compliance certificates thoroughly
• Verify calculations against financial statements
• And investigate unusual add-backs or calculation approaches

Best Practices for Lenders

Early Engagement:

• When monitoring identifies concerning trends, engage borrowers proactively
• To understand drivers and assess whether preventive actions or amendments warrant discussion

Best Practices for Lenders

Amendment Discipline:

• Evaluate amendment requests based on fundamental credit quality
• And business prospects rather than purely contractual compliance
• Balancing enforcement with relationship preservation

Best Practices for Lenders

Consistency:

• Apply covenant interpretation and amendment practices consistently across portfolio
• Avoiding precedents that might obligate similar treatment
• For weaker credits

Conclusion

• Financial covenants and accurate modeling form the foundation of credit risk management
• Protecting lenders while providing borrowers with clear performance expectations
• And operational boundaries

Conclusion

• Proper covenant modeling requires detailed understanding of credit agreement definitions
• Precise calculation methodologies
• And thorough scenario analysis identifying potential compliance challenges before they materialize

Conclusion

• Borrowers benefit from maintaining conservative projections
• Adequate compliance cushions, and proactive lender communication
• Avoiding technical defaults and preserving financing flexibility

Conclusion

• Lenders rely on well-structured covenants, disciplined monitoring
• And consistent enforcement to protect credit quality
• While maintaining constructive borrower relationships

Conclusion

• Success requires both parties understanding that covenants serve as early warning systems
• Rather than punitive constraints, enabling productive discussions and appropriate remedial actions
• When performance diverges from expectations