As we all know, senior debt is at the head of the line when we talk about subordination. That is, if a company is wound up, senior debt lenders receive their money before most other lenders, and certainly before equity holders. Inherent in this concept, is that providers of debt are mostly concerned with risk. That’s absolutely true and is why debt covenants are so important. Lose focus, and you may find your financing called, which means you have to pay it all back immediately.
If I may talk somewhat facetiously, debt providers don’t like much in life (certainly not cute puppies, walks on the beach or the dulcet tones of jazz), but they absolutely love debt covenants. It gives them a chance to apply a tight grip to their customers’ proverbials. As disparaging as this may sound, debt providers are the source of much value for private equity firms (hello leveraged returns!). With that tight grip in mind (and of course the team’s carry), we need to do everything we can to maintain healthy reports and measures against these Machiavellian covenants.
There are three typical covenants used:
- Debt/Earnings: this provides a multiple or value that suggests how many years of earnings will pay back the debt principal (this measure is also called the gearing ratio). The earnings number may be EBIT or EBITDA, depending on the preferences of the provider. A typical multiple for this covenant is between 2-4x, although for larger deals a multiple of 5x isn’t unusual.
- Earnings/Interest: this provides a multiple that suggests how many times the current earnings could pay back the interest on the debt (also called interest cover ratio). The idea being that earnings could fall X% before the business couldn’t pay the interest on its debt. A typical multiple for this covenant is at least 2x, the higher the better.
- Cashflow/Repayment: sometimes referred to as debt service coverage ratio (DSCR), this is similar to the interest cover ratio, except it uses free cash flow (FCF) in the numerator to bypass the obvious downfalls of using an accounting earnings number. It also adds the compulsory principal repayments to the denominator (so the denominator = interest + principal repayments). The reason for this is that the expected repayment often contains a principal component.
There are many other debt covenants in use around the world, but these three are typical in the US, EU and in Asia. Private equity firms, amongst other consumers of debt, report on these covenants quarterly, with a more detailed report expected upon the receipt of audited accounts.
Unlike personal loans, business loans are scrutinised heavily, usually on a monthly basis by banks. Why? Because the amounts are much larger and often the loan is only secured by cash flow.
So unlike a home mortgage, when a bank can repay by selling the house, if a business defaults on a loan, often the bank’s only recourse is to chase insolvency to sell down the assets as recompense. But if the loan is secured by business cash flows, then closing the business down will only further the problems by stopping those cash flows.
With this in mind, banks ask for regular reports from businesses so they can be forewarned of troubles. If anything looks awry, the bank will make their visits and requests for financials more frequently and potentially call a default on the business before their last resort of enforcing a liquidation.