Covenants – What they are and why they are important

Covenants – What they are and why they are important

I wrote his article for my colleagues at Reward Gateway, the employee engagement technology business, because I wanted them to understand how our finances work. As I often meet entrepreneurs who haven’t done a private equity deal yet it seemed sensible to make this a public post in the hope that someone else might find it useful.

Ok so here goes.

 

 

Covenants are promises that you make to your bank or lender.

When you sell some of your business through a Private Equity deal you’re going to end up with a chunk of bank debt – that is a big loan from a bank that needs to be repaid. This is because almost all private equity deals are leveraged buy-out’s. I’ll write a separate post explaining those as soon as I get a minute, for now just accept that you end the deal with a big debt to the bank.

Glenn signing documents
Glenn signing the private equity deal with Great Hill Partners.

This debt that you owe to the bank is for part of the purchase price of the business. The debt or loan is often called “Senior debt” because it is “senior to” or “in preference to” any other debt that the business normally has – in essence it has to get paid back first. Because it gets paid back first, it is the lowest risk debt than a lender has to a business and thats why it gets the cheapest interest rate.

Your lender is often a bank – a number of the high street banks are active in doing private equity deals but PE leading is specialised so its not the normal full high street range of brands and there are lots of lenders that as a consumer you won’t have heard of. Over at Reward Gateway, when we were owned by Inflexion Private Equity our senior debt was provided by HSBC and now that we’re owned by Great Hill Partners, our senior debt is provided by TPG Capital.

OK – so when a bank makes a big loan to a company it obviously wants to make sure it’ll get paid back!

Its important at this stage to understand that banks are actually very risk-averse! That’s because of their role in the whole finance industry. Banks make lots of loans and only have a relatively small number of people to look after them. So whilst an average mid-market private equity firm with ¢750million of capital to spend might have 10 to 12 companies to look after, a typical bank might have hundreds of loans to similar companies out there. So banks are the volume end of the business – that means they take as little risk as possible and that means they can charge as little interest as possible.

So when a bank agrees a loan with a company to find a private equity deal (or to fund anything actually), the bank discuses and agrees a set of covenants with the company as part of the loan deal. And these covenants are simply promises.

Business negotiationsThe idea is simply that the covenant “promises” are indicators that show that the company is trading as expected (or not). So even though a company may be making its loan repayments as planned, if a covenant is breached that is an early warning that something is wrong at the company. If that happens the bank steps in and works with the company to see what’s going on – formally they have the right to “call in the loan” or demand repayment immediately.

They might agree to change the covenants or renegotiate the numbers, for which they will almost certainly charge a big fee, or they might do something more drastic. If a lender really feels the company is trading badly and they fear that they won’t get their money back if they don’t act they can call in the loan demanding repayment immediately. As the company won’t be able to pay the loan (unless cash is suddenly available from one of the shareholders) the bank will be able to take control of the company, install new management and through a new team run the company in the best way the can to make sure their loan is repaid. In serious cases they can wipe-out the shareholder’s equity as part of a refinancing deal, as happened back in 2013 with Yellow Pages.

Covenants are normally “tested” quarterly

Some lending deals have lots of covenants some have only a few. Here are some examples of typical covenants a lender might agree :Calculating financial progress

  • The company’s profit must always be at least 2x the interest payment required
  • The company’s recurring revenue must not fall by more than 5% from a given point
  • The company’s free cash available must always be greater than 3x the next interest payment
  • The company must produce a 12 month budget by 1st March every year

Normally covenants are “tested” each quarter and reported to the bank. It might surprise you (it surprised me) that in most cases the bank does not come in and check, but instead the company works the maths out and self-certifies by sending a signed letter to the lender stating that the covenants have not been breached. Whilst this might seem to require undue honesty, you have to remember that CFO’s are qualified accountants normally who have a reputation and formal certification to protect.

When things go a little wrong

Business isn’t a straight line from A to B for any of us and things can go temporarily wrong for all types of businesses. Retailers can be frequently vulnerable to lost sales from the wrong sort of weather or by stocking the wrong fashions and manufacturers can also be hit unexpectedly. When this happens a board will normally know they are going to breach their covenants before they actually do and they will often open a discussion with their lender in advance to see what the appetite is for a renegotiation. Publicly traded companies have to announce this to the stock market, as the UK model railway manufacturer Hornby Plc had to after having a very difficult year caused in part by the installation of a new computer system.

In summary

So in summary, covenants are important. When  you’re doing a deal you try to negotiate the lightest, most lenient covenants that you can. Post deal, you’ll be closer to your covenants than you’d like for a while and it’ll take you a year or so to trade away from them (immediately post deal your debt is maximum as you haven’t paid any off yet). But ultimately with good financial management, good budgeting and a bit of luck that the weather holds, if you’re a fashion retailer, then covenants are nothing to worry about – they’re a fact of normal business.

Written by 

Glenn is an employee engagement and tech entrepreneur. He founded Reward Gateway, the HR technology company in 2006 and continues to lead it as CEO today.

Now read

One thought on “Covenants – What they are and why they are important

  1. […] Covenants – What they are and why they are important […]

Leave a Comment