"Few are clear about what to do if they breach a covenant or how their lender will react."

Most owner-managers will be fully aware of the loan covenants they signed up to when borrowing to fund growth, but few are as clear about what to do if they breach a covenant or how their lender will react to such an event. Loan documents typically define covenant breaches as ‘potential’ or ‘actual’ events of default. This means that lenders may either have the right to demand immediate loan repayment or in any case, causing potentially extremely serious consequences for the business. Different lenders can take a wide range of actions, so I’ll describe in more detail how businesses can best prepare for all eventualities.

But first, let’s take a step back.

The two types of banking covenant

Covenants can be classified into two camps: positive ones that state what a business must do, such as reach agreed financial thresholds and provide financial statements, or negative ones that state what a borrower cannot do, such as sell certain assets or borrow more money. It’s worth noting here that covenants are not just there to protect the lender, they are also a crucial way of making sure that good businesses can borrow more cheaply. Without such agreements, lenders would feel less secure and therefore want a much higher return on their investment.

Breaches – action and outcomes

Google the subject and you will find general advice about what to do if you breach, or are in danger of breaching, a debt covenant. It will suggest that you are proactive, contact your lender early and cooperate. It may also advise you to prepare a detailed and realistic plan, supported by numbers, showing how you will get back to compliance. Although you could argue that informing your lender immediately and having a detailed plan ready in advance are slightly contradictory, this is generally sound advice. And, in many cases, it may lead to a positive outcome such as having the loan term extended, getting a payment holiday on the principal amortisations or recognising the breach as technical.

But - and this is a very big but -there is no requirement at all for the lender to behave in such a benign manner. We need look no further than the financial crisis to see how banks, anxious about their own survival, took covenant breaches as an opportunity to take greater control or even full possession of business assets or demand high/arbitrary cash penalties. While we are not suggesting such times are about to return, they serve as a reminder that lenders can take a range of actions and they may be driven by matters beyond your immediate visibility or control.

Are credit market changes altering breach behaviour?

As covered in our previous blog, events in the credit markets have seen the rise of so called alternative or non-bank lending. Welcome though this is, it adds some uncertainty. While there is no evidence of debt funds taking a stricter approach to covenant breaches, the fact that many are relatively new to the market means it is harder to predict how they will react, particularly in a tightening market. The infamous actions of major banks during the financial crisis means that their behaviour is under the microscope and likely to be tempered by public exposure. Non-bank lenders may, perhaps, be more likely to follow their commercial imperatives over any PR concerns.

Good advice is vital

Given the range of outcomes your lender can choose from, none of which you are likely to know until you meet their representative, having someone with you who knows the ins and outs – preferably from both sides of the table – is highly valuable. A good adviser would help you deal with the breach and accompany you to lender meetings. They would help you prepare information and present it to the lender in the most convincing or least concerning light. They would also be aware and advise you of the options and incentives a lender might have at each point in the process.

To give you just one example, I recently went into a meeting with a client where the lender requested the payment of a substantial financial penalty for a covenant breach. Without support, the owner manager may have felt obliged to pay up quickly, if only to demonstrate willingness to cooperate.

But with over 25 years’ experience of sitting on the other side of the table as a banker, I was able to argue the owner’s case that this was untypical and the amount was not fully supported by the loan documentation. In this particular case, the penalty was very substantially reduced, but the general point is that the owner manager acting alone is caught between wanting to stay on the right side of the lender and to fight their own corner.

I also know from my experience working within banks that just having an adviser present makes lenders behave more carefully because they assume the customer will have greater awareness of market norms and alternative options.

The value of independence

It is important for an adviser to be fully independent and free to act purely in your interests. That may seem obvious, but many lawyers and advisers have strong business links to lenders and may therefore be less free to press your case firmly. At Shaw & Co we are fully independent and deal with all banks and lenders without incentives or commission. We focus on owner managed SMEs and, with an average of 20 years of banking and finance experience among our debt team, we have a track record through all market conditions.

Our specialisation in SME debt means we can help put together a plan for alternative funding to provide you with the strongest set of options in any eventuality. We have relationships with lenders at many levels – from relationship managers to credit heads and board members – so we’re strongly positioned to handle any dialogue around covenant breach.

Looking ahead

Many businesses breach their covenants and, after making a relatively friction-free agreement with their lender, carry on successfully – so why worry?

The first reason is that until you go in to meet your lender to discuss the breach you will not know their approach and, without experience to call on, you will be at a disadvantage if it is anything other than benign. The second reason is that, with economic clouds still gathered and non-bank lenders generally untested by tightening credit markets, responses to covenant breaches may change. In fact, in certain sectors where lenders have taken on high levels of exposure, we are already seeing a stricter approach to covenant breaches. As in all areas of business, preparation is essential.

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