When Good Companies Go Bad

 

"Well, you look nervous. Is it the scars? You want to know how I got 'em?"

A reader writes:  "I keep hearing about private equity owned companies that have breached their bank covenants.  What does this really mean in practice?"

First, some background.  When a private equity firm buys a company it funds the purchase with capital called from its limited partners (equity) and cash borrowed from a bank or syndicate of banks (debt).  As part of the banking facility the portfolio company makes a set of promises or commitments to the lender-- these are the covenants.

Bank covenants contain specific obligations, such as a commitment to recruit a new CEO by a certain date, as well as a set of quarterly financial targets.  The bank carefully monitors these financial targets to ensure that the business is performing as expected and, most importantly, to warn the bank if the risk profile of the loan is changing.   

Two of the most common financial covenants are:

Debt Service Coverage Ratio (DSCR):  which measures the amount of cash flow available to meet interest and principal payments.  If your DSCR is less than 1 then the business isn't generating enough cash to meet its debt repayments.

Leverage Ratio or Net Debt/EBITDA:  this measure gives banks a theoretical pay-back period on a loan.  In the current environment they would prefer to see this ratio sitting below 4x.

So, what happens when the bank gets a quarterly report (usually called a certificate) and learns that the business has breached its covenants?

The short answer is, it depends.  The best outcome is that the bank just sends a letter of non-waiver.  This "slap on the wrist" is a letter stating that the bank has decided not to take any action but retains its legal rights.   You'll probably get this gentle treatment if:

• The bank believes that the breach was caused by a one-off hiccup.  In other words there has been no change in the risk profile of the loan despite the underperformance.  Examples are a breach caused by a customer failing to pay a bill or a short term COGS blow out due to sudden fx movements.
• Until now, the company has a history of consistently performing to plan.  If this is your fifth breach then you're probably going to get a very different kind of letter.
• It's a small breach and you've met all the other covenants.
• Your covenants were set at a conservative level so a minor breach doesn't constitute much of a risk.  At the height of the equity boom LBO firms were able to demand very generous covenant levels.  By the time one of these portfolio companies breaches a covenant it may well be in severe financial distress, so the banks are now taking every opportunity to renegotiate these measures back down to more conservative levels.  This change reduces the risk profile of the loan by allowing the bank to take early action.
• Management has built a strong relationship with the bank lending team and has always shared information promptly.  Examples of good practice in this area include regular update meetings, briefings on changes in strategy, and drunken dinners at expensive restaurants.

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Next Post:  Performance at the portfolio company continues to slip.  It has now breached covenants three quarters straight . . . what happens next?

Comments

[nkalakatha]

Don't forget about interest cover ratio (ICR) as the other very common financial covenant ratio. Asset-backed facilities often have orderly liquidation value or liquid asset ratio covenants as well.

Worth noting that covenants are usually calculated on a last 12 months' basis, so a poor EBITDA month stays on the books for the following year!

Also, it is important to know that things like blowouts in working capital can screw up your DSCR calculations since the change in WC is usually added to/subtracted from the cashflow available for debt servicing.