Understanding the Terms and Covenants in a Credit Facility Lending Agreement
A credit facility is a loan agreement with a bank or other financial institution that governs the terms under which a business can borrow funds. The terms of a credit facility are detailed in a credit agreement. These terms include the loan structure, the nature of security and guarantees, the maturity date, optional and mandatory prepayment requirements, loan pricing, affirmative and negative covenants, financial covenants, prepayment penalties, and default provisions, among others.
A credit facility provides companies with capital to fund day-to-day operations, long-term investments, as well as new growth opportunities. When managed properly, corporate debt offers executives and business owners lower capital costs, significant tax benefits, and the ability to maintain ownership control. When managed poorly, covenants, interest and agency costs, and default-related risks and expenses can be a significant distraction for management and can negatively impact a company’s valuation and long-term prospects.
Given the importance of corporate debt, the terms associated with a credit facility are critically important for the CEO, CFO and other key stakeholders to understand. These terms are heavily negotiated during the drafting of the credit agreement and any time there is an amendment or restatement of the credit agreement. An experienced financial advisor like Keene Advisors can help you to understand the key terms that will impact your business and negotiate the best possible terms for your credit agreement.
Corporate Debt, A Lenders Perspective
Before discussing the specific terms in a credit facility, it is helpful to understand the mind-set and economics of a typical lender. Lenders include traditional commercial and investment banks, collateralized loan obligations (CLOs), business development corporations (BDCs), credit hedge funds, and other institutional investors. These lenders generate returns by charging interest on a loan and through fees paid by the borrowers. Loans are priced to reflect the perceived riskiness of the borrower. Higher risk borrowers pay higher rates interest and greater fees and will also have more stringent loan covenants compared to lower risk borrowers to compensate for the increased risk for the lender.
When a borrower defaults on a loan, lenders experience losses – either through lost interest, a reduction in loan principal, or a mark-to-market adjustment on the loan. According to S&P Global, between March 2017 and March 2022, lenders of North American first lien debt, which is the lowest risk debt in a company’s capital structure, experienced losses with recoveries varying between 62-71% of the original principal amount. Since lenders depend on minimizing losses in order to generate strong returns for their investors, lenders are intensely focused on the terms of the credit agreement including the financial covenants. These terms help minimize the risk of losses over the life of the credit facility.
There are generally two types of risk that lenders are focused on when evaluating a borrower: credit risk and interest rate risk.
Credit Risk
One of the primary concerns for lenders providing corporate debt is managing credit risk - the possibility that the borrower may fail to meet their repayment obligations. Macro trends in defaults tend to follow broader economic cycles, with defaults becoming more common during economic downturns, however individual company circumstances and specific industry dynamics also play an important role.
*Total defaults includes companies that were no longer rated at the time of default. Sources: S&P Global Ratings Credit Research & Insights and S&P Global Market Intelligence's CreditPro®
In general, highly leveraged companies are much more likely to default than lower leveraged companies. The graphic below shows cumulative default rates by S&P’s credit rating. Companies rated CCC/C are the highest leveraged / highest risk borrowers and AAA are rated as the lowest risk borrowers. In addition, the risk of default for all borrowers increases over time so lenders typically prefer shorter duration loans.
Sources: S&P Global Ratings Credit Research & Insights. S&P Global Market Intelligence's CreditPro®.
Before making an offer to underwrite a credit facility, lenders conduct a thorough assessment to evaluate both the current and future credit risk posed by the borrower. This diligence process directly influences the structure, covenants, and pricing of the loan offer. Various factors, both within and outside of the company's control, can impact their credit risk, and lenders will account for these dynamics.
Some of those include:
Historical and Projected Financial Performance: Lenders are more likely to extend favorable credit terms to companies with a history of strong financial performance. A consistent track record of increasing revenues, controlled expenses, and growing profit margins signal a company’s ability to meet its debt obligations, reducing the lender's exposure to risk.
Leverage: Companies with high levels of existing debt are considered more risky borrowers. Lenders recognize that highly leveraged companies may struggle to service additional debt, especially in periods of earnings volatility or if they face unexpected financial pressure.
Concentration of Key Customers / Suppliers: Lenders prefer to see a large, diverse customer and supplier base as it reduces dependency on any single customer or vendor. When a company relies heavily on a few key customers or vendors, the financial impact of losing one of them could have an outsized negative impact on the financial stability of the borrower.
Economic Cycle: External factors, such as economic recessions or industry-specific disruptions, pose additional risks to a company's ability to repay its debts. Though beyond the company’s control, these factors can weaken earnings and overall financial performance, heightening the risk for lenders.
Interest Rate Risk
Interest rates fluctuate regularly. Many corporate loans, including many credit facilities, are tied to a variable interest rate, often using the Secured Overnight Financing Rate (SOFR) as the benchmark rate.
Declining rates: In a declining rate environment, a lender's interest income decreases, which can compress profit margins. To mitigate this risk, lenders may implement an interest rate "floor," so that the rate does not fall below a certain threshold, ensuring their interest payments don’t drop too low.
Increasing rates: Conversely, in a rising interest rate environment, the lender might benefit from increased interest payments. However, this scenario can put financial pressure on borrowers, as the increased interest expense makes it more difficult to service their debt. Lenders must carefully assess the borrower's ability to manage this potential rise in costs when structuring the loan.
Additional Risks to Lenders
While credit and interest rate risks are generally the most apparent, lenders also face uncertainty with unforeseen regulatory changes, potential legal risks, and unexpected management changes.
Understanding these risks helps borrowers discern the terms and loan covenants proposed by the lender on their credit agreement and may ultimately aid in negotiations.
Terms of a Credit Agreement
When a lender decides to extend a credit offer to a borrower, the specifics of the offer are typically outlined in a term sheet and then are formally documented in a credit agreement. These terms can often be negotiated by the company or by a trusted financial advisor acting as an intermediary. Key terms typically include the following:
Lender Role
Depending on the size of the credit facility, a lender may propose to act as the sole lender, lead lender, or as a participant in a multi-bank or syndicated facility. In a syndicated facility, multiple lenders collaborate on a loan offering. The lead lender, typically makes the largest commitment and maintains the largest hold position in the loan after closing.
Other titles include:
Administrative agent - handles all interest and principal payments and monitors the loan
Syndication agent - leads the syndication of the loan
Documentation agent - handles the documentation (credit agreement, intercreditor, etc.)
Lead arranger or Bookrunner - a title used by banks for marketing purposes and in the preparation of industry “league tables”
Commitment / Hold Amount
The lender will propose the maximum amount of capital they are willing to commit and hold over the life of the facility. For example, if a company is seeking a $150 million credit facility, a lender may commit to and hold $80 million as the lead lender. The remaining $70 million would need to be raised through other lending commitments, which can be facilitated by the company, a trusted financial advisor acting as the company’s intermediary, or the lead lender acting as an arranger.
Loan Structure
Another term in a credit facility is the proposed loan structure. Depending on the company’s liquidity needs, various structures can be proposed, each with unique functionalities. These may include a revolving line of credit, a first/second lien term loan, a unitranche facility, a multicurrency line, a delayed-draw term loan, among others.
Loan Pricing
Loan pricing is one of the most critical terms in a credit agreement. It refers to the interest rate, variable or fixed, that a lender will charge the borrower. Often, lenders will propose pricing tiers based on the borrower’s leverage ratios. A lower leverage ratio typically results in lower credit risk and more favorable pricing, while higher leverage ratios lead to higher costs. Companies should compare the proposed pricing tiers to their financial projections to understand the full cost implications and the impact on liquidity and credit metrics.
For variable-rate debt, pricing is often quoted as basis points (bps) margin over SOFR.
Fees
Lenders include various fees as part of the credit agreement. These can include arrangement and administrative fees for the lead lender, as well as upfront fees to establish the facility. Additional fees may apply for ongoing maintenance as well as undrawn fees for capital that has been committed to the facility but not used by the borrower. Some common fees include:
Arranger fee – a fee paid by the borrower to the arrangers in a syndicated loan. The fee is compensation to the arranger(s) for organizing the participants in a syndicated loan
Upfront fee – a fee paid by the borrower to all loan participants. The upfront fee is typically tied to the commitment amount for each loan participant, or it can be tiered, with the lead arranger receiving a larger allocation
Commitment fee - a fee paid to lenders on undrawn amounts under a revolving credit or a term loan prior to draw-down
Administrative agent fee – an annual fee typically paid by the borrower to the administrative agent as compensation for administering the loan
Collateral monitoring fee – an annual fee paid to the administrative agent in some secured credit facilities / asset-based loans to ensure that collateral is in place to support the loan
Prepayment fee – a fee paid on loan principal that is prepaid before the scheduled amortization / maturity date. The fee may be applied to all repayments under a loan, including from asset sales and excess cash flow or specifically to discretionary payments made from a refinancing or out of cash on hand
Amendment fee – fees charged when a borrower needs to undergo an amendment. These fees are negotiated with the lender at the time of the amendment and can vary based on the scope of the amendment required
Ensuring the right-sized credit facility is important for effectively managing these fees.
Collateral and Guarantees
For most middle market corporate loans (particularly unrated or sub-investment grade borrowers), lenders require collateral to secure the loan. This collateral typically includes all current and future tangible and intangible assets of the borrower. In some cases, loans can secure specific assets. All current subsidiaries typically guarantee the loan as well.
Maturity Date
The proposed maturity date specifies when the loan must be repaid in full. Most often, companies refinance their loan rather than repay it in its entirety. Some loans will also include amortization provisions that require the borrower to repay a specified amount during negotiated intervals.
Mandatory Repayments
Loans typically require a borrower to use a portion of excess cash flow, proceeds from the sale of assets, and proceeds from the issuance of debt or equity to reduce outstanding indebtedness. This is to de-risk the loan over time. The amount of the repayment is often tied to the financial profile of the borrower and can be subject to a leverage.
Change of Control
A change of control, which involves the sale of the borrower’s assets, a merger, or meaningful change in ownership or in the composition of the Board of Directors, is typically an event of default under the credit agreement that requires the loan to repaid in full. Lenders do not want to see significant changes in ownership or the Board of Directors once they have underwritten and priced a credit facility. It is possible to amend a loan to permit a change of control transaction without requiring the repayment of the loan, but this gives lenders an opportunity to reprice the loan.
Loan Covenants of a Credit Agreement
While the terms of a credit facility define its overall structure and pricing, the loan covenants outline specific operational and financial metrics that the borrower must adhere to in order to remain in compliance with the loan agreement. These covenants are designed to safeguard the lender by ensuring the borrower maintains a certain level of financial health and operational discipline.
There are three main types of lending covenants: affirmative, negative, and financial.
Affirmative Covenants: Affirmative covenants require the borrower to meet certain operational obligations to remain in compliance with the lending agreement. These are typically routine requirements, such as paying interest and fees on time, providing audited financial statements, ensuring that taxes are paid and insurance is maintained. Affirmative covenants ensure transparency, and that the borrower maintains basic operational standards necessary to uphold the loan agreement.
Negative Covenants: Negative covenants impose restrictions on a borrower’s operational activities that could increase the lender’s risk. These covenants are often tailored to the borrower’s situation and may disallow or restrict certain actions during the life of the loan such as: issuing new debt, making acquisitions, and/or paying dividends.
The goal is to prevent the borrower from taking actions that could negatively impact their ability to repay the loan or materially increase the lender's credit risk. Sometimes, the lender may allow the borrower to pursue certain actions with limitations. For example, a growing company with low leverage might seek to acquire a smaller competitor using debt financing. The credit facility may permit this through a delayed-draw term loan, but a negative covenant might cap the acquisition size to mitigate risk for the lender.
Financial Covenants: Financial covenants are designed to ensure that a company maintains financial stability and minimizes the risk of default. Credit facilities typically have “maintenance” covenants that require the borrower to maintain credit metrics that are better than or equal to amounts that are agreed when the credit facility is established. Some credit agreements have “incurrence” covenants which permit greater flexibility but prevent a borrower from incurring any additional debt unless credit metrics are better than or equal to amounts that are agreed when the credit agreement is established (these are so called “covenant-lite” loans). While covenants vary by industry and company, they generally fall into the categories of leverage or liquidity.
Examples of Maintenance & Incurrence Covenants
Leverage: Leverage covenants limit the amount of debt a company can assume. Lenders will be particularly sensitive to the subordination level of any new debt and may limit debt that is senior to the credit facility. Leverage ratios, such as Total/Senior Net or Total/Senior Gross Leverage, or Total Debt / EBITDA, allow debt levels to grow in proportion to earnings but keep debt within manageable limits.
Cash Flow Coverage: Lenders want to ensure that the borrower generates enough cash flow to meet its debt obligations. Covenants related to cash flow coverage often include minimum thresholds, such as a fixed-charge coverage ratio (FCCR), or ratios of cash flow to earnings, demonstrating the borrower’s ability to continue making interest and principal payments.
Other Ratios: Other financial covenants may be written to ensure the company maintains adequate short-term liquidity, such as the current or quick ratio, or preserving a certain level of tangible-net-worth (TNW).
Defining Adjusted EBITDA
A critical negotiation point for both borrowers and lenders is the definition of Adjusted EBITDA. Adjusted EBITDA is earnings before interest, taxes, depreciation and amortization and one-time or non-recurring items. These one-time or non-recurring items are subject to caps that are negotiated in advance. EBITDA addbacks have played an increasingly important role across leveraged finance deals, including within the negotiated terms of credit facility lending agreements. EBITDA addbacks have played an increasingly important role across leveraged finance deals, including within the negotiated terms of credit facility lending agreements.
Source: S&P Global Ratings, Leveraged Finance: Adding Up EBITDA Addback Study
Example of Financial Covenant:
To illustrate how financial covenants work in practice, let's consider a company with the following financials:
This business is growing revenue year-over-year with fixed charges that include interest payments, principal owed on debt outstanding, and dividend payments.
A common financial covenant for a credit facility is that the company must maintain a minimum Fixed Charge Coverage Ratio (FCCR). The FCCR estimates the ability of a company to repay its ongoing financial obligations. A FCCR of 1.0x shows that the company can just meet its obligations with cash generated from operations. The higher a company’s FCCR, the more “coverage” it has to repay obligations.
In this example, let’s assume that in the credit agreement, there is a covenant in the credit facility that the FCCR must be greater than 1.50x. To calculate the company’s FCCR, we subtract cash expenditures from EBITDA then divide that result by the company’s fixed charges
This company has a FCCR of around 2.0x and would meet their credit agreement covenant of a minimum of 1.50x. Companies want to be above their FCCR threshold and all covenants as violating a covenant in a credit agreement can be very problematic.
What Happens in a Covenant Violation?
Covenants are contractual obligations, so violating a covenant represents a breach of a legal contract, and the borrower is in “technical default.” The consequences of a breach depend on the previously agreed terms, the severity of the violation, and the lender's discretion. Some lenders may waive certain covenant violations, while others may take more serious action against the borrower.
Equity Cures
An equity cure is a provision that allows the borrower to issue equity to provide temporary covenant relief. The equity is counted as EBITDA for purposes of calculating a covenant. The number of equity cures allowed in a credit agreement is heavily negotiated by both borrowers and lenders.
For Best Results, Work with a Financial Advisor
Our team at Keene Advisors provides clients with the confidence of knowing that every term and loan covenant in the credit agreement will be negotiated with your best interest in mind. We also help to project the impact of financial covenants and negotiate for maximum operating flexibility.
Our team is experienced in advising companies on a wide range of leveraged finance transactions and corporate finance matters. We have advised clients in connection with over $20 billion of financing commitments and corporate debt capital-raising transactions. We have helped clients fund organic growth, issue dividends to shareholders, buyout existing shareholders, refinance existing debt, and make strategic acquisitions. In addition, our team has advised clients on credit agreement amendments, operational and balance sheet restructurings, and a range of bankruptcy-related matters.
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