In one of the sessions with business management students of a leading university – I was asked the importance of credit covenants in sanction letters. This is reminiscent of the confrontations between the business and credit teams on the sufficiency of covenants and the margin of safety to be maintained in each covenant. Let’s debate and deliberate.
Two financial covenants are normally sufficient !
Qualitative covenants can be around maintaining certain shareholding patterns, equity infusion timelines, management control, investment in unrelated activities etc. Non-financial covenants are more judgmental in nature and can manifest in various forms such ‘Events of Default’, material adverse clauses etc. The duplication of covenants can be avoided.
The rest of the section of this article will concentrate on applicability of financial covenants.
Typically, if the sanction letter has multiple financial covenants (more than 2), at the time of breach when business of the borrower gets stressed, mostly all of the covenants start appearing in the exception reports. This makes the job of the stat auditors and regulators easy, since they get so much matter to fill in their reports.
One has to keep in mind that ratios tend be inter-linked and it is sufficient to have maximum of two credit covenants; one does not become a better banker by stipulating multiple covenants. Two covenants are sufficient to trigger any recourse against the borrower. One becomes a better banker when the recourse is triggered much ahead of breach of covenants through better early warning signals and de-risking strategies.
Second, the margin of safety should not be thin, for example, if the existing leverage (TOL/TNW) of the company is 0.50x, one should examine if the company can sustain leverage of say upto 2.0x to have sustainable operations (DSCR being comfortable). Stipulating credit covenant of 0.75x does not give enough head room to the company to borrow- after all the promoter would like to grow the business – that’s in his or her DNA, which is also good for the bank as it gives additional business to the bank. Strangulating the borrower with fine safety margins is like shooting oneself in the foot. This also makes the exception reports fatter and also leaves little margin of safety for credit and relationship managers during audits.
The choice of financial covenants can also change with the nature business of the company, say, for a trading company which barely has fixed assets – having fixed assets turnover ratio would be silly. These companies only manage working capital at thin margins; hence ratios of leverage and current ratio (or any other ratio on working capital management would be sufficient). Even a ratio on profitability may not be suitable since the margins tend to be thin by the very nature of business.
In the case of manufacturing companies, the businesses can be varied – asset light business model for job working business and bulky fixed asset model like steel and pharma companies. In case of heavy dependence on term loans, ratios on debt service coverage can be stipulated along with leverage, however the combination can change. While in case of infrastructure financing, there are barely working capital requirements, hence any ratio on working capital many not be necessary.
Last but not the least, if the company is generating free cash flows and has low leverage, one may consider not stipulating any covenant, or may be only one ratio as covenant. These are judgmental aspects and there cannot be straight jacketed approach to credit covenants.
Invariably for better rated companies, the credit covenants get negotiated post the sanction letter, since all banks are vying for good business which is scarce. Then why not get it first time right !
Sumit Kakkar is a seasoned Banker with more than 24 years of experience in Credit and Risk functions. He has worked with leading banks including HDFC Bank, Yes Bank, Deutsche and last served as a Chief Credit Officer with Federal Bank.
Disclaimer: The opinions expressed here are those of the author and does not reflect the views of FrankBanker.com