Covenants: Keep It Simple!
We get quite a bit of push back when we talk to community-based financial institutions about why they don’t use covenants. Their reasoning is sound; they do not want to give their customers that “big bank” feel. We get it, but that doesn’t mean covenants should be ignored when they can be helpful.
First, let’s focus on the purpose of covenants. Covenants are used primarily to set expectations between the borrower and the financial institution. The financial institution and the borrower have the same incentive to improve (or at least maintain) the financial health of the borrower, especially when it comes to weathering a slowdown in the borrower’s business or general economy. In addition, covenants can provide additional leverage for a financial institution in the management of a commercial loan relationship.
When it comes to covenants, a good place to start is in developing and following an overall philosophy on when and how to implement covenants. We always say: keep it simple and focus on what you’re trying to protect. Debt service coverage covenants set expectations and protect cash flow, while liquidity or leverage covenants focus on the borrower’s balance sheet. You may want to include covenants on more complex loan relationships, or with relationships which carry higher than average credit risk in terms of credit exposure or industry or with borrowers that have had ups and downs in the past. Often, one covenant can protect multiple items. For example, protecting the balance sheet and cash flow can often effectively be done by including distributions in the cash flow covenant definition.
Next, clearly defining covenants is important to eliminate any confusion between the financial institution and the borrower. The covenant should be explicitly and consistently defined in the approval document and in the loan documentation.
Tracking and testing a covenant is where the rubber meets the road. Required covenant tests should be included on your tickler list. Covenant tests should also be performed within a reasonable period of time upon receipt of the information needed to perform the test. In cases where the information necessary to test the covenant are on extension, obtain a company-prepared financial statement to perform a preliminary test, and finalize the test upon receipt of the final information.
Finally, communicating the test result to the borrower and taking appropriate action is the enforcement side of effective covenant implementation. A covenant successfully met by the borrower should be clearly documented in the file and credit presentation. A covenant default should be addressed immediately by the financial institution, with an approved internal course of action and communication with the borrower. You’ll need to take official action, which can be as simple as approving and providing a covenant waiver to your borrower with a re-set for the current period. In some cases, it could include anything from a monetary penalty (fee income) or, in a worse case situation, declaring default. Regardless of pass or fail, covenants create an opportunity to connect with your borrower and document the file.
- Keep it simple: Focus on what you’re trying to protect.
- Clearly define the covenant: Anyone, including the borrower, should be able to read the definition and understand how to test the covenant.
- Train your borrower to test the covenant: Include this as a requirement that the borrower provides in conjunction with the financial statements. This improves the borrower’s understanding of the covenant and reduces administrative burden of the financial institution. Of course, the financial institution needs to check the math, but the heavy lifting should be done by the borrower.
- Track covenants on a tickler list.
- Communicate results to the borrower.
Covenants should not be considered tools that only big banks use. Without much effort, they can be used to help the borrower set expectations and maintain or improve financial wherewithal to improve the overall financial health of the borrower, which could come in handy in the next downturn.
Peter Nugent is Director and founder of Enlighten Financial, a specialized consulting firm that focuses on providing loan review and risk management services to community banks and credit unions. Peter guides the company’s service offerings, which include in-depth loan reviews, commercial and personal underwriting/analysis, internal process improvement and workout services. To talk to Peter directly, please call: (920) 354-6797.