Covenants may become THE story in 2009

Bankers’ Covenants .....You will only find three references to it on the BBC news website archive and it is not a phrase that normally sets the pulses racing, but I suggest that we will be hearing much more about bankers covenants in the coming weeks and months - so bear with the technical stuff - this really does matter!

In basic terms, a covenant is a clause in a loan agreement which has been included by the lender (such as a bank) as a form of protection or insurance. Covenants spell out what the borrower may do and must do in order to satisfy the terms of the loan. For example a covenant might specify that a business must maintain minimum levels of cash flow or stick to maximum levels of leverage (borrowing to you and me) and capital expenditure. Borrowers may also be required to issue reports to bondholders on certain dates.

Once these insurance policies are in place there are penalties for companies that run into difficulties and breach the terms of the covenants. The result can be that businesses are forced to renegotiate their loan covenants and restructure their debts, the downside being the costs of fees for doing so allied to the probability of higher interest rates because of the enhanced risk of loan defaults in the future.

Pulling the plug

In a worst case scenario the lenders simply pull the plug, refuse to renegotiate and call in the loans - at this point business failure is often only a short distance away. Banks then resort to fire-sales of their secured assets.

We are now starting to see a growing number of companies across Europe and notably in the UK being forced back to their lenders because of falling demand, profits, weakening cash flow and problems in meeting the interest payments on existing debts. Companies under particularly strong pressure at the moment include the airlines, commercial property businesses hit by a collapse in the market value of buildings and also construction firms.

Bovis in trouble?

One example is a well known UK house builder Bovis Homes which, according to the Financial Times has “renegotiated its £220 million banking facility with six lenders earlier than expected. The British house builder has relaxed the covenants on its reduced debt deal but will have to pay a higher interest rate. Bovis banks comprise Barclays, HSBC, Royal Bank of Scotland, Bank of Ireland, Intesa and WestLB.”

Businesses in distress must move quickly to lower the risk of breaching bankers’ covenants - the key is to reduce the amount of debt on their balance sheets.

The usual measures include scaling back capital spending, selling off non core parts of the business, making large-scale redundancies (although this too can be expensive in the short term) and aggressive price discounts to boost sales and generate a stronger cash flow. This is easier said than done especially in the property market when buyers for both residential and commercial property remain noticeable by their absence.

Updates on the bankers covenants story

Daily Sport publisher breaches banking covenant
Corporate Britain faces £110bn debt time bomb