Covenants

What are covenants?

Covenants (in German Kreditauflagen) are contractual obligations of a borrower that go beyond the payment of interest and repayment. They require the borrower to meet certain financial ratios, to take or refrain from certain actions and to inform the lender regularly. Their breach gives the lender contractually defined rights, up to extraordinary termination, even if all instalments have been paid on time. A car lease works in a similar way: anyone who pays the instalments but skips agreed inspections still breaches the contract.

Covenants are found mainly in larger corporate loans, including syndicated loans from several banks, in promissory note loans (Schuldscheindarlehen) and bonds, and in mezzanine capital and venture debt. They are set out in the loan agreement, and for larger financings in a separate section with definitions whose wording decides whether a covenant is met or breached. For lenders they are an early warning system that allows intervention long before a payment is missed. In financing rounds and company sales, investors and acquirers specifically examine existing covenants in due diligence, the detailed review before a contract is concluded.

Types of covenants

Financial ratios (financial covenants)

Financial covenants set limit values for ratios calculated from the annual financial statements or monthly figures. Common ones are:

• Dynamic debt ratio (leverage): net financial debt, that is, financial debt less freely available liquid funds, in relation to the EBITDA of the last twelve months, as an upper limit. EBITDA is earnings before interest, taxes, depreciation and amortisation.
• Interest cover: EBITDA in relation to interest expense, as a lower limit.
• Debt service cover (debt service coverage ratio): available cash flow in relation to interest and repayment, as a lower limit; it measures debt service capacity.
• Equity ratio: balance sheet or economic equity in relation to the balance sheet total, as a lower limit. Banks often count shareholder loans with a subordination agreement (Rangrücktritt) as economic equity, that is, loans that rank behind all other creditors (subordinated liabilities).
• Minimum liquidity: a level of liquid funds that must not be undercut at the testing dates or at any time.

Conduct obligations (general covenants)

Conduct obligations prohibit certain measures or permit them only with the lender's consent. Typical is the negative pledge (Negativerklärung), under which no security may be granted to other creditors. The pari passu clause (Gleichrangerklärung) requires that the lender is not placed in a worse position than other unsecured creditors. Further clauses limit additional borrowing, distributions and the sale of material assets. Change of control clauses give the lender a right of termination if the majority of the shares changes hands.

Reporting obligations (information covenants)

Reporting obligations govern which documents are to be submitted and when: the annual financial statements within a set period after the reporting date, quarterly or monthly figures and the plan for the following year. The management regularly confirms in writing that the financial covenants are met (compliance certificate). Certain events such as major legal disputes must be reported to the lender.

Covenant test: testing dates, definitions and headroom

Financial covenants are measured at fixed testing dates, usually quarterly, half-yearly or annually. Earnings ratios generally refer to the last twelve months in each case, stock figures such as debt or liquidity to the reporting date. Whether the measurement is based on the audited annual financial statements under the German Commercial Code (Handelsgesetzbuch, HGB) or on unaudited monthly figures determines how early a breach is detected.

Definitions often decide whether a covenant is met or breached. The EBITDA in a loan agreement is usually a contractually adjusted EBITDA, in which one-off effects or earnings of acquired companies are taken into account under defined rules. For net financial debt, it has to be clarified whether lease liabilities, shareholder loans or purchase price liabilities are included. Loan agreements often exclude subordinated shareholder loans; in a company purchase, by contrast, they count as financial liabilities. Small differences in the definition can consume the headroom to the limit value entirely.

This distance between the planned value and the limit value (headroom) is the most important point of negotiation. It should cover a realistic deviation from plan. Banks generally set the limit values on the basis of the plan that the company itself submits; an overly ambitious plan therefore leads directly to tight covenants.

Covenant breach: consequences, cure and waiver

Under most loan agreements, a covenant breach is a ground for termination (event of default). The lender can terminate the loan extraordinarily and declare it due, refuse further drawdowns, demand additional security or raise the margin, that is, the interest mark-up. If a large loan is declared due, this can directly endanger the company's ability to pay. If another loan agreement contains a cross-default clause, the breach can trigger rights there too. In practice, termination is rarely immediate; renegotiation is more usual, and its outcome depends on the company's situation:

• Cure period: an agreed period in which a breach can be remedied before legal consequences arise.
• Equity cure: The shareholders contribute equity or subordinated funds, which are counted towards the ratio for the test. Loan agreements limit the number of such cures and often exclude them for consecutive testing dates.
• Waiver: The lender waives its rights for a specific breach, usually in return for a fee, a higher margin or additional conditions.
• Reset: The limit values are redefined for future testing dates, often on the basis of an updated plan.

Under Section 1 of the German Act on the Stabilisation and Restructuring Framework for Businesses (Unternehmensstabilisierungs- und -restrukturierungsgesetz, StaRUG), the management of a GmbH (German limited liability company) is obliged to monitor continuously any developments that could endanger the company's continued existence (early crisis detection). An impending covenant breach with possible termination of larger loans is one of them. It belongs in the conversation with the lender early. Banks generally treat a deviation that has been announced, with a reliable plan, differently from a breach that they learn of only from the compliance certificate.

Covenants in growth companies and venture debt

Classic covenants presuppose a positive EBITDA and a stable cash flow. For young technology companies with start-up losses, ratios such as the debt ratio or interest cover cannot be measured meaningfully. Lenders then fall back on other conditions: a minimum liquidity, a minimum cash runway, revenue targets, caps on monthly cash outflow and monthly reporting obligations.

In the case of venture debt, the debt financing of companies backed by venture capital investors, financial ratios are often less prominent. Lenders rely more on reporting obligations, minimum liquidity and in some cases a clause on material adverse changes (material adverse change). Such a clause is less predictable than a ratio, because its interpretation can be open in a dispute. For the company, a few clearly defined ratios with sufficient headroom can therefore be the better solution.

As a complement to equity, debt financing is viable only if its conditions fit the planning of the next round. If a minimum liquidity requirement bites just before that round, a breach threatens before new capital flows, and the position towards investors suffers.

Worked example: covenant breach on the dynamic debt ratio

A software company has taken out a bank loan of EUR 5 million. The loan agreement requires a dynamic debt ratio of at most 3.0, measured as net financial debt in relation to the EBITDA of the last twelve months and tested at the end of each quarter. An equity cure is permitted once a year; the amount contributed is counted towards net financial debt.

• Test at 30 June: net financial debt EUR 4.2 million, EBITDA EUR 1.6 million; 4.2 ÷ 1.6 = approximately 2.63. The covenant is met.
• Headroom at this point: with the same debt, the limit is reached at an EBITDA of 4.2 ÷ 3.0 = EUR 1.4 million. EBITDA can therefore fall by EUR 0.2 million or 12.5%.
• Test at 30 September: through the build-up of sales, the EBITDA of the last twelve months falls to EUR 1.3 million, net financial debt is EUR 4.1 million; 4.1 ÷ 1.3 = approximately 3.15. The covenant is breached.
• Cure via net financial debt: at most 3.0 × EUR 1.3 million = EUR 3.9 million is permitted. Required contribution: EUR 4.1 million minus EUR 3.9 million = EUR 200,000.
• For comparison, counting towards EBITDA: an EBITDA of 4.1 ÷ 3.0 = approximately EUR 1.367 million would be required, that is, a contribution of approximately EUR 66,700.

The breach arises even though the company is growing and pays every instalment on time. The example also shows why lenders usually exclude or limit counting towards EBITDA. There, every euro contributed works with a factor of 3.0, so that a third of the amount would suffice.

Distinction: covenants, collateral and obligations in a purchase agreement

• Collateral: gives the lender access to assets if the loan defaults. Covenants apply earlier and are meant to prevent this case.
• Conduct obligations in a company purchase agreement: Obligations of the seller between signing and completion of the purchase agreement (signing and closing) are also called covenants. One example is the obligation to continue the business in the ordinary course (ordinary course of business). They have nothing to do with loan covenants.
• Information rights of investors: rights of the shareholders under the participation agreement or shareholders' agreement. They resemble reporting obligations towards lenders, but a breach does not trigger termination of a loan.

Common mistakes

• Too little headroom to the plan. Limit values based on an ambitious plan are breached at the first deviation.
• No ongoing measurement. Anyone who calculates covenants only at the annual financial statements recognises a breach only when it can no longer be averted.
• Decisions not tested against the covenants. A debt-financed acquisition or a new cost structure after a round can shift ratios even though it makes economic sense.
• No cure rule agreed. Without a cure period and cure right, every deviation immediately becomes a ground for termination.
• Breach reported too late. A late notification regularly breaches a reporting obligation itself and strains the bank's trust.

Frequently asked questions

Are covenants also common with smaller loans?

Less so. With working capital loans and smaller investment loans, banks often limit themselves to reporting obligations and the termination rights under their general terms and conditions. The number and level of detail of covenants rise with the volume and risk of the loan.

Can a financing round affect a covenant?

Yes, mainly through conduct obligations. Loan agreements often contain consent requirements for changes to the shareholder structure, new borrowing or security in favour of third parties. The bank's consent is then obtained before the closing of the round, often as a condition precedent in the participation agreement.

What does a waiver cost?

There is no fixed amount. A one-off fee, a higher margin for the remaining term or additional conditions are usual. For a minor breach announced early, lenders usually demand less than for a deterioration without countermeasures.

What happens to covenants when the company is sold?

They usually end when the loan is repaid at closing. The history of their compliance remains relevant nonetheless: it shows the acquirer how reliable the management's planning has been in the past.

The Roemer Capital view

Roemer Capital maps the covenants of existing loans in the financial model as a separate calculation for each testing date, in the base case, the cautious case and the optimistic case. This shows before any major decision whether an investment, a headcount build-up or the use of proceeds of a financing round touches a covenant and how much headroom remains.

Before a financing round, Roemer Capital clarifies with the company which bank consents the round requires and aligns the timetable accordingly. The interpretation of the loan agreements lies with the company's law firm; Roemer Capital supplies the figures on the basis of which the bank is negotiated with on headroom, definitions and cure rights.