In the world of corporate finance, bond and loan agreements are typically accompanied by a set of covenants, which are designed to protect the interests of creditors and ensure that debtors maintain their financial health. These covenants typically include financial performance metrics, such as the net debt to EBITDA covenant and the EBITDA to net financing cost covenant, which measure a company's leverage and ability to service its debt. If a debtor violates a covenant, it can trigger a default event, giving creditors the right to accelerate repayment of the debt or even seize collateral.
However, in certain circumstances, debtors may require additional flexibility to manage their financial affairs, and this is where covenant amendments come into play. A covenant amendment is a modification made to the original terms of a bond or loan agreement, which is designed to provide additional flexibility to the debtor. This flexibility may be necessary if the debtor's financial performance has deteriorated, making it difficult to comply with the original covenants, or if the debtor requires additional financing.
Covenant amendments can take various forms, such as changing the calculation or threshold of a covenant, adding or deleting covenants, or resetting the covenant levels for a certain period. For example, a debtor may seek to amend the net debt to EBITDA covenant to exclude certain types of debt, such as debt related to acquisitions or capital expenditures, which would reduce the numerator in the calculation and increase the covenant headroom. Alternatively, a debtor may seek to increase the threshold for the EBITDA to net financing cost covenant, which would require less EBITDA to cover its interest expense.
Covenant amendments can have significant implications for both debtors and creditors. On the one hand, covenant amendments can allow debtors to avoid default and continue operating, which may be in the best interests of both the debtor and the creditors. On the other hand, covenant amendments may reduce the protection afforded to creditors, potentially increasing the risk of default or impairing the value of the debt.
Creditors typically have the right to approve or reject covenant amendments, and their decision may depend on a range of factors, such as the debtor's financial performance, the impact of the amendment on their collateral, and the creditworthiness of the debtor. Creditors may also negotiate additional terms or compensation in exchange for granting the amendment, such as higher interest rates or fees, additional collateral, or enhanced reporting requirements.
In conclusion, covenant amendments are an important tool for debtors to manage their financial affairs and avoid default, but they can also have significant implications for creditors. Understanding the basics of covenant amendments and their potential impact is essential for both debtors and creditors in navigating the complex world of corporate debt.
References:
Altman, E. I., Brady, B., Resti, A., & Sironi, A. (2005). The link between default and recovery rates: Theory, empirical evidence, and implications. Journal of Business, 78(6), 2203-2228.
Crane, D. B., & Michels, J. A. (2014). The Handbook of Loan Syndications and Trading. Oxford University Press.
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About the author
Sabbir Rahman is Managing Director of Langdon Capital. He has held prior roles with Morgan Stanley, Lazard and Barclays Investment Bank. He has executed over £60 billion in notional value of transactions across financing, M&A and derivatives with global corporates, private equity funds and financial sponsor groups.
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