The outcome can be detrimental for both parties, so early communication to avoid such scenarios is key. As a last resort if the borrower is unable to cure defaults, repay dues, or negotiate alternate terms, the lender may force the liquidation of their assets. This involves selling all assets, closing operations, and using the proceeds to repay creditors. By limiting additional debt, the lender can prevent the borrower’s risk profile from increasing excessively during the loan term. Negative covenants limit actions the borrower can take without lender consent, like taking on more debt, paying dividends, or making major asset sales.

Furthermore, the restrictiveness of financial covenants might be related to additional contractual clauses. Therefore, increasing the D/EBITDA multiple by 1× reduces the leverage headroom by 79 basis points (a 1 standard deviation increase results in a 134–basis points reduction in headroom). Our D/EBITDA financial risk variable is larger than the covenant thresholds, both for sponsored and for nonsponsored loans. However, covenants are typically tested for the first time 12 months after loan inception. During this period, the borrower is expected to reduce the outstanding debt and typically increase EBITDA, leading to an expected financial ratio that is considerably below the covenant threshold. In case more than one bank functioned as lead arranger, the highest among these values is selected.

Depending on the risk assessment and the borrower’s financial and operational position, lenders may include one or more of these covenants in loan agreements. A covenant is a promise in any formal debt agreement, that certain activities will or will not be carried out or that certain thresholds will be met. Covenants in finance most often relate to terms in a financial contract, such as a loan document or bond issue stating the limits at which the borrower can further lend. Covenants are often put in place by lenders to protect themselves from borrowers defaulting on their obligations. A financial covenant refers to certain conditions a borrower must fulfill throughout the loan term to prove their continued creditworthiness to the lender.

  1. Panel A focuses on the sponsored loans and Panel B reports the nonsponsored benchmark.
  2. Understanding covenants is crucial when entering into agreements, whether in finance, real estate, contracts, or religious contexts.
  3. The second type of financial covenants is “incurrence” covenants, which are tested only if the borrower takes a specific action (i.e. a “triggering” event).
  4. Here, Tim goes into further detail by outlining typical triggers, consequences and specific types.
  5. Our analysis requires the measurement of lender-specific financial shocks that are independent of borrower fundamentals and that allow us to disentangle the capital channel from the learning channel.
  6. Lenders often impose a maximum D/E ratio as a restrictive covenant to ensure the borrower does not take on excessive debt that could jeopardize its ability to repay the loan.

By understanding the role of debt covenants, borrowers can better manage their financial obligations and achieve their business goals. Specifically, the number of covenant-relief transactions in 2020 is 193—up from 186 in 2009, following the Great Recession. During the 2020 recession, for example, there was an increase in the number of leveraged loan borrowers in violation of their covenant requirements.

What is the Definition of Covenants?

Hence, we are not able to formally test the conjecture that sponsored loans may include more but less restrictive covenants than nonsponsored loans. However, the rich nature of our proprietary LBO data set will allow us in the next section to provide an in-depth examination of the covenant restrictiveness for sponsored loans. We will be able to precisely determine the magnitude of covenant restrictiveness and thereby to test our competing arguments of the impact of information asymmetry costs and financial risk on covenant restrictiveness. Financial covenants are the promises or agreements entered into by a borrowing party that are financial in nature. Covenants require borrowers to comply with the terms agreed upon in the loan agreement.

Negative covenants are put in place to make borrowers refrain from certain actions that could result in the deterioration of their credit standing and ability to repay existing debt. The most common forms of negative covenants are financial ratios that a borrower must maintain as of the date of the financial statements. When a debtor borrows money from a creditor, the loan terms are expressly outlined in a legal document called a credit agreement or a loan contract. The specific loan terms you may find in a credit agreement include the loan amount, the interest rate, the repayment schedule, and (usually) a lengthy list of loan covenants.

Disadvantages of Financial Covenants

This includes having the resources and systems to comply with the covenant successfully. Read the loan terms carefully to understand the requirements and obligations placed upon them from the covenant. It’s crucial that borrowers carefully read their loan agreement and negotiate points of contention with the lender. This limits the risk that the borrower’s risky financial practices do not impede their ability to repay the loan. The loan agreement may specify the type and value of collateral required and how it should be maintained.

What Is an Example of Covenants in Real Estate?

Borrowers should understand the terms of these covenants to manage their obligations under the loan agreement and secure financing. Failure to comply can have serious consequences, like a loan acceleration or legal action. Examples of positive covenants include maintaining certain insurance policies or agreeing to on-site inspections by engineers and consultants. Negative covenants can restrict the borrower from incurring additional debt, offering financial assistance to another party, or engaging in business activities that are not considered characteristic of the business.

What are non-financial covenants?

A bond issuer that violates a bond covenant often suffers from a downgrade in the bond’s rating, which adversely affects their ability to borrow. “Venture debt is primarily underwritten to the quality and reputation of the investors while an operating line of credit is underwritten to the fundamentals of the business,” says Alida. However, venture debt does come with warrants to mitigate the risk to the lender, typically making it more expensive than an operating line of credit. A liquidity to cash burn covenant is a type of liquidity covenant that tracks the cash runway of a pre-profit company.

For property, failure to comply with association rules or covenants may result in fines or liens. Though an HOA cannot force a homeowner to sell their home, other types of property covenants may call for liquidation or transfer of ownership. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. The implications tend to be limited unless other defaults happen – the lender may charge extra fees or increase the interest rate. Please note the information provided here is general in nature and does not constitute financial, tax or other professional advice.

We do not expect a similar increase in capital covenants, however, since they primarily operate via ex ante incentive alignment and because they limit the scope for ex post lender intervention. In fact, the number of capital covenants can decrease if lenders replace them with performance covenants. An affirmative or positive covenant is a clause in a loan contract that requires a borrower to perform specific actions. Interestingly, specification types of financial covenants (1) in Table IX shows that the size of the firm does not have a significant impact on financial covenant restrictiveness. One explanation might be that potential lenders in the credit market are more concerned with the reputation of the sponsor than with the target, implicitly transferring the sponsor-related reputation to the borrowing firm. Removing the size of the PE group does not alter the coefficients and t values of the size variables.

But we would not know whether this tight covenant is the result of a poor performance of firm B or a tight covenant setting at loan origination, or both. A further concern with the actual slack as a measure for restrictiveness is that the definition of the input variables for the covenant and the actual realized ratio may vary. To minimize these inaccuracies, most studies that calculate the actual slack use net worth and current ratio covenants that have relatively few adjustments (see Dichev and Skinner, 2002). Comparing D/EBITDA slack across different deals might introduce measurement errors since the definition of the input parameters (i.e., debt and EBITDA) may vary across deals (Lawler, 2007). To test for the existence of the capital channel, we rerun the analyses above using non-corporate loan delinquencies to measure lender-specific shocks. Recall that non-corporate loan delinquencies deplete capital but carry no information about lenders’ ability to screen corporate borrowers.