In today's competitive lending market, as well as
competing on price, lenders must show flexibility when negotiating
There is a natural tension between what borrowers and
lenders both want. Borrowers want flexible and loose financial
covenants while lenders aim for restrictive and watertight terms.
The outcome is that negotiations often end in a
Successfully negotiating financial covenants often requires some
thinking "outside the box" to find a solution that meets
the interests of both lender and borrower.
In the financial covenant provisions, a borrower covenants with
the lender to maintain a certain ratio between obligations under
the loan and key figures derived from financial data such as the
borrower's balance sheet.
Common financial ratios include the LVR which measures the ratio
between the loan amount to the value of the financed asset and the
ICR, which reflects how many times the income of the borrower can
cover the interest expenses during a certain period.
So, what can be done if there is a stalemate? Here are five
quick tips to break a deadlock.
Firstly, the parties should be clear about the most suitable
financial covenant to cover the specific credit risk of the
borrower. While a strict ICR may be suitable for an investor who
deals with established properties, it is most likely not suitable
for a property developer who might have extended periods of no or
very low cash-flow.
If the lender must insist on using a certain ratio, the
solution may be as simple as testing the ICR only yearly instead of
quarterly thus giving the borrower sufficient time to improve its
Borrowers often push back on restrictive covenants because they
fear the harsh consequences of a default. However, a restrictive
covenant which at first glance seems harsh, may be acceptable if
its breach "only" results in the requirement to provide
cash collateral. In this way, the cash-flow risk for the lender is
managed while the borrower has certainty that the funds provided
under the loan remain available.
The parties could also agree on a honeymoon period during which
certain covenants can be breached or on a so-called
"Mulligan" clause – a provision according to which
only the second (or third) consecutive breach of a financial
covenant bears consequences.
Finally, modifying some financial covenants such as referring
to EBIT instead of EBITDA when calculating the ICR or referring to
debt service (which includes fees) instead of interest might do the
trick to avoid a stalemate and lead to a satisfying outcome of the
negotiations for both parties.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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