8 tips on monitoring financial covenants

How many financial covenants are regularly calculated and monitored across the UK? 10,000? 30,000? 50,000?

The average large corporate banking portfolio may contain between 30 and 60 financial covenants. Mid corporate sized portfolios typically contain a lot more. These financial covenants are monitored by the banks, often by recalculating in Excel or by re-inputting data into in-house systems.

A Private Equity portfolio manager would also have financial covenants on their radar although the monitoring process here is likely to be more forward looking. Financial covenant breaches are ‘Events of Default’ per the facilities agreement so it makes sense for a portfolio manager to keep their eye on future covenant test dates.

What we do know is that across the UK every month literally tens of thousands of financial covenants are being computed, documented, re-communicated, analysed and validated. They are an important aspect of the lending process, particularly for large corporates. In this context we have listed below 8 tips, which may be helpful when setting, calculating or monitoring financial covenants.

1. Accuracy is key – financial covenant testing relies on accurate data, accurate calculation and accurate interpretation of the facilities agreement. Ensure management have signed the compliance certificate confirming the calculation, re-calculate and always confirm the calculation method against the facilities agreement.

2. Monitor the trend – always review the historical covenant headroom trend. Many financial covenants are based on last twelve month (LTM) totals so very often the erosion towards a covenant breach is gradual and foreseeable.

3. Quantify the headroom - Some like to keep an eye on the percentage covenant headroom however this in isolation is not sufficient. For example, what does a 10% buffer mean in terms of actual cash flow? Does this equate to £500k or £50k of cashflow and how vulnerable is the covenant compliance given the current and the expected cash volatility in the business?

4. Test frequently - don’t calculate financial covenants only at their scheduled test date. Calculating these monthly will help to identify adverse covenant compliance trends as early as possible.

5. Perform look-forward testing – Where a financial covenant is based on LTM totals, how will it be affected as earlier monthly values fall away from the computation and are replaced by values that reflect the current run rate. This is a simple check that can help to capture imminent and predictable financial covenant compliance issues.

6. Stay ahead of the curve – It is always easier to negotiate a covenant reset or waiver if this is communicated with the bank ahead of time. Banks have multiple layers of authorisation when dealing with changes to covenant targets, so my recommendation is to allow sufficient time for this process. In some cases, the bank will charge a fee to amend a covenant target however this would never be as costly as an unexpected and poorly communicated covenant breach. It really pays to be one step ahead.

7. Standardise if possible – It is easy to embellish a financial covenant with add-backs and other financial adjustments. This might seem like a good idea because it tailors the computation to the customer’s trading profile but the downside is that the computation becomes more complicated and onerous to monitor and almost impossible to automate. So before you tailor a covenant, consider how valuable your time is and whether a standardised computation could work equally well.

8. If you can’t live with them then try living without them – Our final tip is to challenge the need for any manually monitored covenant. Organisations can now use financial data extracts to automate covenant monitoring. Perhaps all borrowing entities should be tested periodically against a standard set of sector-specific covenant ratios. Automated alerts can inform bankers (and investors) of any issues and the thousands of hours currently spent number crunching could instead be focused on business development or customer service activities.