The truth about loan covenants

When it comes to commercial lending, loan covenants don't have to be scary. Yet many midsized business owners have come to fear how their bank might react to adverse conditions.

As a commercial banking leader in Chicago for the last 25 years with a No. 1 lender to middlemarket companies in the nation, our goal is to demystify loan covenants for clients and recast their punitive stigma with an impression as helpful tool that protects the interests of your business and your bank.

Understanding the methodology banks use to set covenants and covenants' value to your business, should remove some of the angst.

It's true: Strategic loan covenants protect the lender's position and improve the likelihood that the borrower will pay back on time and in full. However, covenants also serve as useful triggers for the business itself. Setting covenants that activate before financial trouble begins will prompt crucial conversations long before the possibility of recovery action by the lender.

Also, recognize that no one does well if a bank has to exercise its rights and remedies under the loan agreement. It's in the best interest of both parties that option-exploring conversations happen sooner than later. More time means more options.

Covenants 101

Financial loan covenants measure alignment of business performance with loan projections provided by the business owner, chief financial officer, or management. Typically, companies considered higher risk will have more restrictive covenants. Companies considered lower risk will have fewer, less restrictive covenants.

Banks determine risk using a number of factors, including cash flow ability, collateral and its relative liquidity, and your business outlook. Historical performance - especially through down cycles - is also an important criteria.

For some, the methodology banks use to determine loan covenants and advanced rates against collateral can be perplexing.

For instance, I'm often asked why banks use a partial percentage rather than 100 percent when determining the value of the company's collateral for lending purposes.

The easy answer is that this allows a built-in flexibility if the business needs additional cash in the future. Banks can then lend more money, restructure loan terms at a later date, or become more helpful in an event driven scenario.

Lending at 100 cents on the dollar leaves no margin for error and does not provide for costs associated with liquidating the collateral in a worst case. Think about it. The business is likely not to get the best value for a sale of its assets if it has to sell or act under duress.

The same applies to covenants. Banks will not set dollar-for-dollar or one-to-one coverage. Decades of experience working with the middle market taught me that the bestlaid plans rarely play out. Banks don't want to put themselves - or their customers - in a situation where covenants are breached and there are no options left. It's smarter to include a reasonable margin of error when initially setting covenants. Frankly, it's good business practice.

The most common covenant is a debt‐service or fixed‐charge ratio. Simply put, it is a measure of a company's cash earnings, generally defined as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) divided by fixed charges (interest expense, taxes, principal payments, and capital expenditures). If coverage is less than one-to-one, the business is not sustainable for extended periods. A company shouldn't have more outflows than inflows. Banks generally require EBITDA to exceed debt payments by at least 20 percent annually. Otherwise, there is no flexibility in loan terms should financial troubles strike.

Another common covenant is leverage maximum. This covenant measures a company's ability to reasonably retire debt. Leverage maximums can be either balance-sheet orientated - a measure of liabilities to equity - or debt-service oriented, expressed as ratio of debt to EBITDA. The same margin-for-error concepts apply.

Some wonder why covenant ratios and advances on collateral are set with margins in excess of the company's projected performance. This leaves room for alternatives well in advance of inability to pay back debt or sell the collateral if the company finds itself in a difficult business environment.

It's a fact: Banks use loan covenants to protect our common interests and limit risk.

However, it's important to remember that we would not make a loan if we did not want your business to succeed. We wouldn't have suggested making the loan in the first place. Have clarifying conversations with your banker early and often. If the customer-bank relationship is strong, covenants reduce fear and protect the best interests of all concerned.

• Douglas Banzuly is senior vice president for Wells Fargo Commercial Banking in Chicago. Doug.Banzuly@wellsfargo.com.