Stating the obvious (Part 1): Covenant breaches
My apologies upfront for the attention-seeking headline; but given this is a business article written by an Accountant/ex-Banker, I’m pretty confident that no-one will be expecting ground-breaking revelations, so I may as well be honest! On the subject of dealing with a Covenant breach however, it is genuinely worth reminding oneself that taking a step back and following ‘the obvious’ process could really pay dividends (not literally though as that would really #@ss off your bank!)
As much as I would love to be writing about something more positive or exciting than Covenant Breaches, it is already becoming apparent that in certain sectors of the market (particularly those with a Consumer angle), growth forecasts are starting to come under some serious pressure (in particular forecasts based on a positive quirk of lockdowns or set during the excitement of the resulting return to freedom).
So what is a Covenant Breach? Not adhering to any aspect of loan documentation is a breach, however it is Financial Covenants that really concern a lender, as these warn of a trading downturn. The important word here is warn, and any lender acting reasonably is unlikely to demand immediate repayment at the first sign of a breach. While technically they can ‘get you’ if your budget is a day late, expect a Covenant breach to signal the beginning of a new type of conversation with your lender.
In a healthy lender/borrower relationship, a covenant breach should be the beginning of a constructive (and hopefully friendly) discussion regarding how repayment of debt and interest can best be maintained while allowing the business to trade as close to ‘normal’ as possible. Ultimately it is in no-one’s best interests to enforce unnecessary changes on a business that is already under stress. An experienced banker knows very well that the biggest loan losses occur when this communication process breaks down.
Step 1 of ‘good communication’ is involving the lender at the right stage. Waiting right up to the documented reporting date to notify a lender is generally ill advised. At this point the breach will have been known to management months before, so this will not only look bad from a trust and communication perspective, but the immediate formal breach will give the lender no choice but to place the business on ‘watch‘ (getting the attention of the restructuring department). Last minute notification will also send your Relationship team into panic mode and increase the likelihood of being transferred immediately to a Restructuring/Recoveries department. In these situations, you really want your Relationship team involved and on-side as they are naturally invested to speak and fight for you internally.
So, when should you communicate an upcoming breach to lenders? As a general rule, as soon as you have a clear analysis of what has happened and a sensible forecast proposal that has the lender at the core of your focus, then this is the time to start talking. Remember that until the covenant legally breaches (check your documents) there is a limited amount that that lender can legally or practically do other than listen to you.
During my banking career, I had the ‘pleasure’ of spending the 2007/8 Financial Crisis in a Work-out role managing multi-banked, distressed loans. During my time on ‘the dark side’, I was pleasantly surprised by the level of support that was shown by lenders (both my own institution and other group lenders) to businesses that were ultimately underperforming. This largely came down to experienced Restructuring and Credit teams recognising that the underlying businesses were not fundamentally broken, and that the management team in situ were the best people to get things back on track. I saw lender groups support cooperative businesses that have now returned to stability and growth. Conversely, I also saw borrowers that came out all guns blazing to chastise lenders for ”meddling”, while in the background the downward trends continued in the absence of management focus. Those businesses no longer seem to exist!
As with the process to obtain a new loan, the key tool that creates the trust in any management team is good quality information (I think this qualifies as the most obvious statement in the article!). Where a breach is occurring, all parties know that things have not gone to plan, so clearly identifying why this has happened and coming to the lender with a balanced and deliverable plan is key. A lender will now be looking for a management team to run the business with the lender as a primary stakeholder.
Balanced and Deliverable are important words here. In a breach discussion the balance of power is very different from negotiations at the outset of the loan. A lender is no longer focussed on winning you as a customer, so their focus will be firmly on protecting their debt. With good information and positive negotiation however, a lender can generally be convinced that supporting your business is the best way to achieve this rather than finding the finding a quick exit (almost always at a loss for them).
In formulating a new business plan, the lender will first need to understand what internal triggers are available to start the process of bringing the business back on track. A revised business case should a) rationalise why a breach occurred, b) identify the potential levers available to management to stabilise current negative trends and c) outline a range of options that would result in debt being protected and ultimately repaid or refinanced. If you can show that the levers have already been ‘pulled’, this is ideal as the lender will be presented with a solution already partially achieved; a difficult proposition to argue with!
As a final point on information, it is worth reminding yourself that banks are not quick decision-makers and they hate being pressured to act faster than their processes allow. The more time they are can be given to assess a plan, the more likely they are to be agreeable. If you have already been moved to the Restructuring/work-out team, then these do have a shorter chain of decision, however they have also ‘seen it all before’ so will recognise an unprepared management team a mile away and take action to ensure they are furnished with the information they need (i.e. you may find yourself with a number of austere looking strangers appearing in your office!).
Think like a lender, not an investor
I have mentioned above the concept of ‘thinking like a lender’. This is something that I generally recommend at all times when dealing with a lender/bank due to the differing alignment of interest that a lender naturally has compared with that of a management team or investor. In ‘distress’ these differences are accentuated, with a lender’s behaviour potentially moving from ‘sales team’ to ‘debt collector’ overnight!
To give an idea of how a lender might be thinking, the list below looks at some options available to them following a covenant breach. I have deliberately started with the most severe, mainly to reinforce how serious a covenant breach can be if handled carelessly, but also to reflect the difference that a well-managed process can make to the outcome:
- Legally declare a default and demand repayment: As already noted, this is a drastic decision and will effectively end the ‘relationship’ between lender and management.
- Appoint an Administrator: This would generally follow point 1) above and has a high potential to crystallise an immediate loss for the lender, and probably a total loss for shareholders. On this basis it is obviously a last resort but will ultimately remain a threat available to a lender until a covenant reset can be agreed.
- Sell the debt: This is something that few management teams will have thought about while negotiating a loan, however it is quite possible that a lender has the ability to sell your loan to a 3rd party to manage / recover. While certainly not an ideal option for a lender (they will certainly make a loss), this will be a disaster for your business!
- Transfer the relationship to an internal restructuring team: This option can have plusses and minuses. On the positive side, you will be talking to personnel with real experience of how to get things back on track. On the negative side, you will be losing the relationship team that believed in the business at the outset. Generally speaking, it is best to avoid being ‘moved to restructuring’ as this will your record at the lender for a long time to come making future borrowing a painful experience. In a time-sensitive situation however, it may be advisable to accept what support is available and get things tied up efficiently.
- Enter into early constructive discussions: This is the ‘option’ detailed in this article and I would expect to be the preference of the vast majority of borrowers (and also lenders). It is however only a good option where time is available and it is fair to assume that the tighter the timeframe, the further up this list of options the lender may be forced to go.
Now, it is important here to emphasise how favourable option 5) is for a lender. During the 2007/08 Financial Crisis, lender behaviour was skewed towards more drastic action as they were largely undercapitalised and in a very uncertain position themselves. The UK debt market is far stronger today, not just from a capital perspective, but also with the number of different lenders in the market and differing areas of expertise and specialism. My expectation is that should a recession materialise, that the lending market will be far better placed to work through challenges and support their customers.
If you want to learn more from a Debt Advisor, please email Gavin to start a conversation.