Audit and Assurance

Effect of Covid on Loan Covenants

Michael Nolan
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Every loan within a company will have an agreement outlining the terms and conditions of the loan between the borrower and the lender.
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The agreement will also outline the covenants that businesses are expected to uphold while in contract with the lender. Breaches of loan covenants give the lenders powers to demand immediate repayment if the terms are not maintained within the agreement. 

There are two main types of loan covenants; monetary and non-monetary. Both include positive debt covenants which state what the borrower must do for the future successful operation of the business and negative debt covenants which state what the borrower cannot do.  An example of a monetary positive covenant would be to maintain a certain EBIT, meanwhile monetary negative covenants may place restrictions on capital expenditure. Another example of a non-monetary covenant would be borrowers must have adequate insurance over assets and business, and the borrower cannot acquire a company or business undertaking without consent from the lender. With the continued impact of the Covid pandemic, these terms and conditions, i.e. “covenants” have become more difficult for some businesses to uphold.

Most lenders have temporarily eased terms surrounding existing loan covenants to help businesses through the worst of the pandemic. In many cases this relaxation on covenants is expected to last until businesses return to full operational capacity and revenue recovers to pre-pandemic levels. However, it is important to note that this is not the case for every business and every lender.

These “breaks” are completed on a case by case basis and it is the onus of each company to review if they are eligible to avail by consent with the lender of any relaxation in the enforcement of loaning covenants.  

The response of lenders in easing loan covenants during the pandemic has been mirrored by government incentives which have been introduced over the last year including the wage subsidy schemes, warehousing of tax liabilities and sector specific grant aid.

Effects of Covid on Loan agreements and covenant from Covid:

1) Deferral of interest and capital repayments.

These are done on a case by case basis with the lender predicated around the preparation of a business plan outlining the impact and solution to the current issues being experienced by the client. These are tailored to each borrower’s specific case and circumstances. If customers are unable to make loan repayments and have not been offered a break in loan repayments communication with the lender is advised outlining the businesses struggle and it has been demonstrated over the last number of months, lenders are mindful of the situation ongoing and in general allow the deferral of capital repayments.

2) Financial covenants.

These are mainly based on the value of assets or by the use of financial ratios measuring risk and profitability to ensure no issues with repayments. This made it difficult to value some assets impacted by the pandemic.

Covid put a halt to valuing assets due to country wide lockdowns and Government restrictions. Lenders started to add “material valuation uncertainty’s” as limitations within loan agreements. Now with the lessening of physical restrictions valuations have recommenced again and caveats are being lifted. However, communication around these areas with your lender is crucial to ensure there are no breaches of the covenants. In regards to the ratio element of loan covenants in some circumstances, such as borrowers in the retail and hospitality sectors, the impact of Covid over the year has been significantly detrimental. Both governmental institutions and private lenders have generally been very accommodating in these situations. As with the valuation of assets above communication with the lender is key to ensure willingness and ability by both parties to work together for a mutually agreed outcome which allows no breaks in loan covenants and keep the relationship on good terms between both parties.

Going forward

Lenders have been extremely accommodating to clients and customers in relation to covenants over the last 18 months. This has been primarily around their wish for customers to protect their assets as best they can, ensuring that once the pandemic is over, restrictions are lifted and a “back to normal” business environment the assets will return to generating returns to service debt requirements. A clear pathway to this must be shown by the customer based on robust profit and cashflow projections adequately stress tested to show repayment capacity. Lenders will then generally remain supportive of the client.