The meaning of "Brexit"

Apparently Brexit means Brexit, although many could be forgiven for wondering precisely what that means. What is clear is that the dramatic fall in sterling that has followed the June referendum result has presented greater challenges for international businesses seeking to comply with financial covenants in their loan agreements.

Financial covenants are used by banks to provide an early warning sign of distress. They require a borrower to meet specified financial tests at regular intervals during the life of a loan. Tested by reference to the financial statements a borrower produces, a breach of a financial covenant will typically result in an event of default. If a borrower is fortunate, it might be able to “cure” a financial covenant default by asking a shareholder to contribute new equity, or failing that ask its bank to waive the default (often easier said than done).

The kind of financial covenants included in loan agreements can vary depending upon the nature of the business and the relevant transaction. Often they will include one or more of the following covenants: the leverage, cash flow cover and interest cover ratios. The leverage ratio is a balance sheet covenant since it measures a company’s debt level against its cash performance measure (or EBITDA), thereby limiting the amount of debt a business can borrow. The interest cover ratio is based on the profit and loss account, since it measures operating costs against finance charges (thus demonstrating the ability of a company to service its debt out of profits). The cash flow cover ratio is also a P&L account based covenant and tests the ability of a company to service its debt costs generally (both interest and principal) out of its cashflow.

The precise wording of financial covenants in loan agreements can cause many a cold towel moment. But putting the wording aside for the moment, it’s clear that many businesses are currently facing economic challenges in the post-Brexit environment and this is putting additional pressure on financial covenants. Difficulties may arise as a result of one or more of the following factors:

  • Importers of goods and services are likely to see costs rise as the value of sterling goes down, which can have a detrimental effect on cash resources, therefore adversely affecting EBITDA figures (a key component of each of the covenants summarised above).
  • Foreign currency borrowings are likely to rise when measured in sterling, thereby having a negative effect on the level of borrowings and debt service costs.
  • Conversely, assets located in non-sterling countries may increase in value when converted into sterling (although the ability to take account of any upward or downward revaluation of assets when calculating financial covenants will depend upon the precise wording of the covenants in any loan agreement).

It is the borrower’s duty to comply with the financial covenants and report to the bank should there be any default (or likelihood of any default). Having a grasp of the constituent parts of each financial covenant will assist in any negotiations you may have with your relationship manager or credit team.

As if often the case, should you foresee any difficulties ahead in terms of your compliance with financial covenants, it is always better to address that now rather than wait until later. Covenant reset exercises are not unheard of but your bank will inevitably appreciate an open dialogue on the possibility of any such requests at the earliest opportunity.

Contact our experts for further advice

Robert Calleja, Matthew Padian, Andrew Dodds

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