Determining the path forward when a company in your portfolio breaches its covenant

This article was originally published by BDO USA, authored by Mark Houston - Managing Director; Financial Institutions & Specialty Finance National Practice Leader.

When a company breaches a covenant in its facility agreement, the reasons behind the breach can be as varied as the strategies lenders (including bank and non-bank lenders) can take to address them. Determining the best path forward must include assessing the company’s history, the details of the breach, its causes, and its short- and long-term impacts on the lender’s overall portfolio.

This information will be critical when determining how to approach the breach, amend the facility agreement, and set the future strategy. Lenders must carefully plan their next steps when navigating a company’s breach of covenant to mitigate the risk of additional, costly breaches in the future.

Determine the landscape of the breach

There are several foundational questions lenders should ask upon being notified that a company may or will breach its covenant. Answering these questions can help lenders build a strong foundation for determining the future of their relationship with the company in breach of its covenant. These items include:

How serious is the covenant the company is about to breach?

Determining the severity of the breach can inform decisions about the kinds of controls to put in place in an amended agreement. In the event of a minor breach, a lender might find it more appropriate to make small changes to the terms of the agreement. If the breach is serious enough, some lenders may consider implementing additional reporting or milestones in addition to amendments. Lenders should consider the short- and long-term impact of the company in question in an overall investment portfolio and how a breach of covenant might affect that role.

What led to this breach?

Thoroughly examining the financial conditions and operational issues that precipitated a breach will aid in developing the future strategy. Lenders will be better able to determine what conditions could help mitigate the risk of further breaches in an amended agreement once they understand how and why a breach occurred. Lenders can also leverage knowledge gained from this examination to inform future decisions about agreements with other borrowers and terms or covenants to be implemented into loan documentation with new borrowers moving forward.

How should the agreement be amended?

After looking into the extent, severity, and causes of a breach, lenders can determine what terms in the facility agreement need to be amended and to what extent. For example, if the company in breach plays an important role in a lender’s portfolio or if the breach is not serious, a lender may choose to amend the facility agreement but may also collect an amendment/restructure fee and, in many cases, increase the interest rate to price in the increased risk.

In these cases, other terms could be added to the agreement. The lender may seek to set milestones or covenants around future debt amortisation, the exit of underperforming divisions, a management change, or other milestones targeted at preventing a future covenant breach.

Are there alternatives when an agreement cannot be reached?

When a consensus cannot be reached on how to move forward or if the risk is too high to overcome, a lender may choose to exit the borrower. While this is not a common or preferred option for most lenders, it could be the case if the breach is significant or a successful recovery seems unrealistic.

In these situations, lenders may elect to terminate the facilities and provide time for a refinance, pursue a distressed loan sale to minimise losses, or enforce their security. Even if this particular loan will no longer form part of the lender’s portfolio, it is still beneficial to incorporate lessons learned from the breach into investment planning moving forward.

Key considerations when amending a facility agreement 

Most lenders opt to remain in an agreement with a company that has breached a covenant and must set conditions for a new agreement following the breach. These lenders should begin by implementing new and expanded controls to guard against another breach and mitigate potentially enhanced risks under the terms of an amended agreement. Banks and non-bank lenders should consider the following questions when developing these controls.

Who should handle this process?

If the breached covenant encompasses a large dollar amount, the lender’s risk function should have input into the strategy. However, if the breach is minor, the investment or relationship managers may manage the process independently, through the usual reporting and delegation frameworks. Some companies may also bring in outside assistance, such as a third-party advisor, to provide specialist restructuring advice and/or due diligence when negotiating the new agreement.

What are the initial steps to amending a facility agreement?

There are multiple priorities they must keep in mind when an amended agreement is contemplated.

This includes:

• Achieving a default rate of interest (where appropriate) to price in the increased cost of capital
• Resetting covenants to a level that is achievable without being too lenient
• Setting appropriate reporting requirements and milestones to ensure the lender has adequate protection.

With these priorities established, lenders should establish and maintain effective lines of communication with the borrower to track the short and long-term progress toward loan repayment and to measure the impact of that progress on overall portfolio performance. These lines of communication will provide lenders with regular insight into the company’s operating and financial metrics.

How do we set the company up for success and mitigate the risk of another future breach? 

Once lines of communication have been established and lenders have assessed the borrower’s financial and operational conditions, the two parties should determine what financial obstacles they should prepare for and the mitigation strategies they can employ to mitigate the risk of a future breach. These strategies could include tactics like:

• Coordinating with the company’s leadership to establish a 13-week forecast
• Performing monthly assessments of operational and financial performance
• Determining what the company will do to improve capital and EBITDA margins
• Establishing how the company will mitigate the risk of breaching additional covenants.

As with any healthy lender-borrower relationship, early, clear, and transparent communication is at the forefront of effectively managing the relationship through a covenant breach and allowing both parties to collaborate on finding viable solutions. By working together transparently and seeking professional advice when needed, both parties can navigate challenges and maintain a strong foundation for future financial partnerships. When lenders have access to as much information as possible, they can better plan the next steps regarding the current and future conditions of the facility agreement.

Amendments are not one-size-fits-all

When amending an agreement following a breach of covenant, lenders must thoroughly assess the company in breach and the environment that led to the breach. The path forward will always vary based on the company’s industry, role in the lender’s portfolio and its financial size, meaning recovery will look different for each agreement.

Continuous monitoring of the borrower's progress in resolving the covenant breach is also essential. Lenders may consider engaging external advisors to assist in navigating difficult times or to act as an independent party to the lender-borrower relationship. Assistance through regular updates and reporting enables lenders to assess the effectiveness of implemented solutions and make informed decisions about relationships moving forward.

At BDO, we help lenders assess the status of the companies in their portfolio following a breach and work with distressed companies to develop clear and reliable operational and financial recovery strategies.