Demystifying Covenant Capacity Calculations – One line item at a time
In what alternate universe do borrowers never generate losses, secured debt doesn’t mean secured debt, and EBITDA growers upward-adjust fixed baskets that never reduce back down?
In Covenant Land, of course!
Recently FLT students and guests joined us at our final quarterly live event of 2023 to ponder these and other fantastical facts in a session that will shortly become the 10th module in our Leveraged Finance Covenant Training course – Calculating Covenant Capacity.
Some of the key points from the session:
- Lenders will never get estimates of capacity 100% accurate, because management have significant discretion to determine when, and how, to calculate capacity
- Financial statements and defined financial terms don’t match, because these are bespoke negotiated contracts drafted by lawyers not accountants
- Borrowers are not required to report capacity calculations – which means that lenders must ask
We then reviewed Monkey Business’s Q2 Quarterly Report and tracked back to the financial statement for the following terms:
- Consolidated Net Income,
- Consolidated Pro Forma Underlying EBITDA,
- Consolidated Senior Secured Indebtedness,
- Consolidated Interest Expense,
- Fixed Charges, and
- All of the ratios.
Together we explored the alchemy of the typical modern covenant package, which allows EBITDA to soar and never reduce back to reality, permits debt commitments to establish high water marks for incurrence capacity, and mandates that management can calculate capacity for any metric on pretty much any “relevant” day.
We learned that, for Monkey Business:
- The debt figure of the ratio calculation does not include RCFs, working capital facilities, and factoring facilities, plus other outstanding debt incurred under specified baskets
- EBITDA can add back lost revenue, costs and other consequences from pandemics, epidemics, natural disasters or acts of god
- Consolidated Net Income for purposes of calculating dividend capacity under the builder basket can only go up, never down (even if there are losses)
Finally, one point that we drove home again and again – always, always, ALWAYS start your review with the Financial Calculations covenant, which contains all manner of calculation bells and whistles.
If you couldn’t make it to the event, don’t panic! We record all of our live events and post them on our online covenant education platform, so we can ensure that no student misses out.
Want to find out more? Get in touch for a demo and to gain access to our taster course!
By Sabrina Fox