What is a covenant waiver?

A covenant waiver is when a lender temporarily forgives a borrower's breach of a loan covenant. Lenders can specify different courses of action in covenant waivers, including unconditional forgiveness of a repayment obligation, a one-time waiver of a compliance obligation, or a new set of tests or conditions for a borrower to comply with.

As covered previously, covenants are rules outlined in loan agreements. Borrowers must maintain and demonstrate compliance with these rules in order to maintain access to their loan. Examples of financial covenants include borrower interest coverage ratios or leverage ratios. When borrowers breach financial covenants, lenders may have the right to terminate the debt agreement and/or demand full repayment. Alternatively, they can waive the covenant violation, and continue on with business as usual.

Why might lenders waive repayment rights after a covenant breach?

Covenant waivers are a lender's formal way of saying to the borrower, "We recognize that you violated a covenant, but we're willing to look past it this time without forcing full repayment of your loan and shutting down this credit facility."

Why might lenders agree to covenant waivers? Let's start by looking at incentives. When corporate lenders and their borrowers agree to a debt raise, the lenders seek to make money on their loan by receiving interest payments, while borrowers seek access to capital. The intention of financial covenants is to alert lenders to potential issues when it comes to borrower creditworthiness.

If a lender finds that a borrower has violated a covenant, but does not think that the borrower's overall creditworthiness is impaired, it may decide that it is more advantageous to continue their relationship with the borrower. After all, the lender still seeks to earn money on its funds by lending those funds to borrowers, and new debt agreements can take a long time to source, negotiate, and execute.

In other words, if a borrower trips a covenant early on in the relationship (but remains creditworthy), a lender may decide that they would rather continue on with the previously agreed-upon loan arrangement than force full borrower repayment.

Given the bilateral nature of private debt, there is no central database that tracks covenant violations and their resulting implications on borrower-lender relationships. Nevertheless, it is fair to say that covenant waivers are commonplace in private debt; in fact, Griffin, Nini, and Smith (2019) find that half of covenant violations do not lead to significant changes in a borrower-lender relationship. (By the same logic, many covenant violations do have dramatic consequences.)

What is an event of default?

An event of default is when a borrower triggers a loan agreement condition that permits a lender to demand full repayment of their outstanding loan balance. The rights and remedies section of the credit agreement outlines the actions that lenders can take after an event of default.

It's common to hear about "foot fault" or "technical" defaults (in contrast to "real" defaults), but the reality is that any event of default gives lenders the right to take punitive action against their borrowers. How lenders choose to react to an event of default, as noted above, is a risk-reward calculation that takes into account the existing lender-borrower relationship, the severity of the covenant breach, the lender's industry reputation (it may be advantageous for a lender to be perceived as "borrower-friendly," for example), and other factors.

How can technology help borrowers avoid events of default?

Debt capital management technology can help your company ensure covenant compliance and avoid events of default by tracking all your credit agreement terms, alerting you to possible covenant violations ahead of time, and generating all the documents and reports required by your capital provider.

As your company scales and diversifies its sources of debt funding, the ability to see all of your credit agreement obligations and compliance requirements in one place can help you manage debt capital proactively, rather than reactively. Managing routine debt capital operations with software also frees up resources for high-value initiatives like planning your next capital raise or exploring new types of funding.

Want to learn more?

As businesses grow, they're likely to require new sources of funding and larger investments in internal capital markets expertise. When it comes to debt capital compliance, the best way to stay on top of the rules of your credit agreement(s) is to adopt technology designed to track financial covenants and monitor compliance against capital provider KPIs. If you're interested in learning more about software that can help you scale your capital markets function, just request a demo of Finley here.

All information presented herein is for informational purposes only, and Finley Technologies, Inc. does not assume any liability for reliance on the information provided. Before making any decisions that may affect your business, you should consult a qualified professional advisor.

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