Top 3 best practices for loan covenant compliance
No member of any finance team wants to explain to their colleagues and their lenders about why they missed a covenant either by surprise, negligence, or performance. However, 40% of middle market companies have violated a loan agreement and didn't know it.*
It is crucial that the finance team members managing existing loan agreements or sourcing a new credit facility, meet the following two requirements:
- Comprehensive knowledge on the full loan agreement terms, triggers and reporting requirements
- Setting up a comprehensive system to continuously monitor the terms throughout the life of the loan and reduce the risk of accidental violations.
While there is rarely any one item in the loan agreement that is difficult to understand, it's near impossible to continuously monitor the entirety of the document without a system in place. (Remember, just one agreement could be fifty plus pages in length. And many companies have multiple credit agreements and capital leases to manage.)
We want to share our top 3 best practices with you, so you can set up the right processes to avoid unnecessary violations. Ensure you never accidentally trip a loan covenant and to give your lenders confidence in your management.
Best Practice #1 - Create an exhaustive summary of all covenants and notification triggers
Don't let the word “exhaustive” scare you. While it does take some time to understand the loan covenant fully, the process can be broken down into a few steps.
- Read all loan documents, including the loan agreement, any modifications, and the promissory notes carefully. Do so for any financial and non-financial covenant.
- Take notes on all the relevant financial and non-financial covenants and all notification triggers buried in the fine print.
- Create a summary document to list out all of the items that you should be tracking for each credit facility. Make sure to include relevant dates, reporting periods, and specific definitions that can affect how you measure and monitor each requirement.
It is okay to ask your legal counsel to prepare this, but don’t be surprised that it can cost thousands of dollars for an attorney to make such summary. On top of that, it will still need to be incorporated into a process for regular review.
Best Practice #2 – Set up calendar reminders for all reporting deadlines
We know how overwhelming it can be to track all your team members’ process when generating required reporting materials for lenders. That’s why it is necessary to mark reporting deadlines clearly on all relevant members’ calendars.
In lean finance teams, this may only be the CFO and the controller. In larger organizations, this could include members of the accounting team, FP&A, and other select members of the finance team.
It is helpful to set reminders with an increasing interval to ensure that team members have it front of mind. In situations where potential delays might happen, make sure to communicate early and be upfront with the lender. Never give lenders any short notice or surprise delays. This could jeopardize a relationship and future opportunities.
Best Practice #3 – Build a model for financial covenant forecasting
Another best practice in managing financial covenants is to forecast out the next 24 months of calculations including any step-ups of required covenant levels.
A careful review of the definition of each term in the loan agreement helps you are capture every element of the financial variables within the calculation. Even if the values are zero for certain adjustments or add-backs, it is essential to indicate those line items in your predictions. This way you will have an easy reminder to incorporate them into the calculation if they ever come up in the future.
If there is ever a forecasted covenant violation, it is essential to discuss with your lender as soon as possible.
Now that you have learned the top 3 best practices for loan covenant compliance, the next step will be to set up your checklists in Word documents, the financial models in Excel, and the reminders in Outlook.
*Based on study of new clients onboarded to Cerebro Capital's Compliance Navigator platform.