Need more Headroom?
Gavin Harrison
Debt Advisory Expert | SME & Mid-Market Corporate Financing | Private Equity & Investor Partnerships | Big 4 Chartered Accountant | Experienced Corporate Banker & Leveraged Lending Specialist
I wrote at the beginning of the summer on the subject of potential covenant breaches, driven by the increased cost of living currently being experiencing throughout the UK and Europe. At the time this was largely focussed on the Consumer sector, however recent events and the resulting spike in interest rate projections has presented a much wider challenge to all Corporate Borrowers.?
As I write, banks and other lenders will have started the process of undertaking ‘Portfolio reviews’ to identify loans particularly susceptible to an increase in the underlying rates (i.e., SONIA or Base rate). Capital intensive businesses in-particular are likely to be first in line for a call from their friendly relationship team to discuss how they plan to manage their cash flows (and associated covenants) should rates reach the 4%+ currently indicated by Forward curves. Putting this into context, a mid-size corporate borrowing £10m at an interest margin of 3.5% could see their annual interest cost double from c.£400k to £800k!??
A specific factor that accompanies higher rates, is that Covenant focus is likely to move towards Cash flow metrics, rather than Leverage covenants which have been the primary test for some time now. With such low historic rates, Cashflow Covenants have not had much ‘bite’ in recent years (outside of leveraged Real Estate structures) so bankers may be a little rusty on what to expect from their borrowers?when addressing the upcoming cashflow pressures.??
So, what can a business do given that interest rates are one of the few variables that a borrower cannot control? (unless of course debt was hedged, in which case please feel free to behave as smugly as you like!)??
The first step must be assessing the likely impact and when this is likely to kick-in. Given Covenants are typically calculated on a look back (last 12 month) basis, the ‘good’ news is that the effect will not fully come through in Covenant tests for another 9-12 months, offering time for?a borrower to put plans in place.??
Waiting is not an option however! As noted above, lenders will already be looking ahead, and elements of loan documentation may technically allow for lender intervention in the event that Covenant breaches can be projected. Also, the genuine cash pressure from rate hikes will be felt immediately by a business, with knock on implications for working capital and investment capacity.?
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So, what are some options available to a business???
Cash flow covenants are typically far less flexible than their Leverage counterparts (generally no cure rights, add-backs etc) so the options available to a borrower without speaking with the lender are limited. This said, there are some constructive concepts that may worth discussing that could avoid a more fundamental solution (i.e., repaying debt until the lender is comfortable!).?
Ultimately, all the above are options that will require a discussion with, and likely an approval from, a lender. The importance of starting those discussions now cannot be overstated; not just because it provides the time to complete what will be a fairly complex negotiation, but also because in 9-12months time, lenders are going to be dealing with other borrowers that chose the ‘ignore’ option and are formally reporting their breaches!?
An absolute must for now though, is to get into the detail of cash flow projections and undertake the same ‘stress-testing’ as the lenders. Hopefully you will find that you have the headroom of a nice comfy Range Rover, but in case things are looking a little tight, being prepared with the analysis will offer the best chance of not being forced to trade-in for a mini! (and to pre-empt any comments pointing out that minis are much more fun and ecologically sound than Range Rovers, I know.... I was unfortunately committed to a poor-quality analogy so that I could use the funny title picture!!)?
Independent Debt Advisory | Business consultant | NED roles | Banking service reviews | Property Finance | East Anglia
2 年Like it Gavin ?? Early discussions with bankers are key. The longer you leave it, the worse the likely reaction.