By Mohith Sondhi, Senior Director at OakNorth
Loan covenants are critical to successful commercial lending, including in the fund finance space. A lender typically uses them to set parameters by which they’re comfortable that a loan can operate – a specific framework so to speak that’s agreed between both borrower and lender.
In recent times, we’ve seen loan covenants heavily debated when it comes to headroom appropriateness, and we continue to see borrowers from all industry sectors, fighting for as much flexibility in a financing agreement as they can possibly get. When this happens, there needs to be a trade-off, and sometimes there’s a trade-off between price of debt and flexibility being offered.
In this case, the key questions that lenders need to ask themselves are what is appropriate and by how much can the covenants be loosened? From experience, the basic principle of setting loan covenants is to be in a situation where if the borrower’s performance isn’t in line with what the lender had underwritten, then a sensible discussion would need to be had around what to collectively do.
Unfortunately, however, this approach and the trust it’s heavily based on between lender and borrower was damaged during the 2008 global financial crash, which saw lenders take heavy-handed actions when businesses breached loan covenants. A devastating and detrimental point in time which still to this day leaves a scar.
Fast forward to today, and one of the main challenges faced when deciding loan covenants is finding the right balance between flexibility and headroom. Too much either way may cause issues for both parties. Moreover, it can seem that loan covenant headroom is the easiest thing to give out. However, there must be a sensible decision made by all parties collectively; the lender needs the borrower to perform so that it can be repaid in accordance with its loan.
In terms of funding structures without covenants, whilst great for a borrower initially, they also provide great disciplines for borrowers on key metrics (which they should naturally be following anyway). Another positive factor about loan covenants is that if a borrower outperforms the specific parameters set, a lender will have a very warm and positive outlook on the borrower. So, covenants are not just negative in that respect.
My view is that sometimes the market forgets this is an important discipline for both sides. It is essential that all explicit parts of setting loan covenants are well thought through and specific for the borrower – a ‘one size fits all approach’ won’t work. From a borrower’s perspective, having a sensible discussion with the lender on covenants with practical headroom is important. Lenders also must be cognisant of working through any problems that may arise directly with the borrower due to it being a collective problem and not solely a borrower issue.
This is the approach we take at OakNorth. We look to set appropriate levels and work closely with each and every borrower we lend to, supporting them through the good times and tougher spells, that the economy has experienced over the past few years. It’s imperative that lenders and borrowers communicate and work together through any issues that may arise impacting loan covenants. Furthermore, it’s important that when new deals are being done, sensible discussions are had from day zero, with both sides fully understanding each other’s positions.
So, to conclude, my overriding message would be a sensible and balanced approach to loan covenants is key. Too many covenants on a business will be restricting and not healthy for growth and too much flexibility comes with associated risks and may not be appropriate. A balanced and sensible approach is key. Something we’ll continue to follow at OakNorth heading into 2025.
