The Arc of a Covenant Breach

At Heron Finance, one of the more common questions we get is ‘what happens when a borrower defaults on a loan?’

Yet many people don’t realize that prior to a default, there are often warning signals alerting lenders that the borrower might default down the road. One such warning signal is called a covenant breach.

In this article, we explain what a covenant breach is, how it differs from a loan default, and what steps lenders and investors can take to mitigate the risk of a covenant breach (and subsequent loan default).

Key Highlights:

• A covenant breach occurs when one party violates a promise or agreement made in a written contract with another party.
• A loan default is a more serious event that happens when the borrower fails to make a scheduled payment on time or violates other key terms of the loan agreement.
• Lenders can take steps to mitigate the risk of covenant breaches and loan defaults, including maintaining strict underwriting, due diligence and monitoring standards.

What is a Covenant?

A covenant is a legally binding promise made by a borrower to a lender as part of a loan contract.^[1] In other words, covenants either require or restrict behaviors by the borrower (e.g. borrowers can be required to maintain certain debt-to-equity ratios, or be restricted from accepting new debt).

We can therefore break down covenants into two main categories: Affirmative and restrictive (negative) covenants.

Affirmative covenants mandate the borrower follow certain behavioral guidelines. Examples may include:

• Maintaining proper insurance, accounting, and tax compliance
• Providing financial statements and other reporting to the lender
• Preserving the value of collateral pledged to the lender

Restrictive covenants prohibit the borrower from taking certain actions without the lender's approval. Examples may include:

• Taking on additional debt or liens
• Selling major assets or changing the nature of the business
• Paying dividends or making distributions to shareholders

There is a third category of covenants called financial covenants. These could be classified under either affirmative or restrictive, yet given their prevalence and the emphasis placed on them by lenders, financial covenants often warrant their own classification.^[2]

Financial covenants require the borrower to maintain certain credit ratios and operating metrics, such as:

• Minimum debt service coverage ratio (DSCR)
• Maximum leverage ratio (debt/EBITDA)
• Minimum liquidity or net worth

Given that lenders are primarily concerned with recouping their invested capital plus interest, financial covenants are at the forefront of every lender’s analysis when monitoring their borrowers after capital has been loaned out. This is because the breaching of a financial covenant can serve as a red flag that the borrower may not be able to make interest payments or repay their loan (though breaching a covenant doesn’t necessarily mean that a borrower will default–more on that later).

One more point on covenant classification–covenants can also be categorized as either standard (common across all borrowers) or non-standard (unique to a particular borrower's circumstances).^[3] In other words, lenders can (and often do) issue bespoke covenants specific to the borrower and credit agreement. These non-standard covenants are based on the borrower’s unique circumstances, coupled with the lender’s degree of risk tolerance.

What is a Covenant Breach?

A covenant breach occurs when one party violates a promise or agreement made in a written contract with another party.

Violating a covenant is considered a technical default, even if the borrower has not defaulted on debt service payments.^[4] For example, if a borrower breaches a restrictive covenant by accepting new debt without the lender’s permission, the borrower may still be making interest payments on time, however the borrower would have technically defaulted by breaching the restrictive covenant.

The consequences of a covenant breach can range from the lender raising its pricing (the interest a borrower must pay on the loan) to an acceleration of the loan’s repayment (borrower must pay back the principal quicker than was originally stipulated). A severe covenant breach can even result in asset seizure and liquidation, whereby the lender takes control of the borrower’s collateral (potentially even the borrower’s entire business) and liquidates it by selling the assets to other parties.

Covenant Breach vs. Loan Default: What’s the Difference?

A covenant breach and a loan default are related, yet they are two distinct events.A covenant breach occurs when the borrower violates a specific term or condition of the loan agreement. As mentioned previously, this can happen even if the borrower is current on payments. Examples include:

• Failing to maintain a required financial ratio, like debt service coverage
• Selling major assets without lender approval
• Missing a reporting deadline or providing inaccurate financial statements

In contrast, a loan default is a more serious event that happens when the borrower fails to make a scheduled payment on time or violates other key terms of the loan agreement.

The key differences between a covenant breach and loan default are:

• A covenant breach is a technical default, while a payment default is a financial default
• Covenant breaches can happen even if payments are on time, while a payment default means the borrower is behind on payments
• Lenders generally have more flexibility in how they respond to a covenant breach compared to a payment default
• Covenant breaches are more common, and can often be ‘cured’ (i.e., solved by the lender via a workaround, such as increasing the interest rate or adding a lender representative to the borrower’s board of directors), or, in certain instances, waived entirely.
• Payment defaults are more severe and can result in legal action whereby the lender recalls the entire principal amount, potentially seizing and liquidating borrower assets

Both a covenant breach and payment default give the lender the right to take actions like increasing interest rates, demanding more collateral, or even accelerating the loan and demanding immediate repayment.^[5] The specific consequences depend on the loan agreement and the severity of the breach, as well as the lender’s relationship to the borrower, and how the lender chooses to proceed.

What Steps Can a Lender Take When a Borrower Breaches a Covenant?

When a borrower breaches a covenant in a lending agreement, the lender typically has several options:^[6]

• Demand immediate repayment of the loan: If the covenant gives the lender the right to accelerate the outstanding debt and request immediate payment, the debt becomes a current liability for the borrower, potentially altering their financial health.
• Increase the interest rate: The lender can sometimes raise the interest rate on the loan as a consequence of the breach.
• Require additional collateral: The lender may demand the borrower provide more collateral to secure the loan going forward.
• Terminate the lending agreement: In severe cases, the lender can choose to end the debt agreement altogether and demand their principal back in full.
• Waive the violation: For less severe breaches, the lender may be willing to waive the violation after negotiating with the borrower.

The specific actions a lender takes depend on the severity of the breach and the terms of the lending agreement. Lenders often have significant flexibility in how they respond, which is why the lender/borrower relationship is so important–it has often been said that ‘lending is a relationship business.’

Given the degree of trust that is necessary for lenders and borrowers to work through any covenant breaches, borrowers should respond to any covenant breach with proactive communication and a detailed plan to cure the breach in a timely manner.

It is worth noting that most (if not all) lenders do not want to seize assets and liquidate them. Lenders are not in the business of acquiring borrower assets, they are in the business of making loans. So any lender would rather the borrower repay their loan in full with interest–therefore most lenders are willing to negotiate with borrowers to get through a rough patch where the borrower has breached a covenant. However, a degree of trust needs to exist for the lender to continue to work with the borrower towards an equitable repayment solution, rather than simply recall the loan in full and proceed with asset seizure and liquidation.

How Heron Finance Mitigates the Risk of a Covenant Breach

At Heron Finance, we take steps to mitigate the risk of covenant breaches before they happen. We partner with experienced lenders who have conducted thorough due diligence on their borrowers, and our credit team provides an extra layer of diligence before investing in the deal. The lenders we invest in all have a strong track record of expertise in the private credit market, with loss rates ranging from 0% to 1.3% at the high end.

We also diversify our overall portfolio with a range of deal types, which systematically reduces risk. By investing in deals that span industries, geographic regions, and credit structures, we provide Heron Finance investors with diversified exposure to the private credit asset class.

And once the investment is made, we continue to monitor the borrower’s behavior through regular communication. Our lending partners do the same, and we consult with one another regularly. This helps reduce the risk of a covenant breach, and the potential for a subsequent default.

For more information, read our article on how we select and monitor deals.