Monitoring the loan. Covenants are put into place to restrict certain kinds of activities and encourage others. Although not all covenants are quantifiable, they are all verifiable. When covenants are broken, they serve as early warning signs in case of a company's performance deterioration. In general, clients will fight for looser covenants and more leeway when a covenant is tripped. There's an unwritten rule of lending that goes back centuries. If a borrower has no issues at all with a very demanding set of loan terms, do not make the loan. Default technically occurs when a covenant is broken. The goal here, however, is for the lender to get back to the table quickly to restructure the loan, or at the very least, get more information on what went wrong. The faster a lender can get back to the negotiating table to either accelerate the debt, change the terms or push for other changes, the better the chances are of preserving capital. This is especially true of situations where there are multiple loans of the same seniority and security. Covenants can be negotiated in different ways. Financial covenants, which deal with coverage, leverage, and liquidity. Negative covenants, these are actions that are forbidden, such as selling assets. Affirmative covenants. These are actions that are required by the borrower. There are also things like change of control provisions in case the borrowing entity gets acquired by a weaker credit entity. The borrowings could be repaid or interest stepped up. Cross acceleration is if the borrower has breached the terms of one agreement and that lender has a right to accelerate, meaning force repayment, then another lender under another agreement can accelerate as well. This is very common in high yield and in investment grade bonds. And last is cross default, and this is if a borrower defaults on one debt tranche, another debt trache will be automatically in default as well. Financial covenants are the most commonly discussed as they're the most easily quantified. The major categories are leverage or the amount of debt in the capital structure, coverage or the ability of the earnings or cash flow to meet the debt service and repayments, liquidity, which is the ability to access cash. Other common financial covenants might deal with the value of the equity net of the intangible assets such as goodwill. This is also known as tangible net worth or a covenant that deals with the amount of asset purchases.
