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Recession Breaks Binding Covenants

Posted: Mar 11, 2009 15:08 PM by Eric Fox

Tickers in this Article: GLG, TXCO, GNK, CBG

The number of companies breaking loan covenants is starting to snowball, and probably has not yet reached its height during the current recession and financial crisis, but so far most companies are successfully getting them waived or renegotiated.

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When lenders make loans to companies, they typically insist that the borrower stay within certain financial coverage and leverage ratios in order to protect the banks' assets and provide an early warning sign of deterioration so that they can keep the loans performing.

One example of a common loan covenant is total- or net-debt-to-EBITDA (EBITDA being earnings before interest, taxes, depreciation and amortization). CB Richard Ellis Group (NYSE:CBG) has this covenant in its lending agreements. At the end of 2008, the company reported a net-debt-to-normalized-EBITDA ratio of 3.28, below the 3.75 allowed in the agreement. This ratio has increased steadily the last three quarters, and the company indicated that it would seek to renegotiate it with amendments or waivers according to Brett White, the CEO. (This measure has a bad rap, but it's still a valuable tool when used appropriately, see EBITDA: Challenging The Calculation.)

Many times covenants are industry specific, and tailored to whatever business the borrower is in. GLG Partners (NYSE:GLG), an asset management firm, has two covenants to comply with, one of which is industry specific. It must maintain a minimum of $15.5 billion in fee-paying assets under management at December 31, 2009. The company ended 2008 with $16 billion.

Some lenders have covenants regarding asset values. Genco Shipping & Trading (NYSE:GNK) is a shipping company that was required to maintain a minimum collateral value on its fleet. Since values of ships have fluctuated so much recently, the company breached its covenant. During the fourth quarter conference call, the company announced that its lender had waived the requirement.

TXCO Resources (Nasdaq:TXCO) recently broke a covenant in its lender agreement regarding its current ratio. The company is required to maintain a minimum current-asset-to-liability ratio of 1. The company hasn’t filed its year-end financial report yet, but it is engaged in talks with its lenders.

If a company does break a covenant, it is not necessarily a life-threatening event. A company will usually enter into talks with its lender to renegotiate the covenant, where the lender will execute a new agreement that increases its collateral and/or cuts the amount of an outstanding credit line. (Learn more in Liquidity Measurement Ratios: Current Ratio.)

The recession and resulting drop in cash flows is pushing more and more companies to break lending covenants, and the wave has not yet crested, as the economy appears to be contracting at an increasing rate. Lenders have been accommodating so far this cycle, but its not clear how long that will that last given the banking systems increased need for capital.

By Eric Fox

Eric J. Fox, is the founder of Brittain Capital Management, LLC., which manages the Alesia Fund, LP., a Value oriented long/short investment partnership. You can read more of his views on investments at his blog - Stock Market Prognosticator.

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