Acquisition Finance Covenants

Acquisition finance covenants are legally binding promises made by a borrower (the company being acquired or the acquiring entity) to a lender as part of an acquisition loan agreement. These covenants are designed to protect the lender’s investment by monitoring the borrower’s financial health and restricting actions that could increase the risk of default.

They are broadly categorized into three types:

1. Affirmative Covenants (Positive Covenants): These require the borrower to do certain things. Common examples include:

• Maintaining accurate books and records: Ensuring transparency and reliable financial reporting.
• Paying taxes and other obligations: Demonstrating financial stability and avoiding legal issues.
• Maintaining insurance: Protecting assets against unforeseen events.
• Complying with laws and regulations: Minimizing legal and reputational risks.
• Providing regular financial reports: Enabling the lender to monitor performance.

2. Negative Covenants (Restrictive Covenants): These prohibit the borrower from taking certain actions that could negatively impact its financial position. Examples include:

• Restrictions on incurring additional debt: Preventing excessive leverage. The debt incurrence covenant often sets limits based on leverage ratios or fixed charge coverage ratios.
• Limitations on paying dividends or making other distributions: Conserving cash for debt repayment.
• Restrictions on asset sales: Maintaining a strong asset base.
• Limitations on capital expenditures: Controlling spending and preventing overinvestment.
• Restrictions on mergers and acquisitions (outside of the original acquisition): Preventing significant changes to the business structure without lender consent.
• Restrictions on transactions with affiliates: Preventing self-dealing that could disadvantage the lender.

3. Financial Covenants: These are quantitative measures the borrower must maintain. Failure to meet these covenants can trigger a default. Key examples include:

• Leverage Ratio (Debt-to-EBITDA): Measures the company’s debt relative to its earnings. Lenders prefer a lower leverage ratio.
• Interest Coverage Ratio (EBITDA-to-Interest Expense): Measures the company’s ability to cover its interest payments. Lenders prefer a higher coverage ratio.
• Fixed Charge Coverage Ratio: Similar to interest coverage, but includes other fixed obligations like lease payments.
• Minimum Net Worth: Ensures the company maintains a certain level of equity.
• Capital Expenditure (CapEx) limitations: May be included within financial covenants, explicitly limiting spending on new assets.

The specific covenants included in an acquisition financing agreement are heavily negotiated between the borrower and the lender. The terms depend on factors such as the borrower’s creditworthiness, the size and complexity of the transaction, and the overall market conditions. Covenants can be tailored to the specific risks associated with the target company and the industry in which it operates.

Breaching a covenant can lead to various consequences, including increased interest rates, required prepayments, or even acceleration of the loan (demanding immediate repayment). Borrowers closely monitor their compliance with covenants and often seek waivers or amendments from lenders if they anticipate breaching them. Early communication with the lender is crucial in these situations.