The most critical enterprise risk for many companies is ensuring that the company maintains full access to the funds required for daily business needs, investment and dividends. Other enterprise risks can cripple a company, but a default can shut it down. Yet, this enterprise risk often is overlooked, misunderstood and minimized. Arguably, the best job in treasury is developing a funding strategy supporting the long-term plan, identifying the debt instruments, securing lenders, negotiating the terms, attending the closing party, and receiving the deal tombstones. Conversly, the worst job in treasury is the resulting debt compliance. Contained within those voluminous and dense debt agreements are scores of promises that must be kept to avoid default and the loss of financing. Managing those promises is onerous, mind numbing, and frustrating. There are no thanks for a job well done, only blame if there is a problem.
While companies think nothing of paying millions of dollars in bank and legal fees to secure new funding, many devote little time or resources to actually managing their compliance. These companies erroneously believe that their covenant risk is limited to their financial covenants, relying on the kindness of their friendly bankers if they default on any of their other covenants.
Any default, no matter how minor, is a default. It gives your lenders the opportunity to rewrite your credit agreement. Unlike in the past, bankers are not as friendly due to their profitability pressures and new regulations. Lenders are now also mutual funds and hedge funds who only want to maximize their return. The cost of default can easily approach $3 million on just a $50 million credit facility, taking into account 50 basis point waiver fees, 200 bp penalty interest, increased LIBOR spreads and commitment fees, and legal fees. Moreover, today lenders are likely to impose new and stricter covenants and possibly reduce the credit line. In the worst cases, they can impose workout or demand immediate repayment. Defaulting has other costs: reputation loss; business disruption; customer, vendor and employee concerns; and possibly financial restatement. With cross-defaults, credit is cut off, creating immediate cash flow issues. The result is an immense diversion of management time, fighting the resulting fires in the business while negotiating with a myriad of lenders and their lawyers. Whether the default is due to ignorance about a covenant, mismanagement, or just bad luck, the treasury group’s lost credibility with senior management is career-threatening. A treasurer speaking of a non-financial covenant default told us, “It was the worst month of my life. Every day, I thought I would be fired.”
In August 2011, Debt Compliance Services completed a survey of 192 U.S. corporates on how they managed their covenants, including their use of these debt compliance practices:
- Having a debt compliance policy vs. only written debt compliance procedures vs. having neither a policy nor written procedures.
- Having a comprehensive checklist of their covenants vs. a list of only major covenants vs. no covenant list at all.
- Preparing a covenant exception report for the CFO’s review vs. no exception analysis. The report identifies which covenant exceptions need to be reported to the lenders and which are emerging issues that need to be watched and managed.
- Reporting on debt compliance to the board vs. no board reporting.
- Using or not using questionnaires and calendars of required deliverable due dates.
The respondents rated the effective-ness of their overall debt compliance on a 1-5 scale, with 1 = Excellent and 5 = Very Poor, and averaged 2.3. The table below of the effectiveness ratings of those using each practice shows that there are four critical practices:
- A debt compliance policy
- Board review of the debt compliance
- A comprehensive list of all covenants
- A quarterly exception report
Managing financial covenants and permitted baskets
The clear best practice for managing financial covenants and permitted baskets is to forecast them four quarters out and stress test them against their limits.
Managing non-financial covenants
A comprehensive checklist is the most effective practice for managing non-financial affirmative, negative, and triggers covenants. Questionnaire and non-questionnaire input from other HQ departments and business units is needed because the compliance with the covenants is likely only known outside of treasury. Incredibly, 20 percent of the group reported that managing non-financial covenants was “Not Applicable,” yet every company below AAA has them. It is a critical point: many companies do not know all of their covenants, yet they attest each quarter to their lenders that they are fully compliant with all of the terms and conditions of their credit agreements.
Download Our Debt Compliance Policy Best Practices Manual
These and other conclusions from the survey were used in developing the following outline of a best practices debt compliance policy.