January 13, 2009 / 3:41 PM / 11 years ago

FACTBOX - Debt covenants in the spotlight

LONDON, Jan 13 (Reuters) - UK companies Taylor Wimpey (TW.L) and Premier Foods (PFD.L) said in trading statements on Tuesday that they are in discussions with lenders to amend their debts and avoid the risk of breaching their loan covenants.

It is now become routine for companies to mention loan covenants — early warning signs a company might be heading to financial distress — when reporting results.

Following are some facts about covenants:

* Covenants are rules in financing agreements between banks and companies, based on the borrower’s financial performance. They can apply to either loans or bonds.

* The two main types of covenants are maintenance covenants and incurrence covenants.

Maintenance covenants are tested regularly — often as frequently as every three months — and are common for heavily indebted companies, for example companies bought out by private equity firms using leverage.

Incurrence covenants are tested for a specific event, such as when a borrower wishes to take out more debt.

* Frequently used tests for maintenance covenants are the interest cover test and the leverage test.

The interest cover test shows how able the company is to pay its interest. It is usually the calculation of earnings before interest, taxes, depreciation and amortisation (EBITDA) divided by the cash cost of paying interest.

The leverage test indicates how much debt the company can handle and typically involves calculating the ratio of net debt to EBITDA.

* Lenders can demand repayment of a loan or seek greater control over the management of the company, if it breaches its covenants.

However, few lenders choose to take such measures because they mean a large amount of costly legal work for both lender and borrower.

Instead, a borrower will try first to reset or amend the covenants to provide more head room, usually by paying lenders higher interest rates and one-off fees with the help of specialised restructuring firms.

* So-called covenant-lite loans, which became common in the United States during the latter phase of the private equity boom, only contain incurrence covenants rather than maintenance covenants. They are not common in Europe.

Many lenders have concerns about companies with covenant-lite loans because it limits their powers to make a company change course if its financial condition deteriorates.

* Covenant packages are individually tailored to suit a particular borrower and its creditors.

Many investment-grade companies have debt with no covenants, though there can be language in the loan documentation that would force them to renegotiate their debts if there was a dramatic change in their circumstances.

Reporting by Tom Freke; editing by Karen Foster

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