Debt covenants are restrictions that lenders (creditors, debt holders, investors) put on lending agreements to limit the actions of the borrower (debtor). In other words, debt covenants are agreements between a company and its lenders that the company will operate within certain rules set by the lenders. They are also called banking covenants or financial covenants.
The Purpose of Debt Covenants
Debt covenants are not used to place a burden on the borrower. Rather, they are used to align the interests of the principal and agent, as well as solve agency problems between the management (borrower) and debt holders (lenders).
Debt covenant implications for the lender and the borrower include the following:
Debt restrictions protect the lender by prohibiting certain actions by the borrowers. Debt covenants restrict borrowers from taking actions that can result in a significant adverse impact or increased risk for the lender.
Debt restrictions benefit the borrower by reducing the cost of borrowing. For example, if lenders are able to impose restrictions, lenders will be willing to impose a lower interest rate for the debt to compensate for abiding by the restrictions.
Reasons Why Debt Covenants are Used
Note that in the scenarios below, it is in the best interest of both parties to set debt covenants. Without such agreements, lenders may be reluctant to lend money to a company.
Lender A lends $1 million to a company. Based on the risk profile of the company, the lender lends at an annual interest rate of 7%. If there are no covenants, the company can immediately borrow $10 million from another lender (Lender B).
In this scenario, Lender A would set a debt restriction. They’ve calculated an interest rate of 7% based on the risk profile of the company. If the company turns around and borrows more money from additional lenders, the loan will be a riskier proposition. Therefore, there will be a higher possibility of the company defaulting on its loan repayment to Lender A.
Lender A lends $10 million to a company. In the following days, the company declares a liquidating dividend to all shareholders.
In this scenario, Lender A will set a dividend restriction. Without the restriction, the company can pay out all of its earnings or liquidate its assets and pay a liquidating dividend to all shareholders. Therefore, the lender would be out of his or her money if the company were to liquidate the company and pay out a liquidating dividend.
List of Debt Covenants
Below is a list of the top 10 most common metrics lenders use as debt covenants for borrowers: