Debt covenants intended to prevent any significant impact on the borrower's cash flow and eventually, repayment ability
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Mergers and acquisitions are often used in non-financial debt covenants by lenders with an intention to avoid any significant impact on cash flow on the part of the borrowing party that may or may not affect their ability to pay back the loan. Hence, by putting limitations on mergers and acquisitions, lenders use them as a non-financial debt covenant to safeguard their interests by making sure their money is not subjected to high amounts of risk.
What are Mergers & Acquisitions?
Mergers and acquisitions are based on the concept that combining two companies or organizations can be of greater value and performance together than the results individually achieved by the two entities.
Two or more organizations merge to combine all of their resources and lead to more efficient operations and higher revenue. It is a very popularly regarded business strategy due to the countless benefits achieved, such as cost savings due to operational efficiencies and revenue generation.
What are Debt Covenants?
Debt covenants are promises or agreements entered into by the borrowing party to comply with the terms agreed upon in the loan agreement with the lending party. They are also popularly known as loan covenants or financing covenants.
Debt covenants specifically refer to certain benchmarks, maximizing/minimizing limits, or restrictions, imposed by the lending party and voluntarily agreed upon by the borrowing party in exchange for the loan.
Limitations on M&A: Use in Debt Covenants (Example)
One of the major real-life examples of putting limitations on M&A deals is Procter & Gamble’s acquisition of Gillette in 2005. According to company reports, when Proctor & Gamble acquired Gillette in 2005, an increase in the annual sales of about $750 million was reported by 2008.
However, say the acquisition was carried out at an unfavorable time or when the economic situation was just unable to support the business environment. In such a case, the acquisition might not have experienced a significant boost in sales. It might have turned out to be an expensive affair instead. Had P&G also increased its borrowing activity at the same time, the lending party might have been exposed to significant risk.
To avoid such major risks, lenders impose limitations on activities related to mergers and acquisitions for the time period concerning the loan, agreeing with the borrowing party that they are not to carry out any M&A activities for the time period of the loan, and any activities of such scale will be passed on to the lender for approval first. It is an example of the use of limitations on mergers and acquisitions as debt covenants.
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