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Restrictive Covenants

Non-financial covenants that limit the borrowing party from performing a certain action or restrict it from going past a certain specified limit

What are Restrictive Covenants?

Restrictive, or negative, covenants are a type of non-financial covenants that limit the borrower from engaging in a certain activity or keep it from exceeding a predetermined limit. They are called “negative” debt covenants because they impose restrictions or create certain boundaries for the borrower that it is not supposed to cross.

 

Restrictive Covenants

 

Features of Restrictive Covenants

 

1. Restricting borrowing activities

Negative debt covenants restrict the borrowing party from engaging in further borrowing or financing activities depending on the loan agreement. It is usually a step taking by lenders with an aim to mitigate the risk of potential bad debts.

 

2. Restricting investment activities

Investment activities include the sale and purchase of physical assets, asset upgrade, investment in real estate, and many others. Negative debt covenants are in effect when a lender restricts the borrowing party from engaging in investment activities without their consent. It is done to lessen risks that may arise from substantial investment expenditure amounts.

 

3. Limitations on mergers and acquisitions

Mergers and acquisitions are often used as non-financial debt covenants by lenders with an intention to avoid significant effects on cash flow on the part of the borrowing party. The activities may or may not affect the borrowing party’s ability to pay back the loan.

Hence, by putting limitations on mergers and acquisitions, lenders use it as a non-financial debt covenant to safeguard their interests by making sure their money is not dealt with in high amounts of risk. Usually, in the case of an M&A-related debt covenant, the borrowing party needs to pass on their ideas and obtain approval from the lender before engaging in any such activities.

 

4. Restrictions on payouts

Lenders may use a negative debt covenant by imposing restrictions on payouts or setting a specific amount limit for payouts. It is done with a view to keep in check the liquidity of the borrowing party. It helps prevent large amounts of cash outflows on the part of the borrower that may or may not affect its liquidity position and its ability to support certain debt levels.

 

Illustrative Example

Company A is planning to acquire Company B in an $80,000,000 buyout. However, in general, the financial markets are experiencing a lot of volatility. As a result, the time is not favorable for an acquisition. Under Company A’s existing loan agreement in place with Bank C Ltd., all the company’s major investment/purchasing activities and M&A activities need to pass through the bank first.

On pitching the idea to the bank, the bank refuses it and says further action on the plan would result in a violation of the covenant agreement. Since the economic conditions were unfavorable, the bank did not want to put their money at risk.

 

Market Preferences

A research study conducted on negative and positive covenants concluded that negative covenants are more often used with higher-growth firms, liquid firms, bank-dependent firms, or financially-dependent firms, whereas positive covenants are more often used by firms working within a lower profit margin (Niskanen and Niskanen). High-growth firms often enter into negative covenants, which are restrictive in nature. In such cases, the lending party prefers to exercise control over the firm’s operations that may directly affect the money lent.

By entering into a negative covenant agreement, the lender gains certain control rights that they exercise as a means of safeguarding their lent-out money from potential losses. It is done by restricting certain operational or financial activities that the lender sees as a threat to their money. The firm is only able to carry such operations out with the lender’s consent, as followed through by the negative covenant.

 

Related Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Credit Administration
  • Debt vs Equity
  • Non-Financial Covenants
  • Top Banks in the USA