Forget Everything You Think You Know About Covenants
I ask students at the start of the LFCT course to forget everything they know about covenants. In a market that has become overly reliant on “precedent”, turning out deal after deal with cookie cutter covenants, this is an essential first step.
Let me explain why.
The similarity amongst deals precipitates a presumption that all covenants are created equal and will work in more or less the same way deal to deal.
This is a dangerous misconception, as covenants will work differently depending on the borrower they restrict. In our course, we take students step-by-step through covenant analysis, starting at the beginning with the foundations of contract negotiation and interpretation.
In the first chapter of the course we explore the identity of the parties and their goals in the negotiation, what covenants are meant to achieve and how, how the deal process unfolds, why the U.S. and Europe differ n deal structures, and – critically – where to look in the offering materials to find potential risks.
In the second chapter, we explore the capital structure analysis – subordination, who sits behind, ahead and part with you, and why that matters. We learn about credit support, dilution, the difference between hard and soft security, why it matters how much of what the borrower owns isn’t pledged to lenders on day one.
By the time students reach the third chapter on Debt and Liens covenant analysis, they have a framework onto which they can layer their learning of covenant analysis. This is absolutely critical, and it’s why I ask students to reset their understanding at the start of the course.
Without that framework, none of the other chapters on covenant analysis make sense – for example, you must understand subordination before you get to Restricted Payments, or you risk missing the key point that any repayment of contractually subordinated debt will require capacity under that covenant.
The history of covenants provided in the first chapter on foundations is also important. The erosion of lender protections caused by the last decade of easy money has resulted in massive departures from the founding principles of these provisions (I explore this in [Knowledge is Power - And Money]).
Covenants don’t work how they’re meant to, but that doesn’t mean lenders can’t negotiate provisions that make sense.
Our course makes that possible by teaching a new generation of credit analysts about covenants, starting with history to pave the way to the future.
By Sabrina Fox - FLT Founder