Companies requiring debt restructuring typically are facing defaults under one or more of their credit agreements. In most cases, these are either payment defaults (when an interest or principal payment is missed) or financial covenant defaults (when a required financial measurement is not achieved). Almost every restructuring, from the most simplistic to the most complex, will require the establishment of new financial covenants. When set properly, these financial covenants provide a borrower with enough flexibility to implement an improvement agenda, yet give the lenders the ability to have some additional rights should the company get off track.

Typical financial covenants include:

• minimum earnings before interest, taxes, depreciation and amortization (EBITDA)
• minimum interest coverage (the ratio of EBITDA to interest expense)
• minimum fixed-charge coverage (the ratio of EBITDA to interest expense, plus scheduled principal amortization, plus capital expenditures, plus cash taxes)
• maximum debt-to-EBITDA ratio
• minimum net worth (or tangible net worth, which excludes the book value of intangible assets).

It is not unusual to see four or more of these or similar covenants in a "cash-flow" loan—i.e., a loan that is not linked to a borrowing base of collateral. Asset-based loans, in contrast, are likely to include fewer covenants because they are associated with a borrowing base.

Lenders include multiple covenants in their loan agreements because each one is intended to protect against a different problem—e.g., insufficient liquidity, overleverage and deterioration of the equity base. However, in troubled debt situations, the number of financial covenants is often reduced, sometimes to only one or two. Additionally, depending on the circumstances, the frequency of measurement may be increased—e.g., from quarterly to monthly.

Requiring fewer covenants in troubled debt situations may seem counterintuitive, but in reality this approach makes sense for several reasons. First, multiple covenants are used as a way to bring the borrower and lenders back to the table when any of several different problems arise. Once a particular covenant is missed, the problem becomes apparent, and the other covenants become less relevant. Second, in these situations, there is a heightened focus on cash flow (see "Liquidity is Lord: Evaluating Imminent Financial Distress," ABI Journal, November 1999), and measures, such as book value of equity, become less meaningful.

Finally, certain covenants can become redundant when components of their calculation are not likely to change. For example, if other provisions of a loan document prohibit the incurrence of additional debt, and working-capital accounts will not vary significantly, changes in a debt-to-EBITDA ratio will be driven primarily by changes in the EBITDA. And it is likely that these changes are already measured by a minimum EBITDA ratio.

To ensure that covenants bear a relationship to a company's actual plans and forecasts and that covenants are internally consistent with each other, an integrated financial projection model should be used when establishing financial covenants. A borrower is encouraged to use a conservative set of financial projections for purposes of setting covenants, but in doing so it walks a fine line. That is because lenders will typically use the same set of projections to evaluate whether the borrower's anticipated performance will be adequate, or to determine whether more significant measures, such as bankruptcy, liquidation or foreclosure, should be taken.

When an integrated financial model is not used and covenants include balance-sheet elements, consideration should be given to the balance-sheet impact of the "cushion" built into the covenants. For example, if a minimum EBITDA covenant is set at 85 percent of a company's forecast, the borrower can miss its EBITDA forecast by up to 15 percent without incurring a covenant violation. It is quite obvious that to be consistent, when setting a maximum debt-to-EBITDA covenant, the EBITDA also should be adjusted downward by 15 percent. What is less obvious is that the debt should also be adjusted upward by a similar amount, because lower earnings generally will translate into lower cash flow and higher borrowings.

In setting covenants, the amount of cushion against projected results is generally established through negotiation between a borrower and its lenders. Borrowers typically want more leeway against their expected results to reduce the risk of another default, while lenders typically seek tighter covenants in order to keep a closer eye on their troubled borrowers. EBITDA covenants are often set at levels between 75 and 95 percent of "plan," and other covenants, if used, are keyed off the chosen level.

Several important factors must be considered when setting an EBITDA covenant against plan. First, strict percentages are not always meaningful, and absolute dollar variances should be evaluated. For example, take a company with $100 million in revenues, but an EBITDA projection of only $2 million. If the EBITDA covenant were set at 80 percent, the company would have to achieve an EBITDA of $1.6 million to be in compliance, affording only a $400,000 variance. If this company has a gross margin of 25 percent, all other things being equal, this $400,000 variance would occur when the company's sales were $1.6 million below plan ($400,000 divided by 25 percent).

While missing EBITDA by 20 percent might sound like a major problem, when viewed as a sales shortfall of only 1.6 percent, it hardly seems worthy of a covenant violation. When EBITDA margins are low, as in this example, it is often helpful to set EBITDA covenants by giving consideration to the percentage achievement of sales rather than the percentage achievement of EBITDA.

A second consideration in setting the amount of cushion against plan is the length of the measurement period. For example, in setting an EBITDA covenant for a full 12-month period, 85 percent against plan may be appropriate. However, if this test is to occur monthly, a company has a much higher risk of missing such a target every single month. For this reason, covenants are often set on a "rolling-period" (e.g., "rolling four quarter") basis to allow a borrower to be below the target in some periods, as long as it can make up this difference by being over the target in other periods.

When covenants are reset, however, a rolling-period measurement fails to serve this purpose for the first several periods because it includes actual results in the calculation, and actual results will never "flex." If this is not properly factored into the covenant setting (e.g., by setting the covenant at actual for three-quarters plus 80 percent of the next quarter's plan), the resulting covenant targets could be grossly distorted.

One way to avoid this is to use a "cumulative" covenant in the first year rather than a rolling-period covenant that includes actual results. For example, the first measurement period will be for one quarter, the second for two cumulative quarters, the third for three cumulative quarters, and thereafter for a rolling four quarters. Earlier measurement periods can be given more cushion against plan than future periods to properly account for risk.

When borrowers and lenders negotiate covenants in a troubled credit situation, their interests are not generally aligned. Therefore, there is no right or wrong answer as to the levels to which they should be set. However, by focusing on the right measurements, ensuring that covenants are internally consistent with each other, and linking their levels to an integrated financial model, both the company and its lenders can ensure that their objectives can be met when covenants are set.